How is Equity Crowdfunding Different?
Equity crowdfunding is perfect for companies that are looking to raise more capital than those that choose a rewards-based approach. These companies are typically seeking sums higher than $50k and have achieved social proof and gained enough traction to incentive their backers with the chance to own a small piece of their company as it grows.
The very nature of equity crowdfunding makes it a considerably more involved fundraising approach than rewards crowdfunding. Add to that the fact that it’s still a fairly new funding method and that the rules and regulations are still evolving with new federal legislation, and it can be a little tricky to navigate. Lucky for you, we’re here to help you get oriented and on your way to a successful equity campaign of your own. In this chapter, we’ll walk through setting your fundraising terms, preparing your campaign, new legislation, and how to drive investors to your business.
Setting Your Terms
Here are the basic terms you’ll need to consider for any equity round, and how you can begin to think about them with our particular fundraising goals:
Raise Amount – The natural starting point for any round raise is deciding exactly how much capital you want to raise, which will stem directly from your predetermined business goals. Whether you’re looking to raise capital for equipment purchase, a facility build-out, or the next year’s operating expenses, you’ll need to decide on a figure that’s high enough to finance your stated goals, but also that’s low enough that you can meet or surpass it by the end of a 60-day crowdfunding campaign.
Duration – How quickly you close your campaign will depend on a number of factors, like the amount you’re raising, the completeness of your business plan and supporting documentation, your ability to pre-empt your potential investors’ questions with these materials, and their own due diligence. A typical equity campaign on Fundable lasts 60 days, and though you decide how long yours runs, your committed investors will have to renew or withdraw their commitment every 90 days. This ensures that both parties—startup and investor—retain some flexibility and control and aren’t locked into an arrangement that doesn’t fit their fundraising and investment goals.
Equity or Convertible Debt? – Most startups will be raising their first equity round using straight equity, which means that investors get an ownership stake in the business at a set valuation when they invest. Another option, convertible debt, is a slightly different instrument that implies that a valuation is not set right now, but will be set at a later date.
Convertible debt is an attractive option for some startups, as it allows them to defer setting a valuation until a later equity round, and it also keeps the founders’ ownership stake intact as they aren’t exchanging investment for shares.
The primary appeal of convertible debt for an investor is the opportunity to invest their money as a convertible note, wherein their initial investment is automatically converted to equity at a discounted rate during a later funding round. By receiving more shares at a later date in exchange for their initial investment. For more about the differences between equity and convertible debt, and which approach may be right for your business, check out Mashable’s Convertible Debt vs. Equity: Which Is Right for Your Startup?
Valuation – The valuation is the proposed value of your company at the time of the investment. Be sure to include the amount that you are proposing to raise in your total valuation (also known as a “Post-Money Valuation”). For Example, if you are valuing the company at $750,000 and are raising $250,000, the valuation is $1 million, and investors in this round are getting 25% of the total value, including their investment.
What’s my Valuation?
Because your early-stage valuation is based mainly on where you project you business will go in the future, it can be tricky to figure out. Here are some major factors that will influence your startup’s valuation:
Traction – This is perhaps the most valuable asset that a startup can show a potential investor, and plays a key role in determining its valuation. Have you achieved social proof? How many users have you acquired? How quickly did you acquire them? Do you have pre-orders? Have you gained exposure or endorsement through favorable media coverage? Do you have any committed advertising partners?
Reputation – Investors will always be more interested in your opportunity if you’ve got a seasoned team behind it. Entrepreneurs with prior successful exits or a Board of Directors comprised of industry veterans are sure to catch the eye of investors and merit a higher valuation.
Revenue – If your company already has paying customers and is generating revenue, it becomes easier to value because your financial projections are based less on estimate. Early-stage revenue, however, can be a double-edged sword when it comes to valuation—it can both raise and lower it. That’s because if you’re already charging users for your product, you may gain new customers more slowly, resulting in slower overall growth. When it comes to valuation, this becomes a balancing act—investors want to see that you’re making money, but they also want to see that you’re positioned for rapid growth.
Timeliness – An up and coming startup in a “hot” industry will often be more appealing to investors, contributing to a higher valuation for your company.
Dilution – The concept of dilution is fairly simple–as you take in equity investment from investors, they become part-owners in your company, which means that your ownership percentage decreases. The more people sharing the pie, the smaller the pieces.
It’s important to carefully consider the total dilution you’re comfortable with as you plan your equity round, and that decision will be closely tied to your company valuation. The idea of coming out ahead as your ownership stake is diluted may seem counterintuitive at first. After all, how do you win by giving up ownership of your company?
