Are you an investor or business owner looking to give Regulation Crowdfunding a try?
A relatively new asset class, Reg CF has evened the investing playing field by providing “ordinary” investors (i.e., non-accredited investors) the opportunity to invest in and support the needs of small business owners.
Perhaps you are an entrepreneur interested in funding a boutique hotel in your local community. Or maybe you are a Millennial investor looking to diversify your portfolio as we head into the next recession.
Whether you want to invest or find investors, Reg CF is a game changer. If you are totally new to the concept of crowdfunding, it’s important to have a strong understanding of the Reg CF fundamentals.
The best place to start? Reg CF offerings.
There are a variety of offerings that business owners can choose from when doing a raise, and understanding each offering is vital to investors and business owners alike. In today’s article, we are going to provide a high-level overview of the most popular types of offerings available through Reg CF, including their similarities and differences.
Let’s get started.
What’s a Revenue Sharing Note?
A “rev share” is a debt structure that works like a royalty payment.
A business pays a set percentage of its revenue until an investor is paid back a “multiple” of his or her investment. For example, a business may agree to pay 5% of its revenues each quarter until investors make 1.5x (the multiple) of their original investment. As an investor, you would expect to turn $1,000 into $1,500.
The amount of time it takes to pay is dependent on the business’ revenue.
The beauty of a rev share is in its simplicity and flexibility. A business knows exactly how much it will pay out, but its growth rate will determine how quickly they pay it back. And for the investor, this debt-investment vehicle provides the possibility of a short timeline for repayment so long as revenue remains high.
What’s a Term Loan?
A term loan is exactly what you’re used to in a loan–regular payments (likely quarterly in this case), a set interest rate, and a maturity date dictating when the loan ends.
A pleasant surprise when offering with Vicinity is that our term loans typically don’t come with personal guarantee requirements or specific collateral against the loan. This is a way for a business to empower its community members to act as its bank, with the benefit of turning investors into local brand ambassadors.
Similar to a rev share, this is a non-dilutive way (i.e., not giving up any ownership) for a business to raise growth capital. Either of these can work well for a business that is in a position to make debt payments and is not necessarily looking for an exit/sale.
What’s a SAFE?
This is where investors place their money in an airtight, fireproof lockbox that is only accessed when… just kidding.
A SAFE is a Simple Agreement for Future Equity–meaning the business is simply agreeing to give investors equity in the future, but without determining a specific price per share at the time of the investment. This offering is often used by early-stage startups because it delays the challenge of determining how much the company is worth.
The number of shares an investor receives is determined at a future-priced investment round, typically with professional investors. Therefore, it only has value if the startup raises capital in the future. When they do convert, the SAFE investor typically gets a lower price per share than the professional investors since they invested earlier.
The share price for a SAFE holder is determined by a Valuation Cap and/or a Discount Rate, making these the really important parts of the agreement!
The valuation cap sets the maximum price on the stock.
Let’s quickly illustrate how a Simple Agreement for Future Equity works with a quick example.
If a valuation cap is set at $3 million and the company later raises at a $6 million valuation, the amount of stock an investor gets will be priced off the $3 million. If the valuation is $3 million or less, then the stock price is set off the actual valuation.
The discount rate simply applies a discount to the share price for SAFE holders as compared to future investors. For example, if the shares at a future priced round are $5 per share, a 20% discount rate would convert the SAFE holder shares to equity at a price of $4 per share ($5 * 80%).
As a Regulation Crowdfunding investor, it’s important to remember that the lower the share price at conversion, the more shares you get. The valuation cap and the discount rate give you the opportunity for cheaper shares for taking the risk of investing earlier.
What’s a Convertible Note?
Also a popular form of capital for an early-stage startup, a convertible note is an unsecured loan that converts to stock in the future.
Similar to the SAFE, this type of offering delays the task of determining the value of the company and converts to shares at a future qualified financing round. Also, like a SAFE, the conversion is intended to be discounted based on a valuation cap, a discount rate, and also accounts for an interest rate (unlike a SAFE) for taking the risk of investing earlier.
Another difference to highlight when comparing a convertible note to a SAFE is if a second round of funding does not happen, the note becomes due at a set maturity date. If not repaid in cash (which can often be difficult for an early-stage company), the note converts to equity at a pre-set target price.
What Are Stock or Membership Units?
These are actual ownership shares in a company.
When investing through Reg CF, these will rarely come with voting rights, but do give investors an immediate legal ownership stake in the company. This may result in dividend payments, preferred returns, and appreciation/depreciation in value over time.
Real estate investments and some startups may sell ownership shares to the public through Reg CF. As part-owners, investors will have different tax implications to be aware of. For example, a tax form called a Schedule K-1 will be issued by the company to all owners and will need to be submitted as a part of the investor’s tax filings.
So, Which Reg CF Offering Is Best?
Every situation is going to be different. Whether you’re an investor or an issuer, picking the right offering is a key component to your Reg CF success.
And while there is no cookie-cutter formula for deciding on a Reg CF offering type, the best approach is to research and understand the fundamentals so you can make an informed decision. Investors have the flexibility to choose multiple types of offerings at once, however, based on the regulations, issuers will have to choose wisely with a single type of security for their raise.
While details of Reg CF offering types might not be the most exciting part about funding a local business, having a good grasp of the fundamentals will give you a leg up on choosing your ideal offering type!