There are a variety of financial instruments that entrepreneurs and startups can choose to utilize when raising capital. Some of the more well-known choices include common stock, preferred stock, and convertible notes, but another alternative is a crowd note. Primarily used in equity crowdfunding, crowd notes can provide unique benefits to startups seeking to raise capital. In this blog, learn more about understanding crowd notes and why startups might want to consider utilizing them.
Understanding Crowd Notes
Crowd notes are a relatively newer form of investment instrument that has gained traction in recent years, particularly within the startup ecosystem. Designed to simplify the fundraising, crowd notes have become a popular option, especially for startups raising through equity crowdfunding.
The JOBS Act
When Title III of the JOBS Act was initially passed[1], startups were able to raise up to $1.07M over a 12-month period from non-accredited and accredited investors alike. The amount a startup was able to raise was subsequently increased to $5M[2]. These regulations helped to expand access to startup investing to the “everyday investor”, or a non-accredited investor who did not meet the prior requirements of accreditation set by the SEC[3].
Capitalization Tables
When a startup is raising capital, they typically keep track of equity investors on a meticulously maintained document called a capitalization table (or cap table). Previously, if a startup was raising equity funding from accredited investors through one of the securities regulations, each investor would typically appear on the cap table as one specific line item.
Crowdfunding Challenges
With the emergence of non-accredited investors on the startup investing scene, the number of investors that should appear on a cap table increased dramatically. Cap tables grew in size and became harder to maintain. Another solution beyond the traditional financial instruments was needed in order to better maintain the document[4].
Enter Crowd Notes
Crowd notes were created to help address the challenges associated with equity crowdfunding, like a large number of equity investors on a cap table. Essentially a modified form of a convertible note, crowd notes can allow startups using equity crowdfunding to keep crowd note holders off the cap table.
Crowd Notes vs Convertible Notes
Convertible Notes
To best understand crowd notes, we’ll first define convertible notes.
A convertible note is a financial instrument structured as a loan that has the ability of converting the debt into equity in connection with a specified equity financing event or maturity date. However, a conversion event may not occur and the convertible note would remain as debt. Sometimes containing additional clauses that include interest rates, discounts, and/or valuations caps, a convertible note in the simplest terms is debt with the potential to become equity.
Crowd Notes
Unlike convertible notes, crowd notes do not have a maturity date. Crowd notes are not debt and there is no repayment obligation. Since there is no maturity date, crowd note holders do not automatically convert to equity shareholders at a predetermined date, allowing them to be kept off the cap table. There can be trigger events at which a crowd note is converted to equity, like qualified equity financing, but these typically do not happen automatically, like with convertible notes.
Final Thoughts
The creation of crowd notes helped alleviate the concerns and problems associated with allowing a larger number of investors to participate in equity crowdfunding opportunities. Providing unique benefits to startups like keeping a “cleaner” cap table, crowd notes can be an appealing option to startups seeking to raise capital.
Is your startup looking to raise capital and you need to decide which financial instrument to use? Apply today to raise capital with MicroVentures – we can help you choose the right path for you!
Want to learn more about tips for startups raising capital? Check out the following MicroVentures blogs to learn more:
- Fulfilling Financial Instruments: Common vs Preferred vs Convertible
- Reaching New Audiences: Effective General Solicitation
- The Art of Bootstrapping: When to Pursue External Funding
- Less is More: Compelling Pitch Deck Design
- Navigating Equity Allocation: How Much Should I Give Up?
[1] https://www.sec.gov/about/divisions-offices/division-economic-risk-analysis/staff-papers-analyses/us-securities-based-crowdfunding-under-title-iii-jobs-act
[2] https://www.sec.gov/newsroom/press-releases/2020-273
[3] https://www.sec.gov/resources-small-businesses/capital-raising-building-blocks/accredited-investor
[4] https://microventures.com/crowd-note-vs-convertible-note-whats-the-difference
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
