An Entrepreneur's Essential Guide to the New Wild West of Funding Opening on May 16
The doors will open on Monday, May 16, to a new wild, wild West of crowdfunding for entrepreneurs.
Traditional crowdfunding is when an individual contributes money to a business or creative endeavor in exchange for a token gift, experience or recognition. Equity crowdfunding, meanwhile, is when entrepreneurs sell a piece of their companies in exchange for cash. Historically, entrepreneurs have only been able to raise money through equity crowdfunding from accredited investors, or those individuals who have sufficient levels of wealth and assets.
As of May 16, thanks to Title 3 of the Jumpstart Our Business Startups Act signed into law by President Barack Obama in 2012, entrepreneurs can raise money through equity crowdfunding from anybody who has the cash and the interest in investing.
Now, your family, friends and anyone with an interest can invest in your company -- not just angel investors and other wealthy individuals.
“Entrepreneurs will be able to raise money like they did generations ago, from their neighbors and communities that know them, not from some conglomerate risk-averse bank headquartered on Wall Street," says Nick Tommarello, the co-founder and CEO of equity crowdfunding platform Wefunder, in an email with Entrepreneur. "We expect that this is that start of a renaissance of entrepreneurship in the United States.”
That means entrepreneurs have a much wider pool of investors to raise money from.
Opening up equity crowdfunding beyond accredited investors “is the greatest advancement for entrepreneurship in a generation. The single most powerful barrier to bringing great innovations and companies to life is the ability to raise capital," says Ron Miller, the CEO of equity crowdfunding platform StartEngine, in an email with Entrepreneur. "Entrepreneurs now have the opportunity to engage their customer fans as investors, who in turn become brand ambassadors.”
Gaining access to new pools of capital is one reason for entrepreneurs to be encouraged, but the new equity crowdfunding rules also have regulations attached to them and potential limitations. Entrepreneurs who are going to attempt to raise money with equity crowdfunding need to know what they are getting into before diving into an equity crowdfunding campaign.
Here’s your hotlist of need-to-know details.
1. The amount you are allowed to raise on a crowdfunding platform is capped at $1 million in any 12-month period.
While that will be plenty of money for some small businesses, it’s definitely not enough to be a complete funding round for some entrepreneurs.
“Nowadays, startups on average raise, at a seed stage, in the neighborhood of $2 million. The fact that startups will have a limit of $1 million per year will either force them to be under capitalized or conduct another type of offering in parallel to doing a Title 3 to raise the remaining capital from accredited investors, which means more costs from a legal perspective,” says Alejandro Cremades, the co-founder of 1000 Angels, a digital platform where accredited investors can invest in startups that venture capitalists are also investing in.
2. Before selecting an equity crowdfunding platform, ask the portal what kind of support it offers.
There will undoubtedly be a flurry of equity crowdfunding platforms bubbling to the surface in the weeks and months following the May 16 start date. Entrepreneurs need to keep in mind not only what the crowdfunding platform will offer during the course of the campaign, but also after the fundraising period closes.
“Choosing a platform is a very critical component of an equity crowdfunding investor’s journey,” says Jonathan Medved, the CEO of equity crowdfunding platform OurCrowd. “How is your platform set up to manage the investment in a startup post funding? Will they sit on a board? Will they provide you with investment reports and how will they provide added value to the companies they invest in? Startup companies need assistance not only to raise funding, but also require help in countless areas such as business development and raising additional funds.”
3. Don’t take money from more than 480 unprofessional investors.
As the law is currently written, a small business with more than 500 unprofessional investors and more than $25 million in assets will be subject to the same regulations as a public company, which is potentially a serious burden for a small-business owner.
“Thankfully, Congress is debating the Fix Crowdfund Act to take care of this issue, but in the meantime, we don't recommend that even a small business accept more than 480 shareholders, unless they have the right to repurchase those securities if they hit the $25 million asset number,” says Tommarello.
4. Marketing is mission critical in an equity crowdfunding raise.
Launching your campaign is only the first step. Startups are going to need to have a plan to get the word out, just as with more traditional crowdfunding campaigns.
