What Equity Crowdfunding Means for Privately Held Companies

May 2014      Download PDF      Print

Over the past five years, crowdfunding has emerged as a popular way for individuals to raise funds for charitable and creative endeavors. This phenomenon influenced certain provisions in the 2012 Jumpstart Our Business Startups (JOBS) Act that are centered on stimulating the growth of small businesses and startups by allowing privately held companies to participate in “equity crowdfunding.”

A key portion of the law went into effect last September and the SEC is expected to finalize regulations regarding another portion sometime in 2014.  These changes are expected to transform how privately held companies raise capital and interact with investors. In this article we will summarize the key JOBS Act provisions relating to equity crowdfunding and discuss what they mean for business owners.

What is Equity Crowdfunding?

Crowdfunding is the process of gaining financial support from large groups of individuals, usually through web-based platforms. Traditionally, campaigns involving startups and small businesses have been “reward-based.” In these types of campaigns, the company provides supporters with some sort of reward in exchange for their financial support. For example, companies may offer their backers product samples, exclusive pre-order rights, or promotional items.

Equity crowdfunding is quite different in that it involves the transfer of capital in exchange for an equity interest in a company. As an equity owner, the investor incurs a loss if the company fails, but he may receive a financial return in the form of a dividend or distribution if the company performs well.

Explaining the JOBS Act Crowdfunding Provisions

The JOBS Act was passed in 2012, but the provisions relating to equity crowdfunding have been implemented gradually since. The first provision, Title II, went into effect last September, while another, Title III, is expected to be implemented in 2014. Details regarding each provision are provided below.

Title II: In this provision, the JOBS Act directed the SEC to create rules that would lift a ban on general solicitation that was put into place in the Securities Act of 1933. This change makes it legal for privately held companies to advertise their capital raising efforts and promote their offerings to the public as long as the securities are sold to accredited investors.

This essentially allows companies to publicize their fundraising campaigns through social media and raise capital from accredited investors through online crowdfunding portals. Overall, this change makes it much easier for companies to reach the estimated 3.4 million accredited investors in the U.S.1

The qualifications of accredited investors, along with more details about the rules relating to Title II, are outlined in this SEC Fact Sheet.

Title III: Once enacted, this provision will open equity crowdfunding to non-accredited investors. Typically, the offer and sale of securities requires registration with the SEC. However, Title III created an exemption that will allow issuers to offer and sell securities in unregistered offerings without placing limitations on who can invest. Soon, privately held companies will be allowed to raise up to $1,000,000 per year from the general public through equity crowdfunding portals.

Title III also established a framework for the SEC to structure regulations relating to investor protections, issuer eligibility, investor and issuer disclosure requirements, crowdfunding portals/intermediaries, re-sales, and limitations on capital raised and individual investment amounts. There has been some delay developing crowdfunding regulations, but the SEC recently released its proposed rules regarding Title III. Many expect them to be finalized in 2014.

The Impact of Democratizing Equity Crowdfunding

So what will happen when non-accredited investors are allowed to invest through equity crowdfunding? As we mentioned earlier, there are approximately 3.4 million accredited investors in the U.S. When Title III is implemented, the size of the investor pool will increase to 233.7 million.2 According to a recent report released by The World Bank, the global equity crowdfunding market could reach $300 billion as a result.3

This estimate is based mostly on the sheer increase in the number of new investors, but it’s impossible to accurately predict how many will participate in equity crowdfunding. However, the potential for a $300 billion market exists. Venture capitalists (VCs) and individual angel investors (who are accredited) already invest over $40 billion in small businesses and startups annually. About 38% of these companies receive funding from friends and family members of the owners (non-accredited investors), which equals approximately $60 billion annually.4 So, while many of the 200 million-plus non-accredited individuals may be hesitant to participate in equity crowdfunding as first-time investors, many are already familiar with the concept after investing in the small business of someone they know. With more freedom to solicit investment through online platforms, businesses may also be able to draw more attention from accredited investors. Furthermore, even if only a small percentage of first-time investors participate in equity crowdfunding, the effect on the size of the market would be substantial.

What Does This Mean For Privately Held Companies?

Equity crowdfunding may not be a realistic option for many businesses that need to raise capital. For example, a family-owned business may not want to share ownership with outside investors. Also, it wouldn’t make sense for a company to share intellectual property and sacrifice a strategic advantage in order to raise capital. However, it does provide a new alternative for owners to consider when looking for new ways to grow their companies. Many companies have experienced slow growth since the recession, and access to capital remains one of the biggest concerns of the average business owner. To stay competitive, companies must find ways to expand, whether organically or through acquisition, and adapt to changes in technology. Equity crowdfunding may be an option for some owners to raise capital to fund their efforts in overcoming these challenges.

Besides financing, equity crowdfunding can provide benefits from a marketing standpoint. Through crowdfunding campaigns, companies share important information about their brands and their plans for the future with new audiences, thereby increasing brand awareness. This helps build relationships with supporters who have a vested interest in the long-term success of the company.

Large companies also pay attention to crowdfunding portals to monitor growing companies and new ideas in technology. Often, they are searching for strategic acquisition opportunities for the future. Many experts also expect private equity firms to become increasingly involved in equity crowdfunding opportunities as they search for ways to deploy investor capital.

Equity crowdfunding may also impact the value of privately held companies. One of the main differences between equity interests in private and public companies is that interests in privately held companies cannot be easily bought, sold, or traded like public company stock can. Minority interests in privately held companies are even less marketable. However, equity crowdfunding should make it easier to purchase an equity interest in a privately held company, theoretically increasing its value. Ultimately, the question of whether equity crowdfunding will increase private company value depends on how many business owners adopt it as a viable financing option, and whether it gains widespread acceptance as an investment vehicle among non-accredited investors.

[1] www.fundable.com/learn/resources/guides/crowdfunding-guide/the-future-of-crowdfunding
[2] www.fundable.com/learn/resources/guides/crowdfunding-guide/the-future-of-crowdfunding
[3] funginstitute.berkeley.edu/sites/default/files/Crowdfundings_Potential_for_the_Developing_World.pdf
[4] www.entrepreneur.com/article/230011#