From dating to gambling to getting a degree, it seems there’s little that can’t be done online these days. But would you guess another thing you can now do online is fund early-stage businesses with your own money, and receive equity in return?
Startups must get their capital from somewhere, and two significant sources of it are angel investing and online crowdfunding. Angel investing – when affluent individuals invest their own money into startup companies in exchange for equity – has been in practice since the late 1970s, but saw a resurgence post-2007 when the recession ate up traditional capital. Online crowdfunding, on the other hand – when startups raise funding from a large number of people via an online platform – is a form of “alternative finance” that’s rapidly growing and evolving. So much so, in fact, that there’s talk it will surpass or even replace angel investing.
Is such a shift possible? Crowdfunding was valued at $34 billion in 2015, and is projected to surpass both angel investing and venture capital this year. In addition, recent changes in legislation as part of the JOBS Act have paved a clear path for online crowdfunding to expand even more. Whether the shift will happen is for time and circumstance to decide, but in the meantime, let’s go over what the new legislation allows and how it may or may not push online crowdfunding to overtake angel investing.
On April 5, 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law. Passed with bipartisan support, the JOBS Act was intended to make it easier for early-stage businesses to raise private capital. The act’s initial provisions allowed only accredited investors – those with a net worth of at least $1 million, or at least $200,000 in annual income – to fund startup companies in exchange for equity. In October of last year, however, the SEC passed Title III of the JOBS Act, allowing unaccredited investors to do the same, permitting what is called equity crowdfunding. Much of equity crowdfunding occurs through online portals, and numerous platforms have popped up as of late to accommodate the newfound demand.
The most obvious outcome of Title III is a wider pool of potential investors being able to fund startup businesses. Rather than relying on huge funding rounds from a handful of wealthy angel investors, startups can now receive smaller amounts of funding from a larger number of everyday investors – which could ultimately translate into more available capital. But will this prove to be a blessing or a curse?
There are a few aspects of equity crowdfunding that make it very attractive to both startup businesses and investors. From the perspective of the unaccredited investor, Title III opens some very exciting doors. It allows such investors to support early-stage businesses they believe in, and participate in the entrepreneurial and startup communities without wealth and income barriers. What’s more, in exchange they will own a portion of the business. If the business is successful, rewards await, but if not, they supported a cause they believed in.
On the startup business’ end, aside from the larger supply of possible investors, it’s a simpler and quicker way of raising money compared to gathering it from angel investors. Because it’s online, there’s no need for in-person meetings or frequent trips to the bank. No credit check or collateral is required, and the startup can set their own terms for rewarding investors rather than negotiating them.
Equity crowdfunding could also prove to be an effective catalyst for organic marketing. To protect their investment, it’s in the best interest of investors to promote the startup they’ve funded, leading to free exposure and word-of-mouth for the business. In addition, what better way to establish a customer base?
However promising it may sound, the prospect of equity crowdfunding isn’t without concerns or drawbacks. A larger pool of investors and a lower barrier for entry also means many of these investors will be inexperienced in the arena of funding early-stage businesses. Angel investors often give more than just capital to the businesses they fund. They also provide advice and support, and that’s when it’s important to have investors experienced in the realm of business and capital. Unaccredited investors may not have that kind of expertise and insight to offer, and might not take their investment as seriously as an angel investor would.
Not all startups are a good fit for equity crowdfunding, either. Companies offering a business-to-business (B2B) product or service may lose out, because it’s difficult to get the everyday investor excited about something they won’t use personally. Similarly, complex ideas that are hard to explain to the layperson may also have difficulty gaining unaccredited investors, who don’t have the patience or desire to learn about obscure projects.
Lastly, equity crowdfunding doesn’t come without a price. Because it’s a relatively new practice that only recently became legal, there is likely to be hefty paperwork involved and perhaps even the need for professional counsel. The online platforms that facilitate equity crowdfunding also need to make money somehow, and many do so by charging fees and percentages on transactions. It’s up to interested startup businesses to decide if the potential capital raised outweighs the expenses, a decision which may require trial and error.
Will online crowdfunding can replace angel investing? Benefits and drawbacks of each method will surface as we watch the battle unfold. For the time being, common sense gives us some basic pros and cons on which to base our projections. There’s no doubt that it will be an interesting ride for startups, and for angels.