As we said, it all comes back to valuation. The goal in closing any equity round is to own a smaller percentage of a much larger, more valuable company.
Let’s look at some numbers for a quick example:
If you own 10% of a $1M company, your ownership stake is worth $100k.
If you kick off a new funding round with a funding goal of $2.5M and a $7.5M valuation going into the round, your post-money valuation is $10M.
After raising that $2.5M, your ownership percentage gets diluted by 25% (2.5M capital raised / 10M post-money valuation), and drops from 10% to 7.5%.
After the funding round closes, the value of your ownership stake increases from $100k to $750k.
For more on equity dilution, check out this excellent explanation and infographic from entrepreneur-turned-VC Mark Suster at his blog, Both Sides of the Table.
Preparing to Launch
As you might guess, preparing to actually launch an equity campaign look a little different than setting up a rewards campaign. Making sure you have all the pieces well in advance of your fundraising round, or at least having a plan for getting them created, will help you avoid any delays or surprises as launch day approaches. Here’s a list of everything you need to put together a successful equity campaign on Fundable:
Executive Summary – This is the high-level overview of what your business does, how your product works, and your strategic plan to develop the business. This is often the first part of your offering a potential investor will read, so it needs to be enough to engage them, but isn’t meant to be comprehensive.
Terms – As we covered above, you’ll need to decide upon and clearly state the terms of your fundraise, including the amount that you’re looking to raise, the total percentage of equity you’re offering potential investors, and any other relevant deal terms. You’ll also have to set a campaign duration so investors know when the deal is expected to close.
Business Plan – This is the comprehensive summary of your business and your detailed plan for growth and profitability. Your business plan should include a detailed analysis of your market segment, sales and marketing strategy, strategic growth plan, and corresponding financial plan. Fundable doesn’t require you to present a full business plan, however it’s an extremely helpful tool in convincing prospective investors that you’ve thoroughly planned and charted your business’s course forward.
Pitch Deck – The pitch deck is a simpler, more visual adaptation of your executive summary, and is most widely used for in-person presentations. More and more, the pitch deck is replacing the executive summary as the first document requested by investors, as it forces entrepreneurs to be brief and to-the-point. Remember, your potential investors are often short on time, patience, and attention, so do everything you can to present your materials in an easily digestible format.
Financials -At the very least, your investors will want to see your use of funds and multi-year financial projections before considering investment. We recommend providing this information as a downloadable file on your crowdfunding profile.
Closing Documents – When you close your fundraising round, you’ll need to have some specific documents ready for your committed investors. For example, you’ll need to complete a subscription agreement which provides detailed terms of the investment. At the very least, have a working draft of your subscription agreement and other closing documents prepared before your round closes.
Rules of the Game
As we discussed in Chapters 2 and 3, the equity crowdfunding landscape is relatively new and is very much in a state of growth and evolution. With the ongoing implementation of the JOBS Act, we’ll continue to see changes well into 2014. Here are the 2 primary areas of crowdfunding legislation, where they currently stand, and what they mean for you:
General Solicitation – Title II of the JOBS Act, implemented on September 23, 2013, deals with the removal of the 80-year-old ban on general solicitation, a company’s ability to publicly advertise that it’s seeking investment. While this gives startups tremendous new flexibility in promoting their crowdfunding and extending its reach, there are still some rules and guidelines in place to protect both startups and investors. The basics are:
Startups must take reasonable steps to ensure that their investors are accredited. For more on the basics of Title II and general solicitation check out the Fundable General Solicitation Infographic, or see the full SEC rules.
Accredited Investors – Title III of the JOBS Act, still pending and slated for implementation in early 2014, will allow non-accredited investors to invest small amounts in private companies online. Currently, only accredited investors, individuals with a net worth exceeding $1MM or an income exceeding $200K for the past 2 years, are legally allowed to invest in private companies. As this changes, the number of available investors in the U.S. will leap from 3.4MM to over 233.7MM, with an estimated combined net worth of over $50 Trillion.
For more information about the Title III rules for potential investors and companies seeking investment, reference Chapter 3 of this guide, The Future of Crowdfunding, see the SEC’s Title III Fact Sheet, or read the Full Title III Rules.
Now that we’ve covered the different types of crowdfunding, we’ll take a look at how to make your campaign a success. In the next chapter, we’ll discuss some of the characteristics of successful entrepreneurs and key considerations as you approach a crowdfunding campaign of your own.