Crowdfunding refers to soliciting money from the public (i.e., the "crowd"), primarily through online forums, social media, and crowdfunding websites to finance a new initiative or venture. Equity crowdfunding takes this one step further. In exchange for relatively modest quantities of cash, public investors get a proportionate share of equity in the business venture.
Previously, business proprietors raised such funds by borrowing from friends and family, applying for a bank loan, appealing to angel investors, or private equity and venture capital firms. Now, with crowdfunding, proprietors have an additional option.
Equity crowdfunding is rapidly expanding in prominence. According to research by Valuates Reports, the global crowdfunding market was valued at $12.27 billion in 2019 and is expected to reach $25.8 billion by 2026. But as with any mode of investment, investing through equity crowdfunding has its own risks and rewards.
Risks of Equity Crowdfunding
Greater Risk of Failure
A business that has been capitalized through equity crowdfunding arguably carries a greater risk of failure than one that has been funded through venture capital or other traditional means that offer seasoned professionals to help steer a start-up through early development challenges. The prosperity of an enterprise cannot be assured exclusively by funding. Without an adequate business plan and support structure, even intriguing ventures can falter.
Fraud
Online forums and social media are ideally adapted for equity crowdfunding because they offer extensive reach, scalability, convenience, and simplicity of recordkeeping. But these very features also make it simple for fraudsters to set up dubious ventures to attract equity crowdfunding from naive or first-time investors. Never neglect the step of doing due diligence on any investment you're considering.
Years to Materialize
Every investor expects some future return. However, returns on equity crowdfunded ventures may take many years to materialize, if at all. For example, management may deviate from the business plan or have difficulty scaling the business. Over time, this may contribute to capital erosion rather than asset creation. There may be an opportunity cost attached to your investment that you should consider since it holds up capital that could be used elsewhere.
Security of the Crowdfunding Portal or Platform
In recent years, hackers have demonstrated an alarming ability to break into seemingly impenetrable data repositories of leading companies and financial institutions and take credit card details and other valuable client information.
A similar danger exists for crowdfunding portals and platforms, which are vulnerable to attacks from hackers and cyber-criminals. So, in addition to investigating the investment itself, make sure to look attentively at the platform, too. Kickstarter, Indiegogo, Crowdfunder, and GoFundMe are a few worth checking out.
Lower-Quality Investments the Norm
For skeptics, the question arises whether a company would only use equity crowdfunding as a last resort. For example, if a company cannot attract funding from conventional start-up financing sources like angel investors and venture capitalists, perhaps it would turn to equity crowdfunding. If that is the case, then equity crowdfunded businesses are likely to be more lackluster investment opportunities with limited growth potential.
Rewards of Equity Crowdfunding
Potential for Outsize Returns
Since the hazards are great, the potential for enormous returns on equity crowdfunding is high, too. The narrative of Facebook's (now Meta) $2-billion acquisition of crowdfunded virtual reality headset manufacturer Oculus Rift in 2014 is now the stuff of legend. Oculus Rift raised $2.4 million on donation-based crowdfunding portal Kickstarter from 9,500 individuals.
However, since these supporters were donors rather than investors, they did not receive any compensation from Facebook's acquisition. Had Oculus Rift raised its initial capital through equity crowdfunding, the Facebook acquisition would have generated an estimated return of between 145 and 200 times of an individual's investment, according to Chance Barnett, CEO of Crowdfunder, and others. That indicates that a modest $250 investment would have resulted in proceeds of $36,000 to $50,000.
Opportunity to Invest Like Accredited Investors
Before the advent of crowdfunding, only accredited investors—high net-worth individuals who have certain defined levels of income or assets—could participate in early-stage, speculative ventures that held the promise of high reward and equally high risk.
The minimum quantity threshold for such investments was quite substantial. Equity crowdfunding, however, makes it possible for the average investor to invest a much lesser quantity in such ventures. In that respect, it has normalized the playing field between accredited and non-accredited investors.
Greater Degree of Satisfaction
Investing through equity crowdfunding can give the investor greater personal gratification than investing in a blue-chip or large-cap company. This is because the investor can choose to focus on businesses or ideas that resonate with them or are involved with causes in which the investor has a profound belief. For example, an environmentally conscious investor may choose to invest in a company developing a more effective method of measuring air pollution.
Equity crowdfunding may offer more avenues for such targeted investments than publicly traded companies.
Greater Business and Job Creation
Small and medium-sized businesses (SMEs), the foundation of the North American economy, are the largest beneficiaries of the equity crowdfunding megatrend. By facilitating simpler access to investor capital for businesses that would otherwise have had difficulty procuring it, equity crowdfunding should stimulate the local and national economies through new business formation and more job creation. Investors can feel happy about their contributions.
Equity Crowdfunding Investor Protection
In 2015, the U.S. Securities and Exchange Commission adopted final rules that facilitate access to capital for smaller companies while providing investors with more investment choices. These standards, referred to as Regulation A+ and mandated by Title IV of the Jumpstart Our Business Startups (JOBS) Act, are designed to promote equity crowdfunding.
While purists may lament that increased regulation will deter the free-wheeling spirit and honor system, the reality is that by deterring defrauders, these regulations may substantially expand the equity crowdfunding arena.
The Bottom Line
Investing through equity crowdfunding entails hazards such as the greater risk of failure, fraud, doubtful returns, vulnerability to cyber attacks, and inferior investments. But it also offers rewards like the potential for enormous returns, a greater degree of personal fulfillment, the opportunity to invest like accredited investors, and the prospect of stimulating the economy through business and job creation.
