Passive income is the holy grail of personal finance. Earning money without having to hustle for it sounds like a pretty good deal.
However, you might assume that passive income is only available to people higher up on the socio-economic ladder than you. If you’re not in the financial position to become venture capitalist, you might think that you’re going to have to toil for every dollar forever.
In the past, it may have been true that the ability to generate passive income required a certain level of wealth. But these days there are several ways to leverage your more modest investments into a passive income stream.
Equity crowdfunding offers a low barrier to entry for anyone interested in making passive income.
Related: The Best Passive Income Ideas That Actually Work
Here’s what you need to know about getting started in equity crowdfunding for passive income:
What is Equity Crowdfunding?
Equity crowdfunding is a modern way for entrepreneurs to get funding for their startup companies.
Banks have long been hesitant to lend money to unproven new companies. In the past, startups would need to seek funding from private equity firms and venture capitalists. But getting funds from such sources is not always easy.
However, entrepreneurs now have another possible source of venture capital: equity crowdfunding.
Equity crowdfunding works like platforms such as Kickstarter and GoFundMe. A company advertises itself on an equity crowdfunding platform, and a large group of individuals each contribute a small amount to raise the necessary funds.
Unlike straight crowdfunding sites, the money you put into equity crowdfunding is an investment rather than a donation.
In essence, you are investing money in a company before it goes public. You’re getting in on the ground floor, which was traditionally against the rules for an average investor.
Imagine what you would be worth now if you had invested $1,000 in Amazon when it was nothing more than a scrappy online bookstore out of Seattle. Becoming such an early investor is now a possibility through equity crowdfunding.
Though straight crowdfunding has been part of the internet almost from the beginning, equity crowdfunding has only been around for a few years. That’s because it’s only been legally allowed for a short time.
The History of Equity Crowdfunding
In 2012, the passage of the JOBS Act loosened many of the federal restrictions governing how companies are allowed to raise funds. Before 2012, SEC regulations prevented startups from using crowdfunding platforms. But until 2016, the rules limited investors in equity crowdfunding to “accredited investors.”
According to the SEC, to be an accredited investor you must earn an income that exceeds $200,000 a year or $300,000 if jointly filing with a spouse. If you don’t meet the income requirements, you can have a net worth that exceeds $1 million individually, not including any equity in your primary residence.
Here’s the full list of the qualifications required for accreditation.
However, because of the JOBS Act, non-accredited investors may also now invest via equity crowdfunding. Specifically, Title III of the JOBS Act, Regulation Crowdfunding, and Title IV, Regulation A+, allow for non-accredited investor funding in equity crowdfunding.
The Regulation Crowdfunding (CF) of the JOBS Act specifies that companies looking to raise up to $1,070,000 are now able to do so through crowdfunding portals.
The Regulation A+ of the JOBS Act is a little more complex. It specifies that eligible entities can raise up to $50 million in any 12-month period.
Related: The JOBS Act and Crowdfunding: New Investment Opportunities for the Average Joe
There are two tiers of crowdfunding available to these eligible entities:
Tier 1 Companies
These companies can raise up to $20 million in any 12-month period.
To do this, the company is required to provide all potential investors with a formal offering circular that has been reviewed by and filed with the SEC, as well as whatever state regulators govern the entity in its home state.
Other than the circular, there is no additional reporting requirement or ongoing audit requirement.
Tier 2 Companies
These companies can raise up to $50 million in any 12-month period.
They are also required to provide formal offering circulars to potential investors. However, they must also meet several other ongoing reporting requirements. These include semi-annual reports, annual reports, and reports triggered by certain “enumerated events,” like a change in the control of the company.
In addition, Tier 2 entities are subject to external, independent audits.
Though non-accredited investors are now allowed to invest via equity crowdfunding, the SEC still has some limits on the amount of money they can invest. Specifically, the SEC has created the following rules about investing in Regulation CF entities:
- Anyone may invest up to $2,200.
- Investors whose net worth or annual income is less than $107,000 may legally invest a maximum of 5% of the lower number. (For instance, if you earn $65,000 per year and your net worth is $100,000, you may invest a maximum of $3,250, which is 5% of $65,000).
- Investors whose net worth and income are both above $107,000 may legally invest a maximum of 10% of the lower number. (For instance, if you earn $110,000 per year and have a net worth of $400,000, you may invest a maximum of $11,000, which is 10% of $110,000).
- No one may invest more than $107,000, not even accredited investors.
For Regulation A+ entities, the rules are a little different. Anyone may invest as much as they like in Tier 1 entities–but non-accredited investors can invest no more than 10% of their net income or 10% of their net worth (excluding their primary residence) in Tier 2 offerings.
These limits were put in place for the same reason why the SEC has ruled that some investments are only open to accredited investors: to protect potential investors from risky investments. The thinking is that accredited investors have both the investing savvy and the excess funds necessary to either avoid or weather a poor investment. Non-accredited investors are more vulnerable.
