Equity Crowdfunding raises interesting questions about the nature of equity and debt finance. Prior to the JOBS Act, equity financing wasn’t available to non-accredited investors (those with less than 1 Million USD in asset wealth or 200K in annual income). Subsequently, small business investments were rarely securitized and rarely allowed for large groups of people to invest and exchange shares of companies. The rise of equity crowdfunding in 2017, over 1 Billion USD of investment annually, raises questions about the role of capital markets for small business.
Capital markets encompass debt and equity finance. How firms apply debt and equity capital varies across sectors and can change based on a firm’s business model. In local economies, equity financing is typically provided by venture capital or private equity firms, or one-off deals between investor and property developer.
Take manufacturing as an example. In local manufacturing economies, the owners of larger firms might make an equity investment into smaller component parts manufacturers. The benefits for the larger firm are beyond a financial return. Their investment might bolster the local manufacturing supply chain. An investment may also have less risk if the larger firm were to manufacturer the component themselves.
Real Estate offers another example as debt and equity financing are typically sourced within the same project. An investor and developer can partner whereby the investor puts up cash for what is essentially the down payment on additional debt financing.
Startup companies typically don’t seek debt financing initially as they don’t possess tangible assets. (A good book on the topic – Capitalism without Capital: The Rise of the Intangible Economy). Over time it is foreseeable that as the business expands, the firm would take out debt financing like any other company might, for example a line of credit.
In many cases, debt and equity financing can be applied together within a company. An article from Entrepreneur talks about the pros and cons of debt and equity financing. Generally, equity financing is seen as more expensive than debt financing because of the cost of the investment could increase by a multiple as the asset increases in value. Over time, this would be more expensive for the firm than the interest paid on debt capital.
Equity Finance for Small Business
Equity crowdfunding allows for small businesses to both equity and debt financing.
Companies can choose how to apply debt and equity financing. For example, a manufacturing firm that is largely a contract shop could seek equity investment to fund the research and development of a new product. The nature of how debt and equity financing is applied within a company is flexible and largely determined by the company’s vision.
Let’s take retail as an example. Could a small retail shop such as a boutique, café, art gallery, entertainment venue use equity crowdfunding to the owner/operator’s risk?
Ownership of the physical space could represent the largest expense in the early years. In those early years it is not uncommon for the owner/operator to not receive compensation.
This limits the nature of starting a business. Many individuals simply cannot afford to go years without compensation. They may have mouths to feed or other costs that require them to earn an income. Single people, single mothers or fathers, young people face a higher risk in starting a small business if they don’t have additional incomes to fall back on. If a business requires 60+ hours a week to start, working a second job might not be feasible.
If an entrepreneur could equity finance part of their investment to cover a salary for the operator, more entrepreneurs might be able to start a business.
Can Investors Still Return on Small Businesses?
Another question that equity crowdfunding raises is the nature of securitizing investments into small business. Can a small business be securitized in a way where annual growth is returned to shareholders?
The promise of secondary markets would mean that investors could potentially exit an initial investment by selling shares on an open exchange.
Even if a small business is only worth a couple of hundred thousand dollars, the volume of tradeable shares could be financially valuable. If a firm grew by 8-10% annually, the stock price would have a measurable change whose value could be extended to investors. That change might only be $0.25, but still enough to trade.
Certainly, more real-time transparency is needed for companies in ways that likely exceed the transparency offered to equities on international exchanges. More regulation may also need applied to trades so that equities don’t fail prey to market manipulators who seek to pump and dump individual securities.
In any case, with the right infrastructure, capital markets can extend to small business in ways that increase rates of entrepreneurship in the U.S., returns appreciation of assets more equitably across society, and brings more transparency to small business.