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Equity Crowdfunding

Updated on March 22, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Equity Crowdfunding?

Equity crowdfunding is a fundraising method in which individuals can invest in a company in exchange for equity, or an ownership stake, in that company. The aim of equity crowdfunding is to raise capital for businesses in return for equity to the investors.

Equity Crowdfunding

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This crowdfunding is a way for early-stage companies, often startups, to access capital from a larger pool of investors. They are usually directed toward small investors. It is an alternative source of finance and provides an opportunity to look into the behavior of investors as it involves them making decisions. It can be an alternative to traditional funding methods, like venture capital or angel investors.

Key Takeaways

  • Equity crowdfunding is a source of financing where entrepreneurs issue an open call to sell a certain number of equity or bond-like shares in a company online.
  • In this crowdfunding, investors receive a share of the invested venture as returns. Therefore, these investors, who own a share, have a right to vote.
  • This platform is a method of raising capital by offering equity to a large number of individual investors. In contrast, venture capital (VC) refers to a form of private equity financing provided by investors to startups. And, IPO is the process by which a private company becomes a publicly traded company by offering its shares to the public for the first time.

Equity Crowdfunding Explained

Equity crowdfunding refers to funding where entrepreneurs offer specific equity or bond-like shares in their company. It is usually given to several small investors through an open funding call online. Moreover, investors choose to depend on the information provided in the open call for funds made by entrepreneurs on a crowdfunding site. The legal atmosphere in each country has a significant impact on the process. Furthermore, it is subject to several regulatory issues because it involves the sale of securities.

It is also known as crowd investing which is similar to another type of crowdfunding called lending crowdfunding or peer-to-peer funding. Investors in both of these funding methods expect a visible financial profit. In crowdfunding with equity, investors receive a share of the invested venture as returns. Therefore, these investors, who own a share, have a right to vote.

Most platforms supporting this type of funding provide two types of ownership: nominees and direct shareholders. A nominee manages the relationship with the investor and also holds shares. On the other hand, a direct shareholder is an investor who directly holds a share and, in addition, possesses the right to vote. These crowdfunding platforms typically charge fees to both businesses seeking funding and investors participating in the crowdfunding campaigns. Hence, equity crowdfunding fees contribute to the platform’s revenue. These also cover the costs associated with maintaining the infrastructure, providing services, and ensuring regulatory compliance.

Here, investors browse the crowdfunding platform to find investment opportunities that align with their interests and risk tolerance. Hence, private equity crowdfunding provides a more exclusive investment opportunity for individuals who meet the accredited investor criteria. In addition, the equity crowdfunding business model relies on creating a transparent and efficient marketplace, which benefits both businesses and investors looking for attractive investment opportunities.

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Process Steps

The equity crowdfunding process involves several steps, from the initial preparation of the fundraising campaign to the actual issuance of equity to investors.

  • Choosing the platform: Entrepreneurs shall choose platforms that support their projects. Since platforms specialize in having groups of investors looking to invest only in certain types of investments. Factors such as the cost of the platform, the attention it receives, and the speed of deals being live on platforms should be considered while picking a platform.
  • Pitching: Entrepreneurs shall then pitch the idea to potential investors, and it shall be in a format permitted by the platform. They shall be mindful of fees and any equity split arrangement to avoid a surge in expenses.
  • Promotion of the campaign: Different platforms have different systems for running a campaign. Entrepreneurs should understand the promotional structure of the platform. Therefore, this is important, as unless there is enough promotion, people will not know about and visit the project. Founders shall understand the technicalities (dynamics and algorithms) to get appropriate funding.
  • Marketing and Promotion: Actively market the crowdfunding campaign to potential investors. Therefore, this may involve creating a compelling pitch video utilizing social media, email marketing, and other promotional strategies to attract attention to the campaign.
  • Investor Onboarding: Investors register on the crowdfunding platform, complete the necessary verification processes, and fund their accounts. They can then browse available investment opportunities.
  • Equity Issuance: After a successful campaign, the business issues the agreed-upon equity to the investors. This process involves finalizing legal documents and ensuring compliance with relevant regulations.

Examples

Let us look at a hypothetical example to get an insight into the concept. 

Example #1

Let’s consider Dan as a driven business person with a ground-breaking concept for a brand-new technology enterprise. He thinks his product has excellent growth potential but needs more money to get it on the market. Dan chooses to use equity crowdfunding to raise the money he requires after weighing his choices for funding. Hence, he decided to offer stock in his company and hence the option.

Therefore, the option to attract investors ready to make sizeable investments in exchange for a piece of the anticipated future earnings of his business. Thus, this is especially advantageous for companies needing large sums of money to create their product, research, and expand their business.

