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What is Equity Crowdfunding, and How Does It Work?

JL Law

What is Equity Crowdfunding.png

Crowdfunding has gone from a niche market that only a few investors are aware of, to a buzzword that anyone with a TV or an Internet connection has heard. What most people might not know, though, is that there are several types of crowdfunding, and each of them obeys different rules. Equity crowdfunding, for example, is something that's quite popular with investors looking to diversify their portfolios and branch out into different income investing opportunities.

But what is it? How does it work? And most importantly, how can you use it to make your investment portfolio just a little bit fatter?

What Is Equity Crowdfunding?

According to this source, equity crowdfunding is when investors who fund a company that is not traded on the stock market receive shares of stock in exchange for their contribution. If the company does well then those who crowdfunded it will receive benefits because they backed the business.

Here's an example to illustrate how the process might work in a hypothetical situation. Let's say Mark wants to open a business to produce 3D printed dice cups. His company is small, and won't be traded on the stock market. Instead of going to the bank for a loan, he uses equity crowdfunding to draw investors to his idea. The investors give Mark the money he needs, and in return he provides shares in the company according to which investors provided capital. If the company does well and makes profits, then the investors will receive part of the profits according to their stock just as if they had bought those shares through a more traditional market.

While this sounds like business-as-usual for most investors, the difference is that equity crowdfunding is open to everyone. It's the difference between traditional patronage, which was seen as the domain only of the wealthy, and a crowdfunding site like Patreon, which allows anyone with an account to provide a little money to a creator they like. In the case of the former, a select few investors would often donate thousands of dollars as patrons of the arts. With the latter, though, there is no limit to how much or how little someone can give. So, while a patron of the arts can still donate hundreds of dollars to an artist through Patreon, hundreds of individuals who like that artist's work can all chip in to give them one dollar a month. This opens up the world of support to anyone who wants to participate, and be a part of that artist's patronage.

Equity crowdfunding works the same way, but with business start-ups. The idea is that by appealing to the biggest possible audience, you're not asking any one person to invest a great deal of time and money. So, while it's perfectly possible for an investor to put up thousands of dollars as an investment, it's also possible for thousands of investors to chip in a few dollars in order to help that company reach its goals.

What Happens If The Company Fails?

Equity crowdfunding is just like buying stock on the stock market, and that similarity includes the potential for failure. Just because someone funds a given project, that doesn't mean the business is going to succeed once it is fully funded. If it does, then investors get a cut of the profits. If it fails, then they lose their investments. The smaller scale of equity crowdfunding often appeals to those who want a more ground-level project, though, and there's often less competition for investments in projects that aren't available through the stock market. So, while the potential for loss is still there, it's offset by the relatively small nature of the investment.

Want to learn more about equity crowdfunding?  Check out this Guide to JOBS Act Crowdfunding.