Like the small businesses it was designed to help, equity crowdfunding is still in its start-up stage. But the U.S. Securities and Exchange Commission reports that it’s rapidly growing into a viable source of financing – and a new investment option for those who want to own a piece of an early-stage company.

Equity crowdfunding allows investors to become part owners of companies by trading their investment for shares of private stock. As with traditional crowdfunding, investments usually take place through a funding portal like Kickstarter, StartEngine or Republic. Investments may also be made through a broker-dealer’s online platform.

There are 45 such portals registered with the Financial Industry Regulatory Authority (FINRA), according to the SEC, but the top three account for about two-thirds of all offerings and proceeds raised. Wealthforge lists Reality Mogul, AngelList and FundersClub as the top three platforms.

Signs Of Success

While equity crowdfunding is still relatively small, it’s showing signs of success. Companies such as Beta Bionics, which is developing a bionic pancreas, and craft beer company Hopsters Brewery each raised $1 million in crowdfunding campaigns. Beta Bionics recently raised $63 million through Series B equity financing.

In fact, a majority of crowdfunding campaigns have been successful, according to a new analysis by the SEC, which found that the success rate for crowdfunding companies increased from 58.9% in 2017 to 63.9% in 2018.

The SEC estimates that 1,351 offerings took place between May 16, 2016 and December 31, 2018. Offerings that were completed raised an average of $208,300 and a total of $107.9 million. The number of investors participating in successful offerings increased from 77,558 in 2017 to 147,448 in 2018.

While the U.S. market for equity crowdfunding is still small, globally equity crowdfunding has raised $2.5 billion, according to Startups.com.

Regulation Crowdfunding

Equity crowdfunding has been growing since it was first allowed by the passage of the JOBS Act in 2011. Initially, only accredited investors were allowed to participate. To be an accredited investor, a person must earn more than $200,000 a year ($300,000 for couples) or have a net worth exceeding $1 million, excluding a primary residence.

The introduction of Regulation Crowdfunding (Regulation A+) in 2015 opened up equity crowdfunding to all investors, although some limitations remain.

Limitations for investors. For investors with a net worth or annual income of less than $107,000, the SEC limits the maximum investment to $2,200 or 5% of the investor’s annual income or net worth (whichever is less) during a 12-month period. If your annual income and net worth exceed $107,000, you can invest up to 10% of annual income or net worth (whichever is less) during a 12-month period, but cannot exceed $107,000. 

Limitations for companies. Companies using crowdfunding are allowed to raise up to $1,070,000 during a 12-month period. The amount of money the company seeks to raise determines the level of financial information it is required to disclose:

• $107,000 or less – Companies must provide financial statements and specific line items from income tax returns, both certified by the principal executive officer.

• $107,000.01 to $535,000 – Company financial statements must be reviewed by an independent public accountant and the accountant’s review report must be available to investors.

• $535,000.01 to $1.07 million – If the company is crowdfunding for the first time, requirements are the same as the $107,000.01 to $535,000 crowdfunding amount. If the company has previously raised capital by crowdfunding and wants to crowdfund again, its financial statements must be audited by an independent public accountant.

Some of the portals also have limitations. Initial investment requirements may be as low as $20 to as high as $10,000, which disallows those who are restricted from investing that amount by Regulation Crowdfunding. Some allow only accredited investors to participate.

Reducing Your Risk

The attraction of crowdfunding, of course, is that an investor can share the wealth if a start-up succeeds. Contribute to a traditional crowdfunding campaign and you may get a free T-shirt or CD. Invest in an equity crowdfunding campaign and you may get rich.

That’s a long shot, of course, but your odds of earning a profit and maybe even getting rich will be improved if you proceed with caution. A few tips can help.

Do your homework. The SEC recommends that, like any investment, early-stage companies should be researched thoroughly before you invest in them. Keep in mind that audited financial statements are not required for companies seeking to raise less than a half million dollars, be especially cautious and complete your own due diligence before participating in small campaigns.

Investing in start-up companies is always risky, but a majority of entrepreneurs who have raised funds using equity crowdfunding have successfully achieved their financial goals, according to Sherwood Neiss, a partner at Crowdfund Capital Advisors. Presumably, so have their investors.

“Unlike venture capital, where less than 6.5% of startups successfully raise funds, the success rate in Regulation Crowdfunding hovers around an impressive 60%,” Neiss wrote in VentureBeat. “A key data point for industry followers is that the average raise ($270,996) helps startups hurdle the ‘valley of death’ they often face after expending their internal or personal capital.”

Regardless, the SEC notes that “investments in startups and early-stage ventures are speculative and these enterprises often fail. … You should be able to afford and be prepared to lose your entire investment.”

Think long term. You can buy and sell stock in a public company anytime. Private stock is illiquid. There are exchanges for trading it, like Forge Global and EquityZen, but otherwise if you want to cash out you will have to wait until the company is acquired or has an initial public offering (IPO).

Understand the value of your shares. Public markets set prices for stocks through supply and demand. If a company performs well, its stock becomes more valuable and its price increases. For a private company, the value of its shares is not as well defined.

An understanding of the company’s financials can help you determine the value of shares you receive through crowdfunding, but most start-ups that participate in crowdfunding don’t have a long enough financial history to provide in-depth information.

“In any equity crowdfunding round, the entity’s valuation is a function of the dollar amount raised against the amount of equity offered, independent of company fundamentals,” according to Moneycrashers. “A funding round that raises $1 million in exchange for 20% of a company’s total share count values that company at $5 million.”

Note, too, that there may be additional classes of equity with rights that are superior to the shares made available to investors through crowdfunding.

Knowing the history and experience of the company’s leadership may help you determine whether an investment is worth the risk. If the leadership has had past success, it is more likely to succeed again.

Beware of fraud. While the SEC analysis failed to identify any civil complaints or administrative proceedings filed against Regulation Crowdfunding issuers or intermediaries, the SEC notes that, “As with other investments, there is no guarantee that crowdfunding investments will be immune from fraud.”

The SEC added, “While factors such as the public nature of crowdfunding campaigns, the requirement to use an intermediary, and various other requirements of Regulation Crowdfunding offerings may have served as deterrents to potential misconduct, we cannot distinguish the low incidence of observed potential misconduct from the possibility of high latency of potential misconduct among crowdfunding issuers and intermediaries.”

Potential For Growth

If traditional crowdfunding is included, crowdfunding globally is a $7 billion industry this year, according to Statista, and it’s expected to grow to about $12 billion by 2023.

Regulatory changes, such as higher funding limits, could also spur growth. Consider that in 1978, only $216 million was committed to venture capital funds in the U.S. After regulatory changes, a decade later the amount committed grew to $3 billion.

Will equity crowdfunding experience similar growth? Investors who think so have a chance to get in early.

John Bowens is a national education specialist and retail sales manager for Equity Trust Company, and a national speaker. He can be reached at [email protected].