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Should You Raise Equity Through Crowd Funding?

Posted By Scott Shane On December 9, 2013 @ 8:00 am In Finance | 5 Comments

raise equity

Last month, the Securities and Exchange Commission (SEC) issued the rules [1] that make equity crowd funding possible. Now that you can, you may be wondering if you should sell shares to the crowd of unaccredited investors. The answer depends on how well equity crowd funding fits your business opportunity.

First, you need to assess whether raising debt or equity is a better way to finance your business. Getting a loan – whether obtained through an online source like Prosper.com or from a bricks-and-mortar bank – makes more sense than selling shares if your business isn’t likely to generate a huge return on investment. Investors buying equity demand greater returns than those lending money to compensate them for the greater risks involved in owning shares.

Borrowing money also makes more sense if you want to keep all of the future profits of your business because equity investors have a claim on future profits, while lenders don’t.

If you want to maintain tight control over your business, you should borrow money, not sell shares. Buyers of equity have the right to participate in your company’s decisions. At a minimum, you will have to discuss future plans with investors before you make them, and you might need their agreement if they own enough of your company. In fact, if the investors disagree with you, and they own a majority of the company, they can replace you as the chief executive.

If you raise equity, you probably need an exit plan. Most equity investors cash out of their investments in start-ups when the business goes public or gets acquired by another business. If you aren’t planning one of those outcomes, equity crowd funding probably isn’t right for your business.

If equity is more appropriate for your business than debt, then you need to evaluate whether tapping the crowd makes more sense than raising money from business angels or venture capitalists. If you need to raise a lot of money, equity crowd funding probably isn’t the right way to go. Crowd funding provides a way to tap the pool of unaccredited investors, but limits those financiers to no more than $5,000 per year invested in any new business. Because you will need more investors to raise more money, and managing large groups of investors can be difficult, the equity crowd funding model probably won’t work well if you need millions of dollars.

Crowd funding also makes more sense if your business needs to raise money just once rather than through multiple investment rounds. Multiple rounds will dilute your investors’ stakes if you don’t give first round investors “pro rata” rights to invest in a new round and make sure your investment rounds occur no more than once per year.

If you plan to tap venture capitalists at some point, beginning with equity crowd funding might not be wise. Venture capitalists might shy away from businesses that have raised a lot of money from unaccredited investors because of the potential legal complications that such situations create.

If you need mentoring from people experienced in building companies or connections to suppliers, customers or management talent, then going the crowd funding route also makes less sense. Unlike venture capitalists or successful business angels, the crowd isn’t likely to offer much in the way of mentoring or connections.

Equity crowd-funding shouldn’t be like the latest iPhone – something people pursue because everyone else they know has it. Rather, entrepreneurs should take a look at their business opportunities and figure out whether raising equity from the crowd is right for what they are doing.

Money [2] Photo via Shutterstock

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[1] issued the rules: http://www.washingtonpost.com/business/on-small-business/sec-introduces-unanimously-approves-crowdfunding-proposals/2013/10/23/f5709630-3bee-11e3-b6a9-da62c264f40e_story.html

[2] Money: http://www.shutterstock.com/pic-126256208/stock-photo-profit-bar-chart-with-golden-eggs-standing-in-front-of-it.html