Regulation Crowdfunding 101 For Entrepreneurs
So you’re interested in raising capital through Regulation Crowdfunding but want to learn more before taking the plunge? Then this article can help you learn the basics and hopefully answer some of your questions along the way.
Regulation Crowdfunding became legal in 2016 and lets companies raise up to $5M annually by selling securities such as equity or convertible note to the public online.
If you’re already feeling a bit overwhelmed, try reading this article on the basics of equity crowdfunding to get an overview of how this funding method works. If not, let’s dive deeper.
What’s the big deal with Regulation Crowdfunding?
The big deal is that through Regulation Crowdfunding, any investor over 18 years old can buy securities in private companies. These offerings are open to the public. This hasn’t been legal since before the Securities Act of 1933.
For over 80 years, only accredited investors could buy equity in a startup or participate in real estate investments, for example. Accredited investors are those who:
- Have made over $200,000 annually over the past two years ($300,000 if combined with a spouse) or
- Have over $1M in net worth, excluding their primary residence
They are better known by other names: wealthy individuals, angel investors, and venture capitalists. It’s estimated that only 10.6% of American households qualify as accredited.
It’s worth noting that the SEC expanded the definition of accredited investors in August 2020 to include individuals with professional certificates (such as the Series 7, Series 65, and Series 82 licenses), LLCs and family offices with $5M in assets, among others, but even with those changes the number of accredited investors is still a small percentage of the US population.
Through Regulation Crowdfunding, you don’t have to raise capital solely from the 10% of the population that are accredited investors. You can raise capital from anyone. This is a fundamental paradigm shift.
Ok, so how does this benefit entrepreneurs?
With Regulation Crowdfunding, you can raise capital from thousands of investors, including your customers, fans, and the public. Getting funding is no longer a question of having the proper connections. This is big news for demographics that traditionally don’t raise money from VCs.
Entrepreneurs also set their own valuation and terms for the raise, and so have full control of the offering. With Regulation Crowdfunding, no one is demanding board seats in exchange for their investment or forcing specific terms on to the founding team.
Plus, in the event of a successful raise, the thousands of new investors you acquire become your ambassadors: they invested in the business and want it to succeed. Oftentimes, they will be willing to help you if asked and are more likely to recommend your product or service to others.
In a twelve-month period, companies can raise a maximum of $5,000,000, though you can successfully close your round even if you do not raise your max funding goal, providing you hit a publicized minimum funding goal. At StartEngine, we encourage you to set that minimum at $10,000 to ensure you can access the funds you raise and grow your business.
How long has Regulation Crowdfunding been legal?
Regulation Crowdfunding is part of the JOBS Act, which President Obama signed in 2012. However, Regulation Crowdfunding itself, also known as Title III or Reg CF, didn’t go live until May 16, 2016.
Where can you conduct a Reg CF offering?
Companies must go through an intermediary that is registered with the SEC to conduct their offering. This intermediary can be a broker-dealer or a FINRA-regulated funding portal. These portals ensure that your offering is conducted properly within securities laws, and they give equal opportunity to all offerings on their platform.
Most offerings go through funding portals, and as of March 24, 2021 there were 67 funding portals. While there are 67 different options to choose from, only 15 platforms have significant investor activity and have helped companies raised over $1M. The largest platforms by funding volume include StartEngine, Wefunder, Republic, Microventures, and SeedInvest.
Can other countries participate?
Unfortunately, non-U.S. companies cannot use Regulation Crowdfunding to raise capital, but international investors can invest in US companies, provided they are following the securities laws within their home country. The sole exception to that is we cannot accept Canadian and UK investors on StartEngine, due to those countries’ securities laws.
Can any company raise capital?
To raise capital on StartEngine, companies must be:
- A registered legal entity
- A U.S. based operating entity
- A corporation or an LLC
- The founder is at least 18 years old
Furthermore, before you can launch a Regulation Crowdfunding offering, you must first go through a “bad actor” check for the executives and 20%+ shareholders of your company, in which there are disqualifying provisions, such as certain criminal convictions/records and SEC disciplinary orders.
Keep in mind that funding portals have different requirements, and so the restrictions may vary slightly from portal to portal. Many funding portals also are application-based. For example, StartEngine has a prohibited companies list that includes things like weaponry, pornography, and tobacco, among others, and we also have eligibility criteria to screen for companies that may pose a risk to investors.
What type of securities can be sold via Regulation Crowdfunding?
Most often, companies choose to issue a type of equity, whether common or preferred stock, in a Regulation Crowdfunding campaign. Alternatively, companies could choose to do a debt offering, convertible note, revenue share and more.
Some funding portals allow SAFEs (Simple Agreement for Future Equity), a popular offering structure created by Y Combinator for early-stage funding rounds. However, we do not believe SAFEs are a suitable investment for everyday investors, and as a result, we do not allow SAFEs on StartEngine.
What’s “testing the waters”?