“Entrepreneurs will be faced with the challenge of standing out and being found by potential investors. Many will quickly learn that ‘Build it and they will come’ only works in the movies. Marketing an offering is rarely cheap and never easy,” says Howard Orloff, the co-founder of the Illinois-based investment platform VestLo.
5. Be careful what you say on social media about your crowdfunding campaign.
Entrepreneurs are allowed to share the name of the business they are raising money for, type of business, location, contact information for interested investors, the platform on which they are raising funds and a general description of the business. They can not, however, get into a pitch about why investors ought to invest.
“Entrepreneurs need to understand that they cannot discuss the specifics of their crowdfunding campaign through social media. Most don’t understand this distinction. While all other forms of crowdfunding piggyback on social media -- this one does not,” says Richard Swart, the chief strategy officer of the equity crowdfunding education resource NextGen Crowdfunding. “They are specifically forbidden from hyping or promoting any detail of the offering aside from communication to investor on the intermediary platform.”
6. There is going to be paperwork.
And the consequences for failing to file appropriate paperwork are not insignificant.
“While regulation crowdfunding affords tremendous opportunity to entrepreneurs, with that opportunity comes responsibility," says Miller of StartEngine. "Specifically, the procedural and substantive requirements must be followed. Otherwise entrepreneurs risk disgorgement, penalties and even possible jail time,”
The goal of the regulation associated disclosure paperwork is to protect the unwitting investor from making an uninformed risk.
“Naturally, when the SEC hears that the general public will get access to this new asset class, their biggest concern is to protect the investors -- the average Joe and grandma from losing their entire life savings. So they really laid on the regulations,” says Cremades of 1000 Angels. “It's a risk for founders to take on the burden of the upfront costs required to get prepared, from a paperwork standpoint, for a Title III offering. Financial audits, disclosures, due diligence, ongoing reporting, etc. -- it all adds up, plus it takes time from the founders.”
The specific financial disclosure paperwork depends on just how much an entrepreneur is raising. Companies raising $100,000 or less must make financial statements and specific line items from income tax returns available to investors, both of which are certified by the principal executive officer of the company. Companies raising between $100,000.01 to $500,000 must provide investors financial statements reviewed by an independent public accountant and the accountant’s review report. For entrepreneurs raising between $500,000.01 to $1 million, the disclosure requirements vary depending on whether it is the first time they have raised money with equity crowdfunding. If entrepreneurs are raising between $500,000.01 to $1 million and it is their first time raising money with crowdfunding, then they have to provide financial statements reviewed by an independent public accountant and the accountant’s review report. If entrepreneurs are raising between $500,000.01 to $1 million and it is not their first time raising money with crowdfunding, then they must provide financial statements audited by an independent public accountant and the accountant’s audit report. (Audits are considered more comprehensive than reviews.)
All of the regulatory paperwork and disclosure documents may be a turnoff for some entrepreneurs.
“The best tech-enabled companies will continue to pursue traditional funding routes to avoid the regulatory hurdles of Title III of the JOBS Act. Certainly, there may be a type of company that will be suitable to raise capital under Title III and that remains to be seen, but our sentiment is that sophisticated tech founders will avoid this funding option like a plague,” says Cremades, who estimates that financial audits can cost up to $50,000. “It comes with too many strings attached and alternative funding options are less expensive, less risky and more sound financially in the short/long-term.”
7. You have to stay in touch with your investors after they give you money.
Larger companies have entire investor relations departments. Smaller businesses that use equity crowdfunding, however, will have to manage these communications on their own.
“Communication, post-offering, is going to be very important and probably a challenge until platforms and the industry, as a whole, matures,” says Vincent Bradley, the CEO and co-founder of equity crowdfunding platform FlashFunders. “Startups will need better tools to help manage and communicate with their shareholders, but it will take time to understand exactly what is going to be needed to make sure companies can interact, engage and leverage their new crowdfunders as efficiently as possible.”