When a business wants to raise funds, it has several options. Many businesses will initially raise funds from the founders, family, friends, and angel investors. Others might apply for an SBA loan or acquire convertible debt financing. Some businesses may go the crowdfunding route.
Internet crowdfunding involves a many-to-one relationship in which many participants or funders put forward a small amount of money in exchange for access to a future or extant product. Other types of crowdfunding involve exchanges of equity or revenue stakes, but these types of transactions have SEC regulations associated with them.
Read on to learn more about how crowdfunding works and whether it makes sense for your small business.
Related: What is the difference between angel investors and venture capital?
How the Crowdfunding Process Works
Every crowdfunding platform operates in a unique way, but there exist some basic principles that apply in general to all of them. The process looks something like this:
- A company or entrepreneur proposes a new product or service they plan to develop.
- In order to acquire funding for this project, the entrepreneur solicits crowdfunding investments with a platform of their choice.
- In return for their investment, participants – also known as backers – receive the product or service when the entrepreneur finishes it as well as discretionary special benefits as determined by the fundraiser.
Other crowdfunding platforms have also allowed investors to participate in equity raises for startups, real estate micro-investments, and more exotic investment vehicles. However, these platforms usually have special regulations such as only permitting accredited investors.
The Different Types of Crowdfunding
As you may have realized by now, crowdfunding comes in all shapes and sizes. Each platform has its own rules and regulations, such as having different levels of participation, rules on the types of products or services permitted on the platform, and rewards that may be granted to the participants in exchange for their upfront cash.
Some of the most common crowdfunding models include:
- Donations: Many nonprofits make use of crowdfunding platforms to raise funds for their projects.
- Rewards: The most common form of crowdfunding involves backers giving funds to promising businesses or ideas in exchange for that service as well as additional incentives or perk(s).
- Equity: A highly-regulated form of crowdfunding involves investors exchanging cash for ownership in young businesses. The U.S. Securities and Exchange Commission regulates these types of platforms.
- Debt: Another kind of crowdfunding, debt crowdfunding, involves backers giving cash to a small business in exchange for their principal repaid at a later date and possibly interest payments.
The Pros and Cons of Crowdfunding
Crowdfunding does not always make sense for a business. Some of the pros and cons include:
Pros
- No Equity Dilution: Business owners usually will not give up equity in their business in exchange for cash.
- Validation: A successful crowdfunding campaign can prove that a business idea has merit.
- Marketing: A campaign can also act as a marketing push for a product or service.
Cons
- Potential for Failure: If a business fails to deliver the promised good or service, massive backlash can result.
- Fees: Platforms charge various types of fees for their services. Businesses will usually not receive 100% of their crowdfunds after fees.
- Suitability: Not all businesses can take advantage of crowdfunding, particularly local companies that serve a geographically-concentrated market.
Legal Considerations of Crowdfunding
Lawyers tend not to like ambiguous contracts, and crowdfunding presents an example of one of the most vague forms of contracting. Various legal problems can arise from crowdfunding, including liability from an inability to deliver a product or service, potential taxation issues, SEC violations in the case of equity crowdfunding, and many more types of legal challenges.
Crowdfunding Platforms
The most popular crowdfunding platforms include Kickstarter, Indiegogo, Patreon, GoFundMe, and CircleUp. Other niche platforms include Substack and Medium for newsletter writers.
Kickstarter
One of the most prevalent crowdfunding websites, Kickstarter focuses on the arts, games, publishing, and technology projects. Entrepreneurs set a funding goal and the number of days available to reach it. Kickstarter operates on an “all-or-nothing” basis.
Indiegogo
Unlike Kickstarter, Indiegogo offers more flexible types of crowdfunding arrangements. The site also offers an integrated platform of products that an entrepreneur might need, including marketing and fulfillment support.
Patreon
Patreon has targeted artists and content creators. For example, many YouTube entrepreneurs have made use of Patreon to create memberships for their content.
GoFundMe
Unlike Kickstarter, GoFundMe targets charities and individuals. Business owners may not find as much benefit from using this platform.
Crowdfunding vs. Other Financing Methods
While crowdfunding shares some similarities with other types of business financing, the model has developed into a cash-raising methodology in its own category.
Compared to equity investment, crowdfunding does not usually result in equity dilution. Instead, backers receive rewards or future delivery of goods or services.
Debt, on the other hand, has some attributes in common with crowdfunding, particularly with respect to the entrepreneur’s promise to provide a benefit in the future to the backers.
Some parallels also exist between crowdfunding and venture capital in that they both involve outlays of cash now in exchange for a chance to be an early investor in the next “big thing.”
Deferred revenue may provide the most interesting comparison. Essentially, crowdfunding involves the exchange of cash for the promise of a product or service in the future. Businesses often treat these types of transactions as deferred revenue, and as any accountant might tell you, deferred revenue functions as a liability rather than an asset.
Is Crowdfunding Right for Your Business?
Ultimately, the decision to undertake a crowdfunding business to raise funds for your next project should involve careful consideration of the following factors:
- Can you deliver the product or service when the time comes?
- Do you have the ability to execute a large marketing campaign for your crowdfunding efforts?
- Would you encounter regulatory or legal issues in operating such a campaign?
- Does a crowdfunding platform exist that meets the unique needs of your business and industry?
Otherwise, it may make more sense to wait for your product to launch and in the meantime raise funds through debt, equity, or a mix of the two.