Through equity crowdfunding, Dan can create a network of backers who share his vision and are prepared to sustain his company over the long term. These investors become stockholders in the business and could offer financial support, helpful knowledge, network, and direction. Moreover, these investors’ dedication can aid Dan in building a solid foundation for his firm and may pave the way for additional fundraising rounds in the future. He understands that this crowdfunding enables him to raise more money compared to more conventional crowdfunding.

Example #2

The equity crowdfunding industry experienced significant growth in the first quarter of 2023, demonstrating a strong upward trajectory compared to the previous quarter. According to a Yahoo report, total funding nearly doubled from Q4 2022 to Q1 2023, indicating the increasing prominence of this alternative financing method for businesses and start-ups.

This growth in equity crowdfunding signifies the strong momentum and increasing acceptance of alternative financing methods in the business market. As investors actively seek new opportunities and innovative platforms, the equity crowdfunding sector is expected to continue expanding and solidify its position as a viable and attractive alternative to traditional fundraising channels.

Pros And Cons

There are various pros and cons to choosing this model of funding, and they are as follows:

Pros

  • It is a good option for funding entrepreneurs with credit issues, revenue limitations, or who cannot meet other requirements to qualify for a business loan.
  • These offer chances to raise further money for the project when entrepreneurs do not have debts.
  • Moreover, it helps attract non-traditional investors; this may bring in additional knowledge and experience that is otherwise unavailable.
  • As owners, it allows them to structure campaigns and retain a major stake in the business.
  • This platform builds visibility and excitement for the business launch.

Cons

  • Even if it is a small portion, it is still a part of the business that needs to be foregone for cash.
  • Ideas, business paths, and financial statements are all in public view, and the chances of a public failure are also high.
  • The platform charges in the form of commissions are high.
  • Traditional investors may not show much interest as it can be difficult to resell their shares in the market, especially for small companies.
  • They can be time-consuming, and the success rate of such a commitment may not always be high.

Equity Crowdfunding vs Venture Capital vs Initial Public Offer(IPO)

Differences between all the concepts are as follows:

Key pointsEquity CrowdfundingVenture CapitalIPO 
Concept  Equity crowdfunding entails collecting money from several individual investors through online platforms. Investors make smaller monetary contributions and are given equity or stock in the company in exchange.  Institutional investors’ or venture capital firms’ financial contributions are called venture capital. These corporations make significant capital investments in exchange for equity participation in start-up, fast-growing businesses.  An IPO is when a private firm first makes its shares available to the general public. The company raises money by offering shares for sale on the open market to both institutional and retail investors.  
Control and ownership  This crowdfunding enables business owners to maintain control over their organizations because individual investors invest smaller sums of money. However, accumulating many investors could require better management of shareholder expectations and communication with investors.  In return for their investment, venture capital investors often demand a significant ownership position and control over the business. They might want a place on the board of directors and the ability to influence strategic choices.  As a sizable number of shares are sold to public investors, the ownership and control of the company may be diluted. Hence, the corporation may still have some ownership held by the founders and current shareholders, but they will have less power due to the public shareholders.  
Investor TypesHere, it draws a wide variety of individual investors eager to fund start-up businesses, such as retail and individual investors.Professional investors, like venture capital firms, high-net-worth individuals, or angel investors, generally invest in venture capital.Moreover, IPOs cater to regular investors who can buy shares through brokerage accounts and institutional investors, including mutual funds, pension funds, and other investors.

Frequently Asked Questions (FAQs)

Is equity crowdfunding a good investment?

Equity crowdfunding’s suitability as an investment depends on several variables, including the investor’s risk appetite, financial objectives, and particular opportunities. Due to the early-stage nature of many businesses and the possibility of failure, equity crowdfunding is seen as a high-risk investment with high profits.

What are the tax implications of an equity crowdfunding platform?

The tax implications of these crowdfunding platforms include:

1 Revenue recognition
2 Equity issuance
3 Valuation
4 Capital gains tax
5 Dividends and distributions

Does equity crowdfunding democratize entrepreneurial finance?

Yes, equity crowdfunding is often considered a mechanism that democratizes entrepreneurial finance by providing a more inclusive and accessible way for businesses to raise capital. Nonetheless, the democratization of finance through this platform has undoubtedly expanded the landscape for both entrepreneurs and investors.

Is equity crowdfunding regulated?

Yes, it is regulated in many jurisdictions to protect investors. Regulations may include limits on the amount businesses can raise, investor eligibility criteria, and disclosure requirements.

This article has been a guide to what Is Equity Crowdfunding. Here, we explain its examples, pros and cons, comparison with venture capital & IPO, & process steps. You may also find some useful articles here –

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