IPO vs Equity Crowdfunding
IPO is frequently compared to equity crowdfunding, and some people even mistake one for another.
Even though both processes are indeed connected with raising capital, they are different.
In this article we are going to explore both.
In an IPO, the shares of a private company go public. An IPO can serve to raise equity capital for a company and to monetize the investment of private shareholders and the company founders.
For an IPO, the company will be listed on a stock exchange. Initially, the company’s shares are offered to a closed circle of institutional investors. Later the shares can be traded freely and thus, become available to the public.
Listing on a stock-exchange is a lengthy and costly procedure that’s why for many startups, an IPO is not an option.
This is one of the main reasons why startups prefer raising funds via equity crowdfunding campaigns.
If a startup executes an equity crowdfunding campaign properly, it can create the basis for a business model capable of supporting an IPO. So crowdfunding platforms can serve as a good base for startups who want to move to an IPO later.
For investors, it also means an opportunity to move to investing in an IPO at a later stage.
What is better: IPO or crowdfunding?
The core of both IPO and equity crowdfunding is the same: it is offering the company’s shares to the public for money. But the requirements for companies raising funds via IPO and crowdfunding differ in many aspects, as well as requirements to investors and limits.
IPOs: legal requirements and limitations
Companies that offer IPO have to meet certain eligibility criteria. First of all, the company needs to register on a stock exchange.
For this, the company is required to pass a costly and time-demanding process that may last up to 6 months. A company hires an investment bank that underwrites the IPO. It helps the company to determine the initial price of its securities.
Further, the company fills in a Form S-1 with the Securities and Exchange Commission in the USA. Along with other relevant data, this form includes also the company’s prospectus where the information about the company is provided. There, the company also indicates what securities will be offered and shares the plans of how the IPO will be processed.
Legally, there are no limitations for investors who want to participate in an IPO.
However, the complexity of the process makes such investment accessible mainly for high net-worth investors and venture capitals. General investors can participate in an IPO directly, which means buying shares at an offering price, only if these investors are direct clients of the underwriter involved in an IPO.
However, underwriters prefer to distribute most shares among their high net-worth clients and institutional investors such as venture funds, pension funds, and similar.
That’s why being able to participate in an IPO directly is a unique opportunity for a private investor. The process of share distribution can be displayed as follows:
Another limitation is the price of the shares as well as requirements to investors. Some shares might be very expensive, and sometimes, brokerage firms can request from an investor to have a specific sum of money or perform a specific number of transactions.
Another option to participate in an IPO is to purchase the shares when they are resold in the public market. This option is more viable for individual investors and there, the price of the shares is dictated by the market.
While IPOs might seem to have a lot of disadvantages for both companies and investors, they have some benefits, too.
The majority of accredited investors and venture capitalists still prefer IPO. The main reason is that a company has to pass a number of procedures, e.g. listing on a stock exchange, and for that, it is checked and assessed by venture investors, regulators, etc. It offers an additional security layer to investors.
The liquidity level of IPOs is high. So, IPOs will, most likely, offer more flexibility when it comes to the investment, and additionally, high liquidity means a higher possibility of getting a return on investment. Statistics show that more than half of IPOs are successful.
IPOs are normally run by those companies that are more stable financially and want to motivate the public or attract attention to a specific product, service or solution. While we cannot say that investing in an IPO is completely safe, it is safer than, say, crowdfunding for inexperienced investors.
Crowdfunding: legal requirements and limitations
Companies that opt for crowdfunding instead of an IPO are not required to be listed on a stock exchange. They do not have to submit perpetual reports, which means that no additional costs are incurred on all the processes associated with an IPO which means significant savings to a company. In turn, the company can make investors benefit from it by offering higher rewards.
Typically, crowdfunding projects have lower liquidity levels than IPOs. They usually offer more reasonable rates and attractive terms to attract investors.
Since almost everybody who complies with the requirements to investors can invest in IPOs and equity crowdfunding, the latter ones have a lower entry bar to fit the investment minimum requirements.
Under different regulations, companies can raise from $5M to $75M.
A standard scenario for a company that is crowdfunding is to raise capital under the Regulation CF. Under this offering type, the company is limited to raising up to $5M in a 12-months period. But companies can also raise capital under Regulation A or A+ or even Regulation D.
Under the Reg CF, a company has to provide a detailed offering statement with the SEC where it shares the information about the company as well as the offering details.
Along with the offering statement, the company also provides financial statements. Further, the company is obliged to publish progress updates and annual reports.
The company is not allowed to advertise the conditions of an offering except for ads that can direct investors to the crowdfunding portal. All communications between a fundraiser and its investors are performed via a crowdfunding platform:
Investors who have purchased securities within a crowdfunding campaign cannot resell them for one year.
There are specific cancellation requirements. If the company doesn’t meet its crowdfunding target, the funds are returned to investors. Investors also have a right to cancel their participation and get the invested funds back if more than 48 hours are left before the offering deadline.
Investing in equity crowdfunding is associated with high risks. Equity crowdfunding campaigns do not have to meet as many requirements as IPOs, that’s why they are launched mostly by start-ups or businesses at the stage of growth.
Such companies do not have enough capital to operate with and thus, they are less stable financially than those companies that choose IPOs.
Bad or improper diversification is another problem investors face in equity crowdfunding. Since the entry level is not high, even inexperienced investors can participate as long as they meet some requirements. Their portfolios aren’t diversified properly, so they can lose money on projects that would be characterized by experienced investors as ill-advised.
Still, some crowdfunding platforms like Mintos or Fundrise allow investors to invest in portfolios.
Bottom line
Crowdfunding offers retail investors a great opportunity to invest in startups directly. Yet, investors need to do their due diligence, depending on the type of platform they are investing through.
For startups, equity crowdfunding is a convenient way to raise capital without having to manage large cap tables or give away too much ownership to investors, because in most cases, fundraising is conducted via preferred equity.
Crowdfunding happens earlier than IPO, so crowdfunding platforms may consider working with underwriters and investment banks as a lead generation channel.
Hopefully, now you have a better idea of these two notions and can make better-informed financial decisions.
