Crowdfunding

What Is Crowdfunding?

Crowdfunding is a method of raising capital by soliciting relatively small individual investments or contributions from a large number of people, typically through online platforms. It falls under the broader category of alternative finance, providing a pathway for startups, small businesses, or specific projects to secure funding without relying solely on traditional financial institutions or a limited number of large investors. This approach democratizes the fundraising process, enabling a wide range of individuals to become stakeholders in ventures they believe in. When a company offers securities through crowdfunding, it must adhere to specific regulatory frameworks designed to protect investors and ensure transparency.

History and Origin

The concept of collective funding has existed for centuries, with patrons supporting artists or community projects. However, modern crowdfunding, facilitated by the internet, gained prominence in the early 2000s, primarily for artistic and charitable endeavors. The turning point for securities-based crowdfunding, where investors receive an equity or debt stake, came with the passage of the Jumpstart Our Business Startups (JOBS) Act in the United States in 2012. This landmark legislation aimed to ease securities regulations to encourage funding for small businesses. Title III of the JOBS Act, specifically known as the CROWDFUND Act, paved the way for companies to use crowdfunding to issue securities, a practice not previously permitted.¹⁶

Subsequently, the U.S. Securities and Exchange Commission (SEC) adopted final rules for Regulation Crowdfunding (Reg CF) in October 2015, which became effective in May 2016.¹⁴, ¹⁵ These rules established the framework for companies to offer and sell securities through online crowdfunding platforms to the general public, including non-accredited investors, within certain limits.¹³ Amendments in 2020 further adjusted these rules, increasing the maximum offering amount a company can raise through Reg CF within a 12-month period.¹²

Key Takeaways

• Crowdfunding involves raising capital from a large number of individuals, often via online platforms.
• It serves as an alternative financing method for startups, small businesses, and projects.
• Securities-based crowdfunding is governed by regulations like the SEC's Regulation Crowdfunding (Reg CF) in the U.S.
• Investors in crowdfunding opportunities may face significant risk, including illiquidity and the potential for total loss of investment.
• Crowdfunding platforms act as intermediaries, connecting issuers with potential investors and facilitating compliance.

Interpreting Crowdfunding

Crowdfunding's interpretation largely depends on the specific model employed. In reward-based crowdfunding, success is often measured by the achievement of a funding goal and the delivery of promised rewards. In securities-based crowdfunding, where investors gain an equity stake or debt instrument, interpretation involves evaluating the potential for financial returns.

For companies, crowdfunding success can signify market validation for a product or business idea and provide essential growth capital. For investors, a successful crowdfunding campaign means their funds have contributed to bringing a project or business to life, with the potential for financial gain. However, evaluating the long-term viability of a crowdfunded business, especially those offering equity, requires careful consideration of its business plan, financial projections, and industry landscape. Understanding the underlying valuation of the company and the terms of the investment is crucial for informed decision-making.

Hypothetical Example

Consider "GreenWheels," a hypothetical startup aiming to develop an innovative electric bicycle. To fund the initial production run and expand their engineering team, GreenWheels decides to launch a crowdfunding campaign. They choose an SEC-registered funding portal to offer equity in their company under Regulation Crowdfunding.

GreenWheels sets a target of $500,000, offering shares at $10 each, implying a pre-money valuation of $5 million. Through the crowdfunding platform, they publish their business plan, financial statements, and details about their team and the innovation behind their product. Individual investors, ranging from enthusiastic cyclists to those interested in sustainable transport, review the offering. An investor, Sarah, who has $1,000 available for speculative investments, decides to purchase 100 shares of GreenWheels. The platform aggregates investments from thousands of individuals like Sarah. If GreenWheels successfully reaches its funding goal, it receives the capital, and Sarah, along with other investors, becomes a partial owner of the company, holding a small equity stake. This allows GreenWheels to scale operations and, if successful, potentially offer Sarah a return on her initial investment down the line.

Practical Applications

Crowdfunding has found diverse practical applications across various sectors, enabling capital formation for entities that might struggle with traditional funding avenues.

