The Functioning of Equity Crowdfunding: An Explanation
Democratizing Startup Investment: The Rise of Equity Crowdfunding
Starting a new business is an exciting journey, but raising the necessary capital can be a significant challenge. In the United States, equity crowdfunding has emerged as a popular mechanism for small businesses and startups to raise funds from a large number of investors. This article will explore the basics of equity crowdfunding, its regulations, and the associated risks for unaccredited investors.
Equity crowdfunding, also known as crowdinvesting, investment crowdfunding, or crowd equity, allows large groups of people to invest in unlisted companies in exchange for shares. Prior to 2015, only accredited investors were allowed to participate in equity crowdfunding. However, the JOBS Act opened up this opportunity to non-accredited investors as well, primarily governed by Regulation Crowdfunding (Reg CF).
Under Reg CF, private companies can raise up to $5 million within a 12-month period from both accredited and unaccredited investors. These offerings must be conducted through SEC-registered funding portals or broker-dealers, with strict disclosure and reporting requirements. Companies must provide comprehensive disclosures, including financials, risks, business plans, and terms of the offering, to ensure informed decision-making by investors. After fundraising, issuers must file annual reports updating investors on company performance, enhancing transparency and accountability.
For unaccredited investors, there are investment limits based on their annual income or net worth to reduce risk exposure. They can invest up to the greater of either $2,000 or 5% of the lesser of their annual income or net worth during any 12-month period, if their income or net worth is less than $100,000. If their annual income and net worth are equal to or more than $100,000, they can invest up to 10% of annual income or net worth, whichever is lesser, but not to exceed $100,000 during any 12-month period. The value of the primary residence is not included in the net worth calculation.
Despite these regulations, equity crowdfunding for unaccredited investors still carries significant risks. Startups often fail, potentially resulting in total loss of investment for equity investors. Shares purchased through crowdfunding are typically illiquid, with limited secondary market options to sell. There are also risks of fraud and misinformation, underscoring the importance of regulatory compliance and platform due diligence. Unaccredited investors also face limited protections compared to public markets, as they invest in less mature companies.
Securities purchased in a crowdfunding transaction generally cannot be resold for one year, unless the shares are transferred back to the company, to an accredited investor, to a family member, or as part of an offering registered with the SEC. As of now, an issuer may sell up to $1,000,000 of its securities per 12 months even to unaccredited investors.
In summary, Reg CF democratizes startup investment opportunities for unaccredited investors, enforcing strict compliance to protect them through funding limits, mandatory disclosures, platform registration, and SEC oversight. However, these investors still face significant risks related to investment loss, liquidity, and potential fraud inherent to early-stage equity investments. It is crucial for potential investors to consider these risks and seek professional guidance before making investment decisions.
[1] Regulation Crowdfunding: A Guide for Startups and Small Businesses. (2021). Small Business Administration. [2] Investing in Startups: A Guide for Non-Accredited Investors. (2020). Securities and Exchange Commission. [3] Understanding Equity Crowdfunding: Risks and Rewards. (2017). Securities and Exchange Commission. [4] Regulation Crowdfunding: A Guide for Investors. (2016). Securities and Exchange Commission.
Equity crowdfunding offers an opportunity for unaccredited investors to invest in businesses through crowdinvesting, investing in unlisted companies in exchange for shares, as Regulation Crowdfunding (Reg CF) has made it possible for non-accredited investors to participate.
Businesses can raise up to $5 million within a 12-month period from both accredited and unaccredited investors, but unaccredited investors are subject to certain investment limits and face significant risks, such as startup failure, illiquid shares, and a lack of protections compared to public markets.
