Crowdfunding: Definition & Overview

KEY TAKEAWAYS

• Crowdfunding helps expand the reach for potential investment and allows investors to choose from hundreds of potential projects.
• There are certain restrictions in place for who is allowed to fund new businesses and how much they’re allowed to contribute.
• Sites generate their revenue by taking a percentage of funds raised and through crowdfunding platform fees.
• In the United States, the Securities & Exchange Commission (SEC) regulates any equity-based crowdfunding ventures.

What Is Crowdfunding?

Basically, crowdfunding uses small amounts of capital that are taken from a wide range of individuals to help fund a business venture or idea. It can be a powerful, and simple, way to help generate additional funds and grow your business. It offers easy accessibility to vast networks of people you otherwise might not get in front of.

It’s essentially crowd-sourced funding that can attract major investors and personal investors. This can get done by leveraging the power of social media and specific types of crowdfunding websites. By spreading the word and building awareness, you will bring entrepreneurs and investors together with a high potential of raising money. 

Using crowdfunding projects is an effective way of expanding the possible pool of investors outside of people closest to you, like family, friends, and other people you know. It’s also a good way to go outside the traditional path of angel investors or venture capitalists.

How Does Crowdfunding Work?

One of the most important things to keep in mind is that a crowdfunding venture has some rules and regulations depending on your location. In several jurisdictions, there are certain restrictions on who can fund new businesses and how much they can contribute. 

It works in a similar way to hedge fund investing, for example. The regulations are meant to help protect people who don’t have the right knowledge or aren’t wealthy investors. All in all, they’re meant to reduce the possibility of people putting their savings at risk.

New businesses can often fail which means that anyone who invests in the business has a risk of losing their initial principal. That said, crowdfunding has helped create new opportunities for entrepreneurs to raise money. 

It works as a type of platform and forum for anyone that has any idea to pitch it to potential investors. And these investors are likely ones they wouldn’t have come across without the reach of crowdfunding. 

Different Types of Crowdfunding

There are a few main types of crowdfunding. These include equity-based, rewards-based, donation-based, or marketplace-lending models. Let’s take a closer look at how each of them works so you can raise capital through crowdfunding and reach your crowdfunding goal.

Equity Crowdfunding

This model mirrors traditional fundraising, where investors give capital in exchange for equity. However, equity crowdfunding has a much lower barrier to entry. Instead of investing thousands of dollars, funders can invest as little as $500 to purchase a small share in a business. 

Setting it up this way makes it more accessible for a wider range of investments. Not everyone has thousands of dollars to invest. So reducing the entry barrier can allow interested people an opportunity to be a part of something they believe in. 

There are some great equity crowdfunding campaigns that you can implement and it’s a type of popular crowdfunding investment. 

Pros of Equity Crowdfunding

• Equity funding often results in higher fundraising amounts than other crowdfunding models
• Even if a large number of investors join the campaign, they’re grouped into a single entity. This makes communication easier and simplifies things on the legal end. 

Cons of Equity Crowdfunding

• Other crowdfunding models remain much more popular than equity crowdfunding. It’s not easy to run a successful campaign and achieve the level of funding needed to get your business off the ground. If you need startup capital, traditional fundraising sources as well. 

Rewards-Based Crowdfunding

Reward crowdfunding is one of the most popular crowdfunding models. Entrepreneurs pitch their ideas to the community and offer different rewards in exchange for funding. Reward-based funding can include products in advance or unique perks and experiences that aren’t available to the general public. 

This model doesn’t require a working product. But, if your idea attracts enough attention you can raise the funds you need to make it a reality. It’s a little bit of a different approach to crowdfunding.

Pros of Rewards-Based Crowdfunding

• One significant benefit to this model is that you don’t have to give away any equity in your company. If you get successfully funded, you still retain 100% ownership of your company.
• Rewards-based crowdfunding is an excellent way to market and test your product before it exists. If your idea doesn’t get funded, you can go back to the drawing board and try again. You don’t have to spend hundreds or thousands of dollars manufacturing a product no one wants. 

