March 29, 2017 | 5 minutes read( 865words)
Early Growth Financial Services is fortunate to have many great clients with diverse business models and capitalization structures. We help many of these clients prepare for equity rounds of financing, so naturally we were excited when the JOBS act passed in 2012 and allowed for equity crowdfunding. While we are big proponents of accredited investing through traditional channels (Angels, Micro VC’s, VC’s), the May 2016 Regulation CF passing for non-accredited investors to invest in companies is a transformational fundraising milestone for new startups launching in the 21st century. The fact that everyday individuals can fund companies and democratize private equity is an exciting concept. That said, we’ve had more than a handful of companies go through this process and it was an eye opening experience that we’d like to share to inform others of what to expect.
Before we dive in, here’s a quick crowdfunding overview. Non-equity crowdfunding or “rewards based crowdfunding” is comprised of sites like Indiegogo or Kickstarter that allow companies to list a product for pre-sale for a promise of a reward without the exchange of equity. The 2012 JOBS Act allowed for equity crowdfunding in 2013 (Title II), but only from accredited investors. The Reg. CF (Title III) passing on May 16, 2016 then allowed for non-accredited investors (as a percentage of their income) to invest in companies who are raising up to a maximum of $1mm over a 12 month period. You can learn more about Reg. CF requirements here. Due to its immense popularity, we are going to focus on our experiences with Reg. CF campaigns.
As you can imagine, in the first half of 2016 we had many companies approach and engage with us to help them launch these Reg. CF campaigns. The work EGFS performed for most of these companies was extensive because of the need to be fully GAAP (Generally Accepted Accounting Principles) compliant per SEC regulations. However, in all of the campaigns, EGFS was just one of a few professional services firms involved. The typical process was as follows:
1) The company contracted with a securities law firm that is familiar with crowdfunding to prepare documentation.
2) The company contracted with EGFS to prepare accounting and financials.
3) The company underwent a formalized review (Audit firm) to review EGFS’ work in order to launch on the crowdfunding portal (different firm than EGFS due to conflict of interest).
4) The company launched on the crowdfunding platform, incurring either a minimum onboarding fee or success fee for the money raised, sometimes both.
5) Occasionally, a PR/Marketing firm was used to promote the campaign. These firms are highly specialized due to the rules of marketing this security.
Due to the cost burden outlined above, if you were to pursue this type of crowdfunding, it makes sense to raise larger amounts of money up to the $1mm/12 month maximum. Many companies choose to raise less than $500k with Reg. CF, but that means that the compliance costs represents a larger percentage of the money raised, leaving less money on the table for business expansion. We’ve yet to see a Reg. CF crowdfunding campaign launch for less than $25-50k by the time all parties are paid for their services. As you can imagine, this is a large amount of cash, especially if the campaign is unsuccessful.
Besides the costs of the campaign, there are some other important considerations that you’ll need to make as a Founder before launching a Reg. CF campaign. If you want to raise traditional VC money after this campaign, Reg. CF causes a crowded cap table and most venture capitalists are not fond of this. It causes their own compliance headache and doesn’t allow them enough room in the cap table to invest. Another important consideration is the strategic value a venture capitalist brings to the table beyond writing a check, which you don’t receive from Reg. Cf individuals. The very best VCs and funds can attract customers, have deep networks to help with hiring and other needs as they arise, and - most importantly - help founders prepare for the next round of financing. Unfortunately, Reg. CF lacks this critical advisory element.
That said, there are particular use cases where Reg. CF makes excellent sense. First and foremost, most businesses are not ideal for venture capital investment. If you are launching a lifestyle business or a small business that is looking to compensate early adopters for belief in your product, then Reg. CF is a solid option. If you are looking for a relatively quick funding source, this is also an advantage, although it is not as fast as non-equity crowdfunding due to the aforementioned regulations process.
Overall, Reg. CF crowdfunding is one of the biggest developments in the startup financing landscape in recent years. This will be a viable funding option for many companies both now and in the future. It is important to dive deeper into learning how a crowdfunding campaign would fit into your overall fundraising strategy. We’ll make sure to send along an update once these early Reg. CF companies experience their first SEC review in the coming months.