• Startup Funding: Many nascent businesses use crowdfunding to secure early-stage capital for product development, market entry, or scaling operations. This provides an alternative to traditional bank loans or early-stage venture capital.
• Real Estate Projects: Real estate developers leverage crowdfunding to finance property acquisitions, construction, or renovation projects, allowing a broader base of investors to participate in real estate opportunities.
• Creative Arts and Projects: Artists, filmmakers, musicians, and game developers often use reward-based crowdfunding to fund their creative endeavors, pre-selling products or experiences to their audience.
• Social and Charitable Causes: Non-profit organizations and individuals use crowdfunding to raise funds for charitable initiatives, disaster relief, or personal causes.
• Community Development: Local businesses and community initiatives can raise money directly from their community members, fostering local investment and economic growth.
• Product Development: Companies, particularly in the tech sector, utilize crowdfunding to gauge market interest for new products and secure funding for manufacturing before mass production, effectively allowing customers to pre-order and fund the product simultaneously.

The U.S. Securities and Exchange Commission (SEC) provides guidance and regulations, such as Regulation Crowdfunding (Reg CF), to oversee securities-based crowdfunding offerings, ensuring certain disclosures and investor protections are in place.¹⁰, ¹¹

Limitations and Criticisms

While crowdfunding offers accessible funding and investment opportunities, it comes with inherent limitations and criticisms that investors should consider.

One significant limitation is the high risk of failure for early-stage startups and ventures, which are common beneficiaries of crowdfunding. Many new businesses do not succeed, meaning investors could lose their entire investment. Furthermore, crowdfunding investments often suffer from illiquidity, meaning there is no readily available secondary market to sell shares, restricting an investor's ability to exit their position quickly. Investors may be restricted from reselling their shares for at least one year.⁹

Fraud and misrepresentation are also concerns, despite regulatory efforts. Inadequate due diligence on the part of investors or insufficient verification by platforms can increase vulnerability to fraudulent schemes.⁸ The decentralized nature of crowdfunding and the sheer volume of offerings can make it challenging for regulators to monitor all activities effectively.⁷

Additionally, the lack of transparency and information asymmetry can be problematic. While regulations require disclosures, the depth and quality of information provided by private companies may not always match that available for publicly traded companies.⁶ Issues such as the complex nature of certain securities offered, like Simple Agreements for Future Equity (SAFEs), can also present challenges for less experienced investors who may not fully grasp the terms or potential for conversion.⁵

Finally, dilution of ownership can be a concern for early investors in equity crowdfunding if the company conducts subsequent funding rounds at lower valuations or issues more shares.

Crowdfunding vs. Venture Capital

Crowdfunding and venture capital are both mechanisms for funding startups and early-stage companies, but they differ significantly in their approach, investor base, and expectations.

Crowdfunding, as discussed, democratizes capital raising by soliciting relatively small amounts from a large, diverse group of individuals, often non-accredited investors, via online platforms. The collective "crowd" funds the venture, typically involving lower individual investment amounts. This model emphasizes broad participation and community engagement.

In contrast, venture capital involves funding from a select group of professional investors or firms who manage pooled funds from institutional investors and high-net-worth individuals. Venture capitalists (VCs) typically invest much larger sums of capital into a smaller number of high-growth startups in exchange for significant equity stakes. VCs often take an active role in the company's governance, providing strategic guidance, industry connections, and mentorship in addition to funding. The decision-making process is highly selective and relies heavily on extensive due diligence. While crowdfunding relies on volume, venture capital relies on concentrated, strategic investments.

FAQs

What types of crowdfunding exist?

There are several types of crowdfunding: reward-based (donors receive a non-financial reward), donation-based (donors receive no reward), equity crowdfunding (investors receive shares or ownership), debt crowdfunding (investors receive loans with interest), and royalty-based (investors receive a share of future revenue).

Is crowdfunding regulated?

Yes, securities-based crowdfunding, where companies offer equity or debt in exchange for funds, is regulated. In the U.S., the SEC's Regulation Crowdfunding (Reg CF) sets rules for these offerings, requiring companies to disclose information and conduct transactions through registered platforms.⁴

What are the main risks for crowdfunding investors?

Key risks include the high likelihood of business failure, limited returns or illiquidity of the investment (difficulty selling shares), and the potential for fraud or insufficient disclosure of financial information. Investors may also experience ownership dilution in future funding rounds. Investors should perform their own due diligence before committing funds.

How much can a company raise through crowdfunding?

Under the current Regulation Crowdfunding rules in the U.S., eligible companies can raise a maximum aggregate amount of $5 million through crowdfunding offerings in a 12-month period.³

Can anyone invest in crowdfunding?

For Regulation Crowdfunding offerings in the U.S., both accredited investors and non-accredited investors can participate. However, non-accredited investors have limits on how much they can invest within a 12-month period, based on their income and net worth.¹, ²