What is equity crowdfunding?

Equity crowdfunding allows large groups of people to place investments, often of modest amounts, in a private company. Through equity crowdfunding a company could raise $500,000 through 500 investors, making the average investment size only $1,000. Each investor receives stock in the company commensurate with the size of her investment.

In the United States, the JOBS Act opened equity crowdfunding up to people who are not categorized as accredited investors by the SEC. This became possible specifically due to Title III of the JOBS Act, which went into effect on May 16th, 2016 with the publishing of Title III equity crowdfunding rules by the SEC.

The legislation did set some constraints:

Companies are limited to raising $1 million through crowdfunding during 12-month period.
Investors with less than $100,000 in annual income are limited to investing $2,000 or 5% of their income, whichever is greater.
Investors who make more than $100,000 a year can invest up to 10% of their income (so there’s a 100% delta between opportunities for investors who make $100,000 vs. those who make $99,999)
Companies must file to IPO once they reach $25M of assets and 500 or more unaccredited investors
Companies raising money through equity crowdfunding must abide by a large set of disclosures and accounting rules—more below.

Equity crowdfunding’s advent in the United States comes in the wake of a surge in popularity of crowdfunding campaigns on websites such as Kickstarter and Indiegogo, where the people who supply capital receive early pricing on a product or a service, rather than actual equity in the company, which would have violated finance law before the JOBS Act.

Startups that raise money through equity crowdfunding are required to supply, on an annual basis, financial statements abiding by GAAP rules, reviewed by a public accounting firm, a service that companies must pay for themselves. In some cases, crowdfunded companies must assent to a full auditing, which brings further expense. Their information also becomes part of the public record.

This is in contrast to startups that raise money with traditional angel investors, venture capital (VC) investors, and online startup investing platforms that do not use Title III and instead comply with existing VC regulations (such as FundersClub). Companies raising with such investors aren’t required by law to supply annual GAAP accounting documents, to publicize financial and other information about their company, to make annual filings, to IPO at a time other than when they choose, or take other measures that companies that raise using Title III portals must do by law.

Occasionally, "equity crowdfunding" is used to refer to online startup investing platforms that do not use Title III equity crowdfunding regulations and rules. A more accurate term than "equity crowdfunding" for such non-JOBS Act online investing platforms is "marketplace investing". Platforms of this type break into two groups:

Online VC (if the platform follows the offline VC model of being paid a percentage of profits generated rather than a commission on dollars invested), or
Online broker-dealer (if the platform follows the offline broker-dealer model of being paid a commission based on dollars invested, rather than a percentage of profits generated)

The primary economic incentive for online VC platforms is to drive profits, whereas the primary economic incentive for online broker-dealer platforms is to drive volume. Per current regulations, marketplace investing is only allowed by accredited investors and is not open to unaccredited investors.