Equity crowdfunding refers to raising money from small public investors (who collectively form the "crowd") primarily through online forums and social media. In exchange for relatively small amounts of cash, investors get a proportionate slice of equity in a business venture. In the past, business owners raised such funds by borrowing from friends and family, applying for a bank loan, appealing to angel investors, or by going to a private equity or venture capital firm.
Equity crowdfunding is rapidly gaining in popularity. According to the research firm massolution®, equity crowdfunding platforms raised $1.1 billion for business owners in 2014, a 182% increase form the previous year (see annual publication "2015 CF - Crowdfunding Industry Report"). But as with any mode of investment, investing through equity crowdfunding has risks and rewards. Would-be investors should first do their research. (For more, see "What Crowdfunding Means To Investors.")
Risks of Equity Crowdfunding
- Greater risk of failure: A business that has been capitalized through equity crowdfunding arguably runs a greater risk of failure than one that has been funded through venture capital or other traditional means of start-up financing. This is because a crowdfunded business may not have access to the experience and guidance of seasoned venture capitalists and other professionals who can steer a start-up through the challenges of its development phase. The success of a business cannot be assured merely by funding. Without an adequate business plan and support structure, even very promising ventures can fail.
- Outright fraud: Online forums and social media are ideally suited for equity crowdfunding because they offer wide reach, scalability, convenience and ease of recordkeeping. But these very features also make it easy for fraudsters and con men to set up dubious ventures to attract equity crowdfunding from gullible investors. Investors who have not had the patience or wherewithal to conduct due diligence before investing may end up losing their entire investment to fraudulent crowdfunded schemes.
- Returns may take years to materialize (or may never accrue): An investor who invests through equity crowdfunding has an expectation of some return on investment in the future. However, return on equity crowdfunded ventures may take many years to materialize. In many cases, equity may not ever accrue to the investor. Management may deviate from the business plan, or could be out of its depth when trying to scale up the company. Over time, this may lead to capital erosion rather than wealth creation. In such cases, there may be an opportunity cost attached to equity crowdfunding because it ties up capital that could be deployed elsewhere to generate returns.
- Security of the crowdfunding portal or platform: In recent years, hackers have displayed an alarming ability to break into seemingly impregnable data repositories of leading retailers and companies and steal credit card details and other valuable client information. A similar risk exists for crowdfunding portals and platforms, which are vulnerable to attacks from hackers and cyber-criminals. The prospect of possible credit card or identity theft from a crowdfunding portal is a risk that needs to be taken into consideration. (For more, see "3 Top Crowdfunding Platforms.")
- Lower-quality investments may be the norm: The question arises whether 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 like angel investors and venture capitalists, perhaps then it would turn to equity crowdfunding. If that is indeed the case, then equity crowdfunded businesses are likely to be more mediocre investment opportunities with limited growth potential.
Rewards of Equity Crowdfunding
- Potential for outsize returns: Investing through equity crowdfunding holds out the potential for huge returns, although it must be stressed that the odds of hitting a home run on such investments are quite low. The story of Facebook's $2-billion acquisition of crowdfunded virtual reality headset maker Oculus Rift in 2014 is now the stuff of legend. Oculus Rift raised $2.4 million on donation-based crowdfunding portal Kickstarter from 9,500 donors. This works out to an average of just over $250 per donor. Unfortunately, however, since these backers were donors and not investors, they did not receive any payout from Facebook's acquisition. Had Oculus Rift raised its initial capital through equity crowdfunding rather than donation-based crowdfunding, the Facebook buyout would have generated an estimated return of between 145 times and 200 times the original investment, which means that a meager $250 investment would have resulted in proceeds of $36,000 to $50,000. The takeaway here is that stellar returns from equity crowdfunding, while rare, are not impossible.
- Greater degree of satisfaction: Investing through equity crowdfunding can give the investor a greater degree of personal satisfaction than investing in a blue-chip or large-cap company. This is because the investor can choose to focus on businesses or ideas that resonate with him or her, or that are involved with causes in which the investor has a deep belief. For example, an environmentally conscious investor may choose to invest in a company that is developing a more effective method of measuring air pollution. An investor who is passionate about sustainable farming may invest in a start-up that is promoting sustainability in developing economies. Equity crowdfunding may offer more avenues for such targeted investments than publicly traded companies.
- Opportunity to invest like accredited investors: Before the advent of crowdfunding, only accredited investors – high net-worth individuals who have certain defined levels of income or assets – could participate in early-stage speculative ventures that held the promise of high reward and equally high risk. The minimum amount threshold for such investments was quite high. Equity crowdfunding, however, makes it possible for the average investor to invest a much smaller amount in such ventures. In that sense, it has leveled the playing field between accredited and non-accredited investors.
- New regulations for investor protection: In 2015, the U.S. Securities and Exchange Commission adopted final rules that facilitate access to capital for smaller companies while providing investors with more investment choices. These rules, referred to as Regulation A+ and mandated by Title IV of the Jumpstart our Business Startups (JOBS) Act, are designed to promote equity crowdfunding. In Canada, six provinces introduced new equity crowdfunding exemptions for early-stage companies in 2015. While purists may complain that increased regulation will deter the free-wheeling spirit and honor system of crowdfunding, the reality is that by deterring fraudsters, these regulations may actually serve to significantly expand the equity crowdfunding arena.
- Greater business and job creation: Small and medium-sized businesses (SMEs), the linchpin of the North American economy, are the biggest beneficiaries of the equity crowdfunding megatrend. By enabling easier access to investor capital for businesses that would otherwise have had a hard time obtaining it, equity crowdfunding should stimulate the local and national economies through new business formation and more job creation.
The Bottom Line
Investing through equity crowdfunding carries risks such as greater risk of failure, fraud, doubtful returns, vulnerability to hacker attacks, and mediocre investments. But it also offer rewards like the potential for huge returns, a greater degree of personal satisfaction, the opportunity to invest like accredited investors, and the prospect of simulating the economy through business and job creation.