Equity Crowdfunding: Elements To Keep In Mind

You may recall from my previous article that in November of 2020, the SEC greatly expanded its crowdfunding rules. Among the most noteworthy changes in regulation crowdfunding were:

PROMOTED

1. Raising businesses' offering limit from $1.07 million to $5 million;

2. Giving unaccredited investors more wiggle room to spend: The greater of either their income or net worth (instead of both) now determines how much they may invest.

For potential equity crowdfunding investors, this change is significant because the amount they are allowed to contribute will largely dictate which deal terms they choose. All equity crowdfunding platforms will offer traditional debt-based terms such as revenue shares, pure equity-based terms such as common stock and SAFEs (Simple Agreement for Future Equity), or the hybrid debt/equity convertible note

Convertible notes and SAFEs tend to be the most popular offerings, so we'll focus on these two in this discussion. The two share many similarities and helpfully avoid setting any valuation for the business when it has little to no operating history. However, important caveats to keep in mind are that SAFEs, unlike convertible notes, are not debt instruments and therefore carry no guarantee of return. SAFEs should also only be used when investors trust the business' ability to raise future financing from professional investors. Ironically, SAFEs are not the safest choice in terms of ROI. Don't let the acronym fool you.

A Concrete Example Of What We're Talking About

Let's say you invest $10,000 into a company valued at $5 million. Depending on the terms outlined in your equity/investment agreement, you would have "X" percentage of ownership. If, in three to four years, that company sells for a value of $25 million as a result of successful growth, you'll then receive a return five times greater than your initial investment. (Please note that this is just an example and does not relate to any specific live campaign.)

What To Look For When Considering An Investment

When considering any investment, you always want to look for the following elements:

• A team with strong experience and prior exits (e.g., veteran leadership with proven performance history is a solid bet).

• Revenue potential.

• Future plans (i.e., how many years ahead they're looking at).

• Market growth.

• Traction (i.e., year-over-year growth).

• A unique value proposition and an undersaturated market (e.g., who the competition is, if any exists).

• Exit potential.

Red Flags To Look For When Considering An Investment

If any of the above points are missing, that could be a red flag. But "red flags" are literally anything that doesn't sit well with you, so trust your gut instincts here. What has your due diligence revealed? Has the business experienced glaring amounts of turnover since it started? Do the team members' respective ownership stakes reflect faith in the trajectory of the business (i.e., high ownership versus low ownership)?

First Dividends Paid From Equity Crowdfunding

Up to now, it seems we have spoken only about the inherent uncertainty of ever receiving a return on investment with equity crowdfunding, but last year saw the first-ever dividends paid out from an equity crowdfunding campaign. The company, New Zealand-based Thankyou Payroll, raised $460,000 from 186 investors in 2017. They experienced 120% year-over-year growth post-campaign, and dividends paid resulted in an ROI for investors (though specific numbers have not been released).

The Different Ways Investors Can Make ROI

Even if the return is not an outsize one, investors realize their return on investment in a variety of ways, often in the form of dividends (as in the Thankyou Payroll example), exit payouts, capital gains and distributions. The physical characteristics of ROI depend largely on an investor's preference for yield or total return. Your preference for yield or total return depends on your circumstances at the time; do you have enough financial reward from your investments that you now want to earn income from them? Or do you wish to keep growing your portfolio? You may even be able to have both.

The bottom line? Yes, investing in startups is risky, but if you do your due diligence and invest intelligently, you can get in on the action early and potentially win long term.