Initially, crowdfunding was limited to a reward or donation basis, and was made popular by sites such as Kickstarter and Indiegogo. By collecting incremental donations from hundreds or thousands of backers, these sites pool the capital necessary to launch products and support ideas of various sizes. In return for backing products, funders receive prototypes, discounts, or special product packages, while those participating in donation-based funding do not expect or receive anything in return. Although these types of crowdfunding skyrocketed in popularity, growing by 524% from 2009 to 2012, their potential to benefit startups pales in comparison to that of equity crowdfunding.
Today Crowdfunding exists in 4 main forms:
- Reward-based Crowdfunding: Funders back products, arts, and other ideas in exchange for products, discounts, or other incentives.
- Donation-based Crowdfunding: Funders contribute to philanthropic causes, expecting nothing in return.
- Equity Crowdfunding: Funders back startups and other projects, receiving equity, as well as revenue or profit-share, in return for their investment.
- Loan or Debt Crowdfunding: Funders loan money, expecting income and the return of their initial investment. Also seen as an alternative to a traditional loan.
JOBS Act, Intrastate Crowding Rules and Exemptions
On April 5, 2012, President Obama passed the Jumpstart Our Business Startups (JOBS) Act. The initial document also referred to as Title I of the JOBS Act, allows accredited and sophisticated investors to view investment opportunities involving startups and related projects via password-protected sites.
Title II of the JOBS Act went into effect on September 23, 2013. This allows brokers and crowdfunding portals to publicly advertise the need for funding, although these investment opportunities are still limited to accredited investors.
The goal of Title III is to level the playing field for everyday citizens looking to invest. Once enacted, Title III will allow issuers to advertise and extend investment opportunities to unaccredited investors, potentially causing the U.S. investing market to grow to $300 billion.
According to Title III rules proposed by the SEC in October of 2013, transactions involving these unaccredited investors must meet specified requirements, such as: 1) The amount raised must not exceed $1,000,000 in a 12-month period, 2)
Individual investments in a 12-month period cannot exceed the greater of $2,000 or 5% of net worth for those making less than $100,000 annually, and $10,000 or 10% of net worth for those making at least $100,000 annually, 3) These transactions must be conducted through an intermediary that is either a broker or a funding portal.
With a less sophisticated investment audience comes more regulation. Thus, there is no effective date currently in place for Title III of the JOBS Act. To circumvent this issue, numerous states such as Indiana and Michigan have created their own exemptions to this regulation by passing less restrictive legislation. To date, nearly 15 states currently have intrastate crowdfunding regulations in place.
Benefits of Equity Crowdfunding vs. Reward-based Crowdfunding
In reward-based crowdfunding, a target amount and deadline are set for a project. Once a raise begins, promotional videos are usually released to generate and maintain interest in the project. Funders then pledge in certain tiers, receiving different rewards based on the amount donated. If the target amount is hit on or before the deadline, backers are charged the amount they pledged and are given the corresponding reward. This creates an incentive for individuals to promote the project themselves through social media and other channels. However, if the target is not hit, none of the backers are charged or rewarded. Because of this process, rewards-based crowdfunding is an all-or-nothing approach.
Though equity crowdfunding and reward-based crowdfunding provide support for up-and-coming projects and products, equity crowdfunding offers a greater reward for startups and investors who desire to back them. Equity crowdfunding allows individuals the opportunity to invest on a larger scale, raising 40 times more per company than any other type of crowdfunding today. This provides a middle ground between the $ average reward-based donation and the traditional five-figure minimum sum required to invest in a company.
With reward-based crowdfunding, the bragging rights of those who donated at early stages grow with a company, but the reward remains the same. Conversely, equity crowdfunding allows the investor’s commitment to growing side-by-side with a startup, providing a growing revenue or profit-share.