Preparing for Equity Crowdfunding
Equity crowdfunding will not become available for mass use until early 2013. However, it is expected that a great deal of investor money will be ready for equity crowdfunding when it comes online. Wefunder.com reported on April 6, 2012, just one day after the JOBS Act was signed into law, that it had close to 4,000 investors pledging more than $9.6 million dollars into equity crowdfunding offerings.
#1. Create Target Equity Crowdfunding Goals
In order to participate in equity crowdfunding, you will be required to choose a target investment amount that must be reached before a crowdfunding intermediary will be legally allowed to release any funds to your business. Clearly, the target amount should be set so that even a moderately successful funding results in an influx of capital for your business. However, be sure that you can at least achieve a minimum set of goals that will in turn be capable of producing returns for you investors with the target amount set. If the target amount is set too low, investors will be unhappy when you have spent their money but are unable to give a return on their investment. Start doing your homework and specifically research what you will need to spend to reach a minimum set of achievable goals.
Similarly, if you raise excessive funds compared to what is needed to achieve your goals, the returns you generate for investors will be diluted by the number of investors and the amount of money raised. A little padding for unforeseen contingencies is fine, but try to avoid raising $250,000 if $100,000 would have met all your goals. If you are returning $10,000 per year to investors, a 10% return on $100,000 will make your investors much happier than a 4% return on $250,000.
#2. Determine the Number of Shares to Sell to the Crowd
If you are equity crowdfunding an existing business, the amount of equity you will be giving away is directly related to the current value of your business. There are dozens of methods for arriving at the value of a going business, but each method will rely upon factors of assets less liabilities plus some multiple of net profits.
An oversimplified example for a business which owns $30,000 worth of equipment, owes $10,000 to creditors, and has a steady net profit of $60,000 per year over the past several years may be worth approximately:
($30,000 – $10,000) + ($60,000 x 3) = $200,000.
If that business owner wants to use equity crowdfunding to raise $50,000 capital to open a second location, then the amount to be raised divided by the total value of the business would yield the amount of equity the owner would have to sell, which in this case is:
$50,000 / $200,000 = 0.25 = 25%.
To sell 25% of the equity to a crowd, a decision must be made as to how to set the share price, which will then directly dictate the number of shares that must be held by the owner, and the number of shares that must be sold to the crowd. Assume it is thought desirable to sell a minimum of 100 shares per investor at a price of $2.00 per share. Divide the value of the company by the desired share price to arrive at the total number of shares which must be issued and outstanding, as shown in this example:
$200,000 / $2 per share = 100,000 shares.
Of these shares, 75% will be held by the owner, and 25% will be sold to the crowd, thus:
75,000 shares held by owner; and
25,000 shares sold at $2 per share to the crowd.
If the value of your company and share price you believe will be ideal leads to a number of shares which exceeds the number authorized by your current articles of incorporation or charter, now is the time to meet with your attorney and amend your founding document to allow for sufficient shares in your capital structure.
Start-Ups with No Operating History
Determining the share price for a start-up with no operating history is simple compared to a preexisting business because essentially the stock is worthless (or maybe worth the price you paid to incorporate) if you have zero operating history and no assets. In such a case, be clear in the business plan (and later in the investment documents) that the share price selected is arbitrary due to the lack of operating history. Also, make sure that if the same class of securities is being held by the founder and equity crowdfunding investors, that the percentages are balanced to allow for healthy dividends to be paid to investors without overly enriching an already compensated founder. It may be advisable to issue at least two classes of securities, one to founders, officers, and directors, and another to investors so the dividends paid to each class may be managed equitably.
#3. Start Working on a Business Plan
Creating a solid business plan is key to enticing prospective investors to entrust you with their money, and equity crowdfunding will be no different. A good business plan includes solid numbers for how investor funds will be used and how those funds will create or grow profits.
Investors do not usually invest in small or startup businesses because you are a nice person; they invest because they are expecting a return on their investment. Make sure the business plan clearly states how and when investors will receive a return on their investment.
Another thing to consider while working on your business plan is an exit strategy for your investors. While securities acquired through equity crowdfunding may be resold one year after issuance, it is unclear whether a strong secondary market will develop to facilitate such sales. Will your investors want to remain your investor indefinitely? Will you eventually want the option to repurchase the securities? Including such flexibility in a business plan (and later in the investment documents) may ease your potential investors’ fears of illiquidity.