Passive Income with Equity Crowdfunding
So how exactly can you create passive income by investing in equity crowdfunding? That depends in part on the investment options offered by the crowdfunding platform. Here are the most common options you could potentially invest in:
Simple Agreement for Future Equity (SAFE)
With a Simple Agreement for Future Equity agreement, investors have the right to obtain equity in a startup when the company sells shares at a future date. In this case, the company typically issues shares when an institutional investor comes in and sets a value for the company.
However, shares can also be sold if another entity acquires the company. A SAFE allows you to buy shares at a lower price than an investor buying shares later in the process. It is also possible to lose all of your money in a SAFE if the terms of the SAFE are not met.
This is also not a crowdfunding option that will provide you with passive income.
Convertible Notes are the most common type of investment in equity crowdfunding. The convertible note starts as a debt instrument that will convert to equity after a specific timeframe or after a specific triggering event.
Such notes have an interest rate and maturation date, similar to traditional loans, but instead of receiving cash back, you receive the equivalent amount of equity. If the company is unable to raise another round of funding, then the loan amount plus interest is due on the maturation date. The interest on the loan accrues and can be paid in cash or added to the note amount to be converted into equity.
This is also not an option that can offer passive income.
Revenue Share Loans
Unlike typical loans, revenue share loans do not have a fixed repayment amount or schedule. Instead, the business repays a fixed percentage of their monthly revenue to investors. This continues each month until they’ve reached a predetermined repayment amount.
For instance, if you invest $10,000 in a revenue share loan with a revenue share of 3% and a repayment multiple of 1.2x (or $12,000), the business will pay you 3% of its revenue each month until it has paid you a total of $12,000. This means you’ll receive more in months the business is thriving, and less in the months it is struggling.
These kinds of loans can offer you a nice passive income stream.
Related: My $10,000 Real Estate Crowdfuding Experiment with PeerStreet [Review]
Preferred Equity provides investors with shares in the company, either directly or through an intermediary. The investors can potentially receive regular dividend payments after a set period of time with this instrument, making it a potential option for passive income.
The traditional loan is always a well-used option, even through equity crowdfunding. You will receive principal and interest payments according to a set schedule. It is another good option for creating passive income.
How to Get Started
There are several different equity crowdfunding sites, each of which focuses on a different type of startup. The following platforms are all open to non-accredited investors:
This is one of the largest equity crowdfunding platforms online. While the platform is open to non-accredited investors, most of its deals are for Rule 506(b) and 506(c) under Regulation D, which is mostly limited to accredited investors. But non-accredited investors can still sign up and be notified when there are offerings available for them.
Minimum to invest: varies, generally no lower than $5,000
This popular platform has partnered with MicroVentures to offer equity crowdfunding to anyone over the age of 18. The offerings are varied, including everything from moviemaking to an organization that creates prosthetic limbs with a 3-D printer.
Minimum to invest: no lower than $100, although each campaign sets its own minimums.
Wefunder aims to help the scrappy startup save the American dream through equity crowdfunding. With a number of offerings that are both socially conscious and tech savvy, Wefunder is all about connecting the little guy investor with the startup that will grow to be a giant.
Minimum to invest: no lower than $100, although each campaign sets its own minimums.
This platform generally lists small businesses with a consumer-facing focus, such as breweries, restaurants, and apparel manufacturing. The goal is to connect local investors with local businesses.
Minimum to invest: $250 to $500
StartEngine has both small and large startups on offer for investors. The focus is on driving innovation in many different industries, from agriculture to tourism.
Minimum to invest: $500
While equity crowdfunding has a lot going for it such investing is not without risks. And these are different from the risks associated with traditional investing. Anyone looking to create passive income with equity crowdfunding needs to consider the following potential drawbacks:
If the business you invested in fails, then you will lose all of your money. And the majority of small businesses fail. According to the Small Business Administration, only about half of new businesses are still around after five years.
Lack of Liquidity
Once you have invested through equity crowdfunding, you’re in it for the long haul. In general, there is no secondary market for selling your shares, which means you cannot access your funds in an emergency. You should not invest any money you cannot afford to have tied up for a long time.
Need for Due Diligence
It’s important to think about why these companies are turning to crowdfunding in the first place. While the platforms do their best to only offer viable options, at the end of the day it’s your money. You are the one who needs to be sure of your investment.
The Bottom Line
Equity crowdfunding can be one savvy method for creating a passive income stream for yourself–but it should not be your only passive income or investing plan. Between the investment limits and the risks inherent in equity crowdfunding, this should only be a portion of your passive investment strategy. However, this can be a great place to start (or add to) passive income in your financial life.
Have you ever wanted to get into equity investing? Do you think crowdfunding is a good option?