When it comes to raising capital for companies, private equity has been the gold standard for years. However, there is now a new kid on the block. This is “crowd funding” and it is on the rise. This new approach is positioning itself to overtake private equity as the primary means that businesses are using to raise capital. While both private equity and crowdfunding are used to raise capital for business, the manners in which they do so are very different.
CROWDFUNDING
Crowdfunding is a method to raise capital through family, friends, customers and individual investors. The technique used is to raise small amounts from a large group of people. This is typically done via the internet. On a global level, crowdfunding has increased dramatically. In 2013, $6.1 billion was raised in funding. In 2014, that amount went up to $16.2 billion. Business and entrepreneurship was the most popular crowdfunding category, collecting $6.7 billion in 2014, followed by social causes ($3.06 billion), films and performing arts ($1.97), real estate ($1.01 billion), and music and recording arts ($736 million).
There are three different types of crowdfunding.
1. Donation Based. This type of crowdfunding is not usually used for businesses but more for non-profits, charities, and disaster relief.
2. Reward Based. Individuals who invest in your business will be rewarded generally in the form of a product or service offered by your company.
3. Equity Based. Investors will become part owners in the company and will receive a financial return on their investment.
The Massolution Crowdfunding Industry report forecast strong growth for crowdfunding in 2015, with a year-end projection of $34.4 billion. Globally, the largest volume of investments in crowdfunding have come from Asia, Europe, and North America. According to the report, there are 1,250 active crowdfunding platforms (CFPs) across the world. Last year, the top crowdfunding platforms included GoFundMe, which raised $470 million in 2014 and Kickstarter which raised $444 million, according to Crowdfunding.com.
Advantages of crowdfunding over private equity funding.
• It can be a fast way to raise funds without paying upfront fees.
• The internet makes marketing easier than relying on traditional marketing firms.
• You can receive feedback and guidance from experts along with the opinions and reactions from the public.
• Most importantly, you may be able to find funding when conventional forms have failed.
Disadvantages of crowdfunding for your business.
• Not all businesses that apply for a platform receive crowdfunding.
• It is your responsibility to build up your platform.
• If you do not receive the necessary investments that you require then everything raised is returned to the investor leaving you with nothing.
• You reputation can be damaged by failed projects.
• If you do not have a patent or copyright on your idea someone may see it and steal it.
Weighing the pros and cons of each option is key.
PRIVATE EQUITY
Private equity is an investment made into a business often by a private equity firm. These investments are administered by managers that use a variety of strategies such as a leveraged buyout, venture capital, and growth capital to infuse cash into a business. Private equity firms generally charge a management fee and a performance fee. There are three ways that private equity firms receive a return on their investment.
1. Initial Public Offering (IPO): When shares of a private company are offered to the public for the first time thereby offering some immediate financial gain to the investor.
2. Merger or Acquisition: This means the company is either sold for cash or shares in another company.
3. Recapitalization: This occurs when the investor distributes cash to public shareholders through funds produced by the company. Investments can also be made by a venture capital firm where investors provide money to startup firms and small businesses that they believe have long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets.
Yet another way to raise capital is through an angel investor which is also known as a business investor. This is a wealthy individual who is willing to provide capital for a business startup in exchange for a convertible debt. Convertible debt is a type of bond that the holder can convert into ownership equity, a specified number of shares of common stock in the issuing company, or cash of equal value.
Private equity firms invested $347 billion in 2,083 U.S. companies in 2012, spread across different industries and in different states—the biggest recipient of private equity funding was Texas, followed by California, Colorado, Illinois and Florida. Private equity funding is also available to companies in many countries around the world. However, it is important to understand the advantages and disadvantages to private equity. While the potential of making a great deal of money is possible, it is also possible to lose control of your company. Private equity is able to provide large sums of money and the investment firm can be very hands on while finding ways to increase your capital. Making sure that the legal agreements that govern these transactions are well drafted to protect your rights is very important.
There are a variety of reasons why private equity is declining while crowdfunding is on the rise. The major reasons for this are new tax laws, rising interest rates and the fact that private equity is not the most efficient approach for businesses so that they can maximize their profits.
When companies are heavily leveraged with debt, they have less financial flexibility as a company which can negatively affect the economy. However, with crowdfunding you are not guaranteed to raise the funds that are necessary for your business. Your decision on what is the best choice for your company will be determined on the amount of funding you are looking for and the type of business that you own. You must also consider the amount of control of your business you are willing to give to others.
DISCLAIMER: The information contained herein is not intended to be specific legal advice for your particular situation. It is meant to provide general information on the changing landscape of the law. You are encouraged to contact legal counsel for legal advice specific to your particular legal situation.
