After the passage of Regulation Crowdfunding (“Reg CF”) in May 2016, investing in private companies is no longer an exclusive privilege of the wealthy. Since then, the mainstream media has been fixated on how regular Americans have been impacted by equity crowdfunding. Equity crowdfunding is where investors receive ownership of a small piece of the company in return for their investment. The debate remains hot and center, leading the public and entrepreneurs to believe equity crowdfunding is the only innovation under Reg CF.
What has been missing in the big debate is that the scope of Reg CF has actually unlocked the capital markets for private companies. Like publicly listed companies that can raise capital through selling stocks or issuing bonds to the American public, private businesses can achieve the same goals using either equity crowdfunding or debt crowdfunding under Reg CF. That’s right – the secret is you don’t have to give up equity under Reg CF. Debt crowdfunding exists, and is also a highly attractive fundraising method for private businesses.
Then why all this focus on the equity part of Reg CF?
The public has been dazzled by the stories of Silicon Valley unicorns. The dreams of becoming an early stage investor to one, or to be a founder who gets “funded” and propelled to the next generation of tech darlings like AirBnB, Snap or Oculus, are just too sweet. For investors, why worry about how to cash out, or for entrepreneurs, why worry about the cost of capital when equity crowdfunding seems like another gateway to the American dream? Act fast, or you can only be a part of Silicon Valley by watching HBO.
As the old proverb says, “when it is too good to be true, it probably is.” The reality is, equity crowdfunding doesn’t make sense in lots of cases, especially for entrepreneurs. For many entrepreneurs, sale of equity should be the last resort in your fundraising efforts. Equity has the highest cost of capital for businesses owners because you are selling a piece of future profits to investors – forever. For many businesses, there are viable debt solutions, such as subordinated loans or revenue sharing based financing that could address their growth capital needs. However, if your business needs large infusions of expansion capital, if your start-up costs are high and you don’t have visible revenue streams, or if every dollar you make needs to be reinvested – then giving up equity is probably what you must do. Fast growing consumer packaged goods and tech companies are often the ones that need equity investors for these reasons.
Innovation in debt crowdfunding is what gets seasoned entrepreneurs really excited.
Away from the eyes of the public, many startups are focused on bringing innovation under debt crowdfunding to American businesses. Instead of just pursuing a cookie-cutter, highly restrictive bank loan, entrepreneurs now have access to alternative leverage structures, such as subordinated or revenue-based sharing loans. Small and medium-size companies can now fundraise across the capital structure between senior secured loans to equity, just like the big boys do in public markets.
Moreover, investors are just as vested and believe in you enough to put money into your company. Your business stays at the top of their minds because you’re paying them regularly. Most people actually like being debt investors. As a debt investor, they have visibility on their expected return – how much, how often, and for how long they’re getting paid.
Of course, it also needs to make sense for the business. If your business is sharing revenues with investors or paying them a set amount each month, the business needs to generate enough revenue to do so.
Equity or debt?
The actual cost of selling equity may be more than what you think. If it’s friends and family, maybe they’ll cut you a deal. Traditionally, bigger investors will get the first bite, and you’ll likely end up paying them every year until you can buy them out. With equity crowdfunding, you have more ability to set the terms because you’re proposing a take-it-or-leave-it deal to investors. Either way, the total cost of selling equity may not be evident until much later.
The cost of debt may also seem high for first-time business owners. Unless you’re getting an SBA loan or a standard bank loan with lots of collateral, interest rates probably aren’t going to be in the single digit range. Despite the cost, more experienced entrepreneurs prefer to borrow or self-fund to keep control over their company. With debt crowdfunding, you have more flexible payment options and your business should be assessed in line with your industry’s standards, not with one blanket test that treats all businesses the same. Keep in mind that most lenders won’t lend the entire amount you need to open a business and will expect to see other sources of financing. Shop around for rates, but pay attention to what you need to give up to get it.
Now you have more choices.
Regulation Crowdfunding came in to open up a new way to jumpstart businesses. And not necessarily by forcing a business owner to give up equity. Business funding is usually made up of different sources – angel investors put in some money, owners put in some money, get bank loans and get money from other places. Crowdfunding can be a part of that equation now.