What is Crowdfunding?

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Definition:

Crowdfunding is a strategy for raising capital by taking small contributions from many different people, including friends, family, and investors.

🤔 Understanding crowdfunding

Crowdfunding offers a way to raise money by taking small contributions from many different people, often through social media and websites. Typically, individuals and businesses can set up a crowdfunding campaign through an online platform, then share it widely with the goal of attracting attention and investment. Crowdfunding platforms make money by facilitating investments (through a designated campaign page and payment processing services); they take a percentage of the fundraiser’s profits as revenue. Crowdfunding often attracts creative business ideas that may not thrive as well in the traditional venture capital arena. Depending on the type of crowdfunding arrangement, investors may get their money back later via a payout with profits (in the case of equity-based crowdfunding). Or, they might receive a perk, like the first edition of the proposed product (in the case of reward-based crowdfunding). In addition to business ideas, people often use crowdfunding to raise donations for charitable causes.

Example

One of the most successful crowdfunding campaigns to date took place in 2016, when the company Pebble Technology raised funds for a new smartwatch.

The company used its crowdfunding page to differentiate its smartwatch from others on the market through its customization and water resistance. In the end, more than 78,000 people contributed more than $20M to the company via Kickstarter. Contributors could pledge specific amounts of money to receive different rewards. Today, Pebble Technology’s smartwatch is sold in major online retail shops like Amazon and Walmart.

Takeaway

Crowdfunding is like selling Girl Scout cookies…

Each year, Girl Scouts rely on their massive cookie sales to support the organization. They rely primarily on friends, family, and local communities to sell the cookies. Crowdfunding uses a similar approach — You often start with friends and family to promote and gain broader support, and ultimately, investment.

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How does crowdfunding work?

Crowdfunding gives people a way to raise capital online through websites and social media. Usually, those raising money set up a campaign page explaining their product or cause, then share the page with friends and family in order to attract attention and funding.

Both individuals and businesses can use crowdfunding to raise money. Some organizations use it to raise funds for charitable causes. Companies and entrepreneurs also use crowdfunding to raise capital for their firm or a particular project, without going through traditional routes like venture capital.

What are the types of crowdfunding?

There are several different types of crowdfunding, depending mainly on the reason for raising money. Here are some examples:

Donation-based crowdfunding

Donation-based crowdfunding happens when contributors give money to a cause as a donation without the expectation of a financial return. Individuals and organizations might use this type of crowdfunding when raising money for a personal or charitable cause. Some examples of causes include medical emergencies, job loss, or natural disaster relief. Sites like GoFundMe allow you to start a campaign and raise funds for yourself or others.

Reward-based crowdfunding

Reward-based crowdfunding allows donors to contribute money to a campaign and receive a reward in return. Companies often use this model on sites like Kickstarter to raise capital for creative business ideas. For example, a company using reward-based crowdfunding to produce a new board game might offer donors a free copy of the game before its official release.

Equity-based crowdfunding

Equity-based crowdfunding allows a startup to raise money by selling equity in its company. