Equity crowdfunding (aka crowdinvesting, investment crowdfunding, or crowd equity) is the mechanism that allows large groups of people (the “crowds”) to invest in a company that is not listed on a stock market (unlisted company) in exchange for shares (equity) in that company.
It is a new mechanism. Prior to 2015, only accredited investors (persons with high income or net worth) were allowed to invest.
Now, an “issuer” (startup) may sell up to $1,000,000 of its securities per 12 months even to unaccredited investors.
If either your annual income or your net worth is less than $100,000, then during any 12-month period, you can invest up to the greater of either $2,000 or 5% of the lesser of your annual income or net worth.
If both your annual income and your net worth are equal to or more than $100,000, then during any 12-month period, you can invest up to 10% of annual income or net worth, whichever is lesser, but not to exceed $100,000. The value of your primary residence is not included in your net worth calculation.
Companies may not offer crowdfunding investments to investors directly. Transactions must be conducted through an intermediary that either is registered as a broker or is registered as a “funding portal.” Some of the most popular crowdfunding portals are AngelList, CircleUp, Fundable, Crowdfunder and EquityNet.
Securities purchased in a crowdfunding transaction generally could not be resold for one year, unless the shares are transferred back to the company, to an accredited investor, to a family member, or as part of an offering registered with the SEC.
Some equity crowdfunding platforms act as intermediaries between investors and startups. Such platforms normmally hold investors’ funds in escrow until the round ends successfully and then transfer equity to the company.
Other crowdfunding platforms only act as advertising outlets. Through such platforms, investors can make an either binding or nonbinding pledge to invest within a specified period of the funding round’s closing. Startups then reach out to individual investors off-site, arrange to accept investments in exchange for shares in the company.
There are also crowdfunding platforms that operate investment funds that own shares in multiple companies – offering participation in an entire asset portfolio with a single investment.
Equity crowdfunding platforms generally earn the bulk of their income from fees charged to listed entities, though investors in multi-company funds often have to pay annual management fees.
The main reason the SEC has always limited who can invest is to protect the public from the high risks inherent in early-stage investments. Crowdfunding is no exception and the SEC encourages investors to consider the following risks:
– Investments in startups are highly speculative as these enterprises often fail. Valuation can be problematic. Listed companies are valued publicly through market-driven stock prices, however, the valuation of startups is difficult and investor may risk overpaying for the equity.
– Illiquidity. Limited ability to resell investment. You may need to hold your investment indefinitely.
– Investment in personnel. An early-stage investment is largely an investment in the management of the company. A portion of the investment may fund the compensation of the company’s employees.
– Lack of professional guidance. Many successful companies partially attribute their early success to the guidance of professional early-stage investors (e.g., angel investors and venture capital firms). These investors often negotiate for seats on the company’s board of directors and play an important role through their resources, contacts and experience in assisting early-stage companies in executing on their business plans. An early-stage company primarily financed through crowdfunding may not have the benefit of such professional investors.