Cons of Rewards-Based Crowdfunding

• Creating a successful crowdfunding campaign on Kickstarter is one thing. Actually making the product and successfully shipping it out to all your backers is another thing. Some entrepreneurs hit their target before realizing their business plan doesn’t work in the real world.

Marketplace Lending

This form of crowdfunding allows businesses and individuals seeking a loan to turn to the community instead of banks. It’s also known as peer-to-peer lending. 

Pros of Marketplace Lending

• With marketplace lending, interest rates can often be better than banks. However, there’s no guarantee that someone will fund your request.
• This is a possible option for businesses or individuals who can’t get a loan from a bank. 

Cons of Marketplace Lending

• Unlike the other models on this list, marketplace lending requires you to pay back the loan. So even if the interest rate is low, it’s still an added liability. 

Donation-Based Crowdfunding

Donation crowdfunding gives individuals and non-profits access to large amounts of capital. It doesn’t require you to give anything away in terms of products, rewards, or equity. 

Usually, all that’s needed is a compelling story to help entice and encourage additional investment.

Pros of Donation-Based Lending

• Donation-based lending is an excellent way to gain exposure for your cause. You can connect with a large group of people who can donate or provide help in other ways.

Cons of Donation-Based Lending

• Donors should be aware of scams. Since this is not a heavily-regulated area, there are instances of scammers taking advantage of people’s generosity.

Advantages of Crowdfunding

An advantage of crowdfunding is that it presents many benefits compared to traditional fundraising models. Three of the main advantages are:

Lower Risk

Crowdfunding allows entrepreneurs to raise capital without having to demonstrate a working product. This makes it ideal for testing the demand for your product before investing in inventory, materials, or manufacturing.

Maintain Equity

When you secure funding from traditional investors or venture capitalists, you give up equity in your business. In contrast, crowdfunding allows you to retain complete control of your business. This can have significant financial implications further down the line if you ever decide to sell your business.

High Visibility

Crowdfunding is an excellent strategy for drumming up interest in your company. It gives you access to a large group of potential customers before you even have a product on the shelves. This doesn’t just apply to first-time entrepreneurs. 

Small businesses often use crowdfunding campaigns to gain visibility for new products. If you have an exciting idea, there’s always the chance your campaign will go viral,

Disadvantages of Crowdfunding

Even though crowdfunding has several benefits, it’s still a type of investment. And investments of any kind always bring a level of risk with them. Some of the primary challenges of crowdfunding can often include things like:

Time Limitation and Initial Investment

Crowdfunding requires you to raise your entire funding goal in a short amount of time. To be successful, you might be required to invest in a sizable marketing campaign. You also have to consider your delivery timeline if you secure funding. Many funded campaigns have lost credibility with their backers by delivering late products or not delivering them at all.

High Rate of Failure

The success rate for crowdfunding campaigns on Kickstarter is around 39%. This number may also be inflated by smaller projects with a meager funding target. For more ambitious campaigns, that number is likely much lower.

 If you decide to go the crowdfunding route, treat it like a business. Approach it with the same dedication you would have if you were pitching to professional investors. 

A Bigger Company Might Steal Your Idea

Crowdfunding campaigns are open to the public. This means your idea is on display for any company to copy. Before launching a crowdfunding campaign, think about the risks. How easy would it be for a business with more financial resources than you to recreate your idea?

For example, let’s say you come up with an idea for a better spatula. A large kitchen utensil manufacturer might be able to get a replica product on the shelves before you even produce a prototype. 

Summary

Crowdfunding is an excellent option to consider when figuring out how to raise money for a new business venture. It has a low barrier to entry and makes it possible for your product to go viral before it even exists. This helps widen the possibility for different kinds of funding instead of through a typical angel investor or other accredited investors.

Are you thinking about launching your own crowdfunding campaign? Make sure you carefully weigh the pros and cons outlined in this article. This way, you can ensure you have successful crowdfunding projects regardless of the type of crowdfunding you use.