Crowdfunding refers to raising money from the public (i.e., the “crowd”), primarily through online forums, social media, and websites for crowdfunding to finance a new project or business. Crowdfunding equity is taking that one step further. Public investors are getting a proportionate slice of equity in the business venture in exchange for a relatively small amounts of cash.
Business owners previously raised these funds by borrowing from friends and family, applying for a bank loan, appealing to angel investors or going to a private equity or venture capital company. Now, they have more choices with crowdfunding.
The popularity of equity crowdfunding is rising fast. The global crowdfunding market has been valued at $10.2 billion in 2018, and is expected to reach $28.8 billion by 2025, according to research from Valuates Reports. But as with any investment style, investing through equity crowdfunding has risks and rewards of its own.
Risks of Equity Crowdfunding
Greater Risk of Failure
A company capitalized by equity crowdfunding can have a higher chance of failure than one financed by venture capital or other conventional means providing experienced practitioners to help navigate a start-up by early development challenges. A company’s progress can not be guaranteed solely by funding. Also promising projects will fail without proper business plan and support structure.
Forums and social media are ideally suited for crowdfunding equity, as they offer a broad scope, scalability, comfort, and record-keeping ease. But these very features also make starting up questionable projects easy for scammers to draw equity crowdfunding from inexperienced or first time investors. Never skip the step of taking due diligence on any investment that you consider.
Years to Materialize
Every investor expects some return in the future. However, if any, returns on equity ventures that are crowdfunded may take many years to materialise. Management, for example, can deviate from the business plan or may have difficulty scaling the business. Over time this may lead to the depletion of resources rather than the production of wealth. There may be a cost of opportunity attached to your investment, which you should consider as it links up capital that could be used elsewhere.
Security of the Crowdfunding Portal or Platform
Hackers have shown an alarming ability in recent years to break into seemingly impenetrable data repositories of leading corporations and financial institutions, and steal credit card details and other valuable customer information.
A similar danger exists for websites and channels that are vulnerable to hackers and cyber criminals targeting crowdfunding. And make sure to look closely at the program, in addition to investigating the investment itself. There are a few worth checking out on Kickstarter, Indiegogo, Crowdfunder and GoFundMe.
Lower-Quality Investments the Norm
A question arises for skeptics – if a company would only use equity crowdfunding as a last resort. For example, if a company is unable to attract funding from conventional start-up funding sources such as angel investors and venture capitalists, then it might turn to crowdfunding for equity. If that is indeed the case, then crowdfunded equity businesses are likely to be more mediocre investment opportunities with limited potential for growth.
Equity Crowdfunding Rewards
Potential for Outsize Returns
The potential for huge returns on equity crowdfunding is also high, since the risks are high. The story of a crowdfunded virtual reality headset maker Oculus Rift’s $2-billion acquisition by Facebook in 2014 is now the stuff of legend. Oculus Rift has raised $2.4 million from 9,500 people on the donation-based Kickstarter crowdfunding portal.
However, since these backers were donors rather than investors, they did not get any payout from the acquisition of Facebook. Had Oculus Rift raised its initial capital through equity crowdfunding, the Facebook buyout would have created an approximate return on an individual’s investment of between 145 and 200 times, according to Chance Barnett, Crowdfunder’s CEO. That means a mere investment of $250 would have led to proceeds from $36,000 to $50,000.
Opportunity to Invest Like Accredited Investors
Before the advent of crowdfunding, only accredited investors — high net worth individuals with certain defined income or asset levels — would be able to participate in early-stage, speculative ventures that held promises of high reward and equally high risk.
For such investments the minimum amount threshold was quite high. However, equity crowdfunding helps the average investor to spend a much smaller sum in these projects. In that sense, the playing field between accredited and non-accredited investors has leveled off.
Greater Degree of Satisfaction
Investing through equity crowdfunding can bring a greater degree of personal satisfaction to the investor than investing in a blue-chip or large-cap business. This is because the investor can choose to focus on companies or ideas that resonate with them, or that are engaged in causes in which the investor has a deep belief. An environmentally conscious investor, for example, may choose to invest in a company developing a more effective method of measuring air pollution.
Equity crowdfunding can offer more avenues than publicly traded companies for such targeted investments.
Greater Business and Job Creation
The largest beneficiaries of the equity crowdfunding megatrend are small and medium-sized enterprises (SMEs), the linchpin of the North American economy. By allowing businesses easier access to investor capital that would otherwise have had a hard time getting it, equity crowdfunding should stimulate the local and national economies through new business formation and more job creation. Investors can feel at ease with their contributions.
Equity Crowdfunding Investor Protection
The U.S. Securities and Exchange Commission in 2015 adopted final rules enabling access to capital for smaller companies while offering more investment options for investors. Such laws, referred to as Regulation A+, are intended to encourage equity crowdfunding and are required by Title IV of the Jumpstart Our Business Startups (JOBS) Act.
While purists may complain that increased regulation will dissuade crowdfunding’s free-wheeling spirit and honor system, the reality is that by dissuading defrauders, those regulations can serve to significantly expand the crowdfunding arena for equity.
Investing through equity crowdfunding carries risks such as increased risk of failure, fraud, questionable returns, vulnerability to hacker attacks and mediocre investment. Yet it also provides incentives such as the potential for big returns, a greater degree of personal satisfaction, the ability to invest like professional investors and the possibility of improving the economy by generating employment and businesses.