Equity-Based Crowdfunding: The Answer for Small Business Capital?

As the availability of small loans steadily decreases, equity-based crowdfunding remains off-limits for the vast majority of Americans, but that is expected to change later this year. The Securities and Exchange Commission (SEC) is expected to release its final rules for equity-based crowdfunding in October 2015, and 16 states are currently working on their own rules. The Small Business Administration (SBA) Office of Advocacy recently released the new issue brief “Equity-based Crowdfunding: Potential Implications for Small Business Capital” to shed light on current crowdfunding policies, the impact of the proposed SEC rules, and how their passage could help small businesses gain access to capital. The report speculates that equity-based crowdfunding “could provide the crucial stream of funding for small business owners and entrepreneurs that is highly sought after.”

Crowdfunding allows people to make investments in various projects and ventures outside of a regulated exchange by way of online social media platforms, which allow direct interaction between the fund-raiser and the investor. The three main types of crowdfunding, according to the SBA report, are:

• Reward crowdfunding, where money is given to the fund-raiser in exchange for a good or service;
• Peer-to-peer, where there is a loan agreement between the fund-raiser and the investor; and
• Equity-based crowdfunding, where the investor acquires a piece of the venture.

Equity-based crowdfunding, created under the Jumpstart Our Business Startups (JOBS) Act in 2012, would allow entrepreneurs to sell equity to investors online via a licensed broker. The SEC, which issued a notice of proposed rulemaking on November 5, 2013, is continuing its deliberations, with final rules expected to be announced this fall.

The Federal Deposit Insurance Corporation (FDIC) reports that small loans (less than $1 million) are decreasing in availability and are more difficult to obtain. The issue brief points out that, in lieu of small loans, equity-based crowdfunding “could create an efficient alternative for small businesses” that are not able to attain their desired level of credit.

Equity-based crowdfunding offers benefits to small businesses that traditional loans do not, the brief states. For example, it does not require a business to put up collateral to receive funds, and it does not increase the chance that a small business may go bankrupt. “Payback is ongoing as a share of future revenues,” the report notes, but investments, unlike a traditional loan, do not need to be repaid if the business fails.

The equity-based form of crowdfunding may be more amenable to small business owners than venture capital funding because it allows them to maintain control over their businesses. While a venture capitalist is often allowed to take a board position or advisory role with a firm, with equity-based crowd-funding a small business owner has the option of making investors “B shareholders,” who do not have a vote in business decisions. This allows the owner to maintain majority control. Moreover, by having a large group of investors, equity is diluted among shareholders.

The SBA issue brief concludes: “[It] is reasonable to assume that ensuring legality, preventing fraud, and protecting investors as well as business owners will be points of emphasis in the SEC’s final rulemaking on equity-based crowdfunding. It could prove to be a beneficial new way for small businesses to buy new equipment, hire employees, or purchase real estate amongst many other possibilities. This new avenue of funding could ultimately shift the way prospective business owners decide to start their firms. It could also provide a new growth option for small businesses that are ready to begin growing, but lack the capital to do so. In essence, equity-based crowdfunding could provide the crucial stream of funding for small business owners and entrepreneurs that is highly sought after.”