Every business has options when it comes securing financing for the next phase of growth. In general, these options fall under one of two categories: debt or equity.
Debt, or taking out a loan, is by far the most popular method, thanks in large part to the variety of loan terms and repayment options. At BFS Capital, we offer small business loans and merchant cash advances of up to $2 million with daily or weekly payments. Each loan is customized to fit the needs of the particular business.
But another option now available to business owners is equity crowdfunding. Although equity crowdfunding is mostly intended for startups and early-stage businesses, it is an important addition to the business financing world that bears careful consideration. So what do small business owners need to know? First, some background:
The 2012 Jumpstart Our Businesses Act, or JOBS Act, made it possible for privately held businesses to raise funding by offering equity, or a small stake in the company, to accredited investors.
According to the SEC, an accredited investor is defined as a person with at least $200,000 in individual annual income ($300,000 for couples) or a net worth exceeding $1 million, excluding the value of his or her home. These restrictions are intended to protect unaccredited investors (i.e., everyone else) from investing in potentially risky securities, such as equity in a small business or startup.
However, on October 30, 2015, the SEC approved Title III of the JOBS Act, which will for the first time allow non-accredited investors to participate in equity crowdfunding. The official rules will go into effect 180 days after they are published in the Federal Register.
Now, let’s review how equity crowdfunding works and what restrictions currently exist.
To participate in equity crowdfunding, a company needs to register with the SEC and indicate how much capital they are trying to raise (up to $1 million in a 12-month period) and for how much equity. Once approved, the company can begin to offer securities, typically online via a broker-dealer.
Individual investors, meanwhile, face specific restrictions in terms of how much they can invest. Investors with an annual income or net worth equal to or more than $100,000 may invest 10 percent of the lesser of their annual income or net worth up to $100,000 over a 12-month period. Meanwhile, smaller investors (i.e., those with less than $100,000) may invest the greater of $2,000 or 5 percent of the lesser of their annual or net worth.
There will be a 60-day public commenting period before the rules go into effect, so the exact numbers may vary slightly by the time everything is formalized. In particular, the SEC already proposed raising the maximum amount of capital a company can raise from $1 million to $5 million. There may also be other rules to discourage “bad actors” and provide additional investor protection.
So what does this mean for small business owners? For companies in need of capital, it provides another option to raise funds. However, there are some important considerations business owners need to keep in mind. For example:
- Crowdfunding typically requires a marketing budget. Instead of having to convince a bank or alternative lender that a company is worth lending to, a business pursuing equity crowdfunding has to convince hundreds or even thousands of potential investors. If your business doesn’t already have a well-established brand, then a crowdfunding campaign may eat into your marketing budget as you try to get the word out. Make sure to take the added cost into account before pursuing this strategy.
- A crowdfunding campaign can take a long time. Just because you have a great business idea doesn’t mean that investors will agree. And even if a few do, you typically won’t be able to collect any investor dollars until you close the entire fundraising round. That means waiting, potentially for a long time, for money that may never come. For small businesses dependent on quick access to funding, this waiting game may not be the right way to go.
- You lose the upside if your business takes off. If you run a business valued at $1 million and offer investors access to up to 5% in equity via a crowdfunding campaign, then that means the most you can raise is $50,000. However, if your business begins to do incredibly well and is valued at $10 million the next year, then that equity stake becomes worth $500,000, meaning you lost out on $450,000 in potential upside. So if you’re confident that your business is going to grow, then you may want to hold on to as much of the equity as possible and opt for a loan or merchant cash advance instead.
We are still in the very early stages of the equity crowdfunding industry and it remains to be seen how successful companies will be at raising capital. Before pursuing equity crowdfunding as a fundraising strategy, make sure to think about what your business financing needs really are and to consider what other options are available to you.