Crowdfunding emerged as a popular and innovative method of fundraising for startups, providing a platform for entrepreneurs to raise capital through soliciting relatively small individual investments or contributions from a large number of people. Unlike traditional fundraising avenues that rely on a small group of investors or financial institutions, crowdfunding leverages the collective power of the public, allowing startups to pitch their ideas to a broad audience. Crowdfunding offers several benefits that make it an attractive option for startups. Understanding these advantages as well as the limitations of crowdfunding can help entrepreneurs determine when crowdfunding is the preferable means of fundraising for their ventures.
When could crowdfunding be the appropriate fundraising method for your business?
- Early days. Crowdfunding is an effective way to raise money from a large, diverse pool of investors, which makes it particularly suitable for startups that provide products or services that pique consumer interest and resonate with the general public. When larger institutional investors may be reluctant to make investments due to factors such as unfavorable market conditions or lack of confidence in the performance of the company, crowdfunding can help startups raise money directly from individuals motivated by factors beyond investment returns. Following the amendments adopted by the SEC in 2020, startups with audited financial statements can now raise up to $5 million through crowdfunding in a 12-month period, up from the prior $1.07 million limit. (For first-time crowdfunders without audited financial statements, the post-amendment limit is $1.235 million with reviewed financials.)
- Transition stage. Crowdfunding can be crucial for companies transitioning from early-stage venture capital to later-stage financing by supporting crossover financing. It can help bridge the gap between private funding and public markets by offering flexible, incremental capital that can address specific milestones and funding needs of a company and support its growth and development during a critical phase of its lifecycle. Additionally, crowdfunding can provide broad market validation and enhances visibility, which can attract further investment from institutional players. This combination of flexible funding and market support can facilitate a smoother transition to more substantial financing rounds or an eventual public offering.
- Late-stage financings. Crowdfunding can also be advantageous for startups in their late-stage financing as it provides an avenue to secure the final tranche of capital required before an exit through an Initial Public Offering (IPO) or acquisition. At this stage, companies typically have a validated business model, a strong customer base and promising growth metrics, making them attractive to a broad audience of potential backers. By leveraging crowdfunding, these startups can tap into a large pool of small investors who are often eager to participate in the success of emerging companies. A successful crowdfunding campaign not only provides the necessary funds to scale operations or refine the product, but also serves as a powerful signal to institutional investors and acquirers, demonstrating market validation and public interest, thereby potentially increasing the company’s valuation and attractiveness during negotiations for an IPO or sale.
What are some of the key benefits of crowdfunding?
- Marketing and publicity advantages. By representing their innovative ideas to potential customers, startups can not only secure the necessary funding but also generate early buzz and validate their market concept. This consumer-driven support often leads to a more engaged and loyal customer base, providing valuable feedback and advocacy that can propel a startup’s growth and success.
- Federal exemptions for registration. For startups that would like to offer and sell securities through crowdfunding, federal securities laws must be complied within the offering process. Under federal securities laws, any offer or sale of a security must either be registered with the U.S. Securities and Exchange Commission (SEC) or meet an exemption. Regulation Crowdfunding (Reg CF) provides compliant startups an exemption from the registration requirements of the Securities Act of 1933, as amended, and permits them to offer and sell up to $5 million of their securities. Notably, anyone can invest in a Reg CF offering, including those who do not meet the stringent income or net worth criteria required to qualify as accredited investors.
- Direct listing considerations. Boosting the number and diversity of investors can be particularly beneficial for companies considering a direct listing. The New York Stock Exchange (NYSE) requires issuers in a direct listing to meet specific initial listing requirements, including having 400 round lot holders, at least 1.1 million publicly held shares, and a minimum share price of $4 at the time of listing. Nasdaq Global Market imposes the same initial listing requirements for a direct listing. Crowdfunding can play a crucial role in helping a company satisfy these requirements before the time of listing. By attracting a large and varied pool of investors through a Reg CF offering, companies can ensure they meet NYSE and Nasdaq’s initial listing requirements, thereby facilitating a smoother transition to the public markets and enhancing their visibility and credibility among potential future investors.
What are some of the major downsides of crowdfunding?
- Reputational impact. One of the potential drawbacks of crowdfunding is the reluctance of institutional investors to engage with companies that have previously utilized this fundraising method. Institutional investors often prefer to collaborate with a known group of investors and may be hesitant to invest in subsequent financing rounds when the company’s investor base comprises numerous individual investors with varied financial backgrounds. This hesitancy stems from the difficulty in assessing the reliability and intentions of a diverse group of small-scale investors. However, if a company’s ultimate objective is to pursue an IPO or otherwise enter the public market, the involvement of individual investors becomes an inevitable and necessary step in the process, as broad public participation is a fundamental aspect of the public markets.
- Complications with exemption requirements. While Reg CF exempts companies from the requirement to register securities offered in a securities-based crowdfunding, it also imposes several limitations that must be carefully considered when a startup determines whether crowdfunding would be the most appropriate avenue to achieve its fundraising goals. Such limitations include but are not limited to:
- Restrictions on the amount of capital that can be raised: under Reg CF, a company is permitted to raise a maximum aggregate amount of $5 million through crowdfunding offerings in a 12-month period;
- Restrictions on the amount individual non-accredited investors can invest across all crowdfunding offerings in a 12-month period; and
- Requirements to make certain disclosures in filings with the Commission and to investors and the SEC-registered intermediary facilitating the offering, including audited financial statements. This can be costly for startups due to the expenses associated with hiring external auditors, preparing comprehensive financial documentation, and ensuring compliance with auditing standards. However, it is important to note that if a company’s long-term plan includes going public, audited financials will generally be required regardless. Therefore, the requirement for audited financial statements should not be seen as a deterrent to pursuing crowdfunding, as it aligns with the broader financial transparency and regulatory compliance needed for a future public offering.
Conclusion
Ultimately, determining whether crowdfunding is the right fundraising avenue for your company depends on several factors. It is crucial to assess this option in light of your company’s current stage, the nature of your business, and your future plans.
