Equity Crowdfunding for the Rest of Us
Crowdfunding—the fine art of raising money from thousands of strangers—has taken the Internet by storm in the past few years, generating an eBay-ish level of enthusiasm.
The major success stories, like Pebble’s and Coolest Cooler’s, have already become legendary. Pebble was the first mega-hit, raising over $10 million on Kickstarter.com in May 2012, to finance production of the original Pebble Watch. Coolest Cooler topped that in 2014, raking in more than $13 million for, well, a way cool cooler. Then, in March of this year, Pebble returned to the top spot with its fund-raiser for the new Pebble Time watch. That campaign obliterated every record in the Kickstarter book, pulling in a million dollars in the first 49 minutes, $7.4 million the first day, and $20.3 million by its campaign end date.
The early sites, like Indiegogo (founded in 2008) and Kickstarter (2009), established the model for reward-based crowdfunding. Under this setup, you offer your product or service to the world, and respondents get to offer different levels of financial support. As the value of the donation rises, so does the value of the reward the donor gets.
This May, however, a giant holding dam is about to break. It involves “unrestricted equity crowdfunding,” and it promises to unleash an enormous deluge of capital in the direction of the world’s budding entrepreneurs.
Transformative is the word for what’s about to happen.
The first equity crowdfunding regulations were implemented in September 2013, as a result of the provisions of President Obama’s JOBS Act, signed in 2012. Title II of JOBS permitted the sale of shares in a new company through crowdfunding, sort of like an IPO with no requirement to cut JP Morgan (or some other investment bank underwriter) in on the take. And it was a great success. In its first year under Title II, equity crowdfunding brought in an estimated $250 million in seed capital.
However, there was a catch. The right to buy in was restricted to accredited investors, as is also the case with most private placements. An accredited investor is anyone who earned more than $200,000 (or $300,000 together with a spouse) in each of the past two years and expects the same for the current year, or has a net worth of over $1,000,000 (either alone or together with a spouse), usually excluding the value of his or her primary residence. This leaves a galaxy of smaller investors on the outside looking in.
Whether the right to participate should be extended to non-accredited investors has been a question before SEC regulators for three long years. On March 25, however, they finally moved, releasing new Title IV/Regulation A+ rulings. As of 60 days after publication, or around late May, virtually all restrictions will be lifted. The democratization of individual investment in startups and small businesses will arrive.
As Peter Diamandis, author of Abundance, blogged:
Now, if you have a strong community, and you need to raise money, you can sell shares (stock) in your company directly to your community of followers, users and raving fans.
This is a huge development that could rattle the country’s financial structure to its core, given the immense size of the early-stage financing sector, which is where startup hopefuls go for money. Currently, they have three choices. The current VC investment market amounts to about $30 billion annually. The angel investment market adds about another $20 billion. And both are dwarfed by private placements, which total around $1.2 trillion each year in the US.
Heretofore, smaller investors were not permitted to participate in any of that except peripherally, through the purchase of shares in publicly-traded VC firms. Now, they’ll have direct access.
How much might they siphon off? That’s anyone’s guess, but even given the dollar caps on crowdfundings, it could be a substantial amount—to the detriment of investment banks, which will lose some percentage of their fat underwriting fees. Chances are, no one’s going to cry for you Goldmantina.
In terms of specifics, Regulation A+ is divided into two tiers:
Tier I allows companies to fundraise up to $20,000,000 from both accredited and non-accredited investors. Tier I will require companies to register the offering in each state where its securities are sold. However, while subject to review by state regulators, Tier I offerings will not be required to perform formal audits and annual reporting.
Tier II allows companies to raise up to $50,000,000 from both accredited and non-accredited investors. The companies do not have to be registered in each state where securities are sold. But they will be required to have audited financials and annual reports. The tradeoff looks to be worth it, and most observers believe Tier II will prove the most popular.
One obvious question is: What does this mean for angels and VCs?
Chance Barnett, CEO of Crowdfunde, takes a guess. Writing on Forbes.com, he says:
For the time being, equity crowdfunding will work best when the funding rounds are validated or led by experienced angels [and] VCs, as well as notable influencers & celebrity investors and entrepreneurs.
But with these new Title IV rulings, we’re about to see the birth of a new class of investors, as now everyone will have the opportunity to invest in what could be the next great startup, consumer product, feature film, or clean technology venture alongside experienced angels, VCs, and influencers.
This new class of investors will grow to become influential, powerful, important voices in the early stage ecosystem: they’ll validate new companies and ideas, fuel their early growth, and then late stage investors will have good reason to pay attention.
The most important thing here is that equity crowdfunding adds in the element of profit. If you invest in a normal Kickstarter offering, what you get back is simply a promised reward, like a Pebble Watch. You’re paying for it with your contribution and, if it’s relatively small, you get the product at a modest discount to the projected market price. No matter what, though, if the company is wildly successful you get nothing more. Oculus VR (maker of the Oculus Rift), to take an extreme example, raised $2 million on Kickstarter. When the company was later sold to Facebook for $2 billion, its 9500 early backers didn’t get a dime.
In the brave new crowdfunding world, however, you can be not just a backer, but an investor. You get a stake in the company, for better or worse. If you’re smart enough or lucky enough to buy into the next big thing, your shares will appreciate nicely—it’s estimated that if Oculus had been equity funded and had given real shares to its early supporters, they would have made a 200x return on investment.
All is not sweetness and light, of course. There will be a flood of capital solicitation as ever more folks with grand visions clamor for investor attention. As with any group of early-stage businesses, most will fail. Some will surely be scammers. Speculators will lose money. It cannot be otherwise.
But the good truly outweighs the bad. If equity crowdfunding works like it should, it represents a revolutionary opportunity, unique in human history. Thousands, and perhaps millions, of bright, risk-taking entrepreneurs will have at least a shot at capitalizing their dreams that they never had before. And millions of average investors will have the opportunity to tap into potential jackpots that were previously accessible only to the 1%.
Except for a few grumpy bankers, this is a win/win situation all around.