New rules mean entrepreneurs don’t have to court wealthy investors to fund their big idea.
Crowdfunding a business
What rules have changed?
Until recently, investing in a startup or small business has been limited to the wealthy—roughly 8. 5 million accredited investors with more than $200,000 in annual income or a net worth of at least $1 million. But thanks to changes under the 2012 Jumpstart Our Business Startups (JOBS) Act, which went into effect last May, people making less than $100,000 a year can now invest in small businesses—putting in up to $2,000 or 5 percent of their annual income, whichever is greater. In return for investments as small as $10, they get shares of the company, or equity, and small businesses can sell up to $1 million of their shares over a 12-month period. “This levels the playing field,” says David Mandelbrot, CEO of Indiegogo, the first major crowdfunding site to add such equity offerings. “This was one of the few areas of the law where citizens were treated differently based on the amount of wealth that they have.”
How does this crowdfunding work?
By law, companies can’t offer shares directly to investors, but have to go through an online fundraising platform registered with the Securities and Exchange Commission. These can either be broker-dealers such as Venture .co, which take an active role, helping startups draft paperwork and solicit investors, or more basic crowdfunding portals like NextSeed or StartEngine, which are fairly hands-off. There are some two dozen approved crowdfunding portals, all of which take a portion of any funds raised, usually 5 to 9 percent. The law also requires firms to file paperwork with the SEC before a campaign can begin, including detailed financials that are made available to potential investors online. “It’s not something where you slap together a video and people come running with their checkbooks,” says Ron Miller, who co-founded StartEngine.
Is it worth it?
It depends. More than a quarter of small businesses say they aren’t able to raise the funding they need via traditional methods, like venture capital or bank loans, according to the National Small Business Association. Equity crowdfunding provides entrepreneurs another way to quickly and efficiently raise capital. Crowdfunding investors can also be powerful brand ambassadors, because they have a stake in a company’s success. But opening up your business to small investors is not a decision to be taken lightly. Indiegogo estimates that companies need to spend about $7,000 on compliance and regulatory costs before their campaign can be launched. The House of Representatives passed a bill last year to simplify the campaign process, but the Senate has yet to take it up.
Are there success stories yet?
Yes, though equity crowdfunding has been a little slow to take off. A little more than 250 small businesses and startups have launched fundraising campaigns since last May under the new rules, according to NextGen Crowdfunding; only a handful have raised the maximum of $1 million. But a wide variety of businesses have met their own specific funding goals, including a national food truck chain serving high-end grilled-cheese sandwiches, an Indiana company that builds indoor farms to grow herbs and salad greens, and an electric-car company in Malibu, Calif. Beta Bionics, a Bostonbased firm working on an artificial pancreas for diabetics, was the first company to raise $1 million last July, with 775 investors contributing an average of $1,300 for a slice of the business. The company is now valued at $100 million. Hops and Grain Brewing, a craft brewery in Austin, was another $1 million fundraiser, and is using the money it raised to open a second location.
What’s in it for investors?
The chance to get in on the ground floor of the next big thing. But such investments remain a highly risky endeavor. Half of all new businesses don’t survive past five years, and some companies seeking equity crowdfunding may have already been passed over by professional investors, who specialize in identifying promising firms. And because startup shares aren’t publicly traded, it can be difficult to cash out until a firm is acquired or goes public. Although there are other reasons to back a company— like believing in the product— most investors won’t see a return for years, if ever. “This has to be discretionary money that you can afford to lose,” says Richard Swart of NextGen Crowdfunding. For the average investor, it is crucial to look for deals “where you understand the market.”