Before companies go through the launch process, they can launch a “test the waters” campaign to gauge public interest in their offering. This means that companies can launch a campaign page in a matter of days and begin marketing the offering to see if their community is interested in investing in them.
If they get sufficient interest, the company can then go through the associated time and costs of preparing to launch their Reg CF raise, and once they launch, the company can then accept those reserved investments and continue to raise capital.
What’s the launch process?
In order to launch a campaign, companies must file a Form C with the SEC. The form involves basic legal disclosures, information on key executives, the company’s business plan and use of proceeds, and the terms of the offering, among other info. This form is public and can be found in the SEC’s EDGAR database.
For the first $107,000 of the raise, the business owner can sign off on the legal and financial paperwork without using outside services. However, to raise between $107,000-$1,070,000 businesses must bring on an independent CPA to review their financial books for the past two years, or since the businesses’ data of incorporation if that was less than two years ago. At this point, many of the clients we work with choose to work with legal counsel in order to verify the contents of their Form C.
To raise between $1,070,000-$5,000,000, you will need an audit.
Once a company files their Form C, they can launch their offering. Generally, companies take anywhere from 3-6 months or longer to reach their maximum funding goal. If companies want to extend their raise beyond their close date, they can file an amendment to continue their raise. If an offering is incredibly successful and reaches its maximum in just a few days, legally the offering must remain up for at least 21 days.
COVID-19 Relief Measure
It’s a difficult time for entrepreneurs, and the SEC has tried to make it easier for small businesses to survive and thrive while the economy is largely shut down by reducing the burdens associated with Regulation Crowdfunding. For 18 months beginning February 28th, 2021, companies can raise a total of $250,000 with self-certified financials (without the relief measure, this maximum is $107,000).
How much does it cost?
It varies on a case-by-case basis, but a Regulation Crowdfunding offering roughly costs between $4,000-$10,000 for the financial review and legal documentation. If you need an audit, that will incur an additional cost.
However, it’s worth noting that this excludes the platform fees taken by the funding portal. Funding portals generally take 7% of the raise, and there may be additional fees for international investors or certain payment methods. Some platforms also take an equity stake in the companies that raise on their platform.
How can you market your Reg CF raise?
All investments must go through the funding portal (or broker-dealer) the offering is hosted on, and you cannot provide substantive posts elsewhere outside of your campaign page where your offering is hosted. This means that you could post on social media that you are raising capital with a link to your offering, but you cannot also discuss the terms of your offering, or vice versa. The key is that you can’t talk about terms and non-terms at the same time.
As long as companies follow those restrictions, they should share their raise across as many channels as they have access to. Regular communication and updating potential investors is key to a successful raise, though companies cannot market at all until the Regulation Crowdfunding campaign is live and accepting investments. Plus, the funding portal they use will also market campaigns to their own investor audience.
What happens after the raise ends?
If your campaign fails and you fail to meet your minimum funding goal, any money put in by investors is refunded to them. If your campaign succeeds, you can disburse that money: it’s now yours.
However, the company is obligated to maintain its public disclosures and file annual reports and update those disclosures. Those annual reports must continue as long as there are shareholders who participated in the round (i.e. until acquisition or shareholder buy out).
An important note: after one year, investors’ shares are tradable. This means that if you want to provide liquidity to the shareholders who invested in your Reg CF campaign, you could do so by signing a quotation agreement to launch on an alternative trading system (such as StartEngine Secondary) and let your investors have an opportunity to access liquidity.
That access to liquidity means that there is less risk in investing in your business as the investors are not locked into the investment until the business is acquired or goes public (generally 5-10 years later). With less risk, investors are willing to accept smaller returns, which means better deal terms for the business.
How popular is Regulation Crowdfunding?
As of December 31, 2020, companies have launched a total of 3,217 Regulation Crowdfunding offerings, raising a combined $500M. You can read more stats about Regulation Crowdfunding by reading our quarterly index on the industry.
What’s the catch?
Regulation Crowdfunding is a way to raise capital while growing and attracting new users and brand ambassadors, but it does require publicly disclosing the company’s financial conditions as well as ongoing annual reports. It may not be a method suited for companies trying to build a product in stealth as the very nature of Regulation Crowdfunding is public. There’s also the risk that if the campaign fails, that failure is public as well.
But there are also unique benefits of Regulation Crowdfunding that other means do not give: you can raise capital and simultaneously use the raise as a marketing tool for more exposure for your business. You can grow your audience and acquire thousands of brand ambassadors, all while controlling the terms of your funding round. As with all methods of fundraising, it’s a measuring of pros and cons.
Learn more about raising capital with StartEngine here.
Editor’s note: this article was originally published on January 24, 2019 and was updated on March 26, 2021 to reflect new industry data as well as the SEC’s regulatory changes to Regulation Crowdfunding that went into effect on March 15th. Those changes include increasing the maximum limit of what companies can raise in a calendar year from $1.07M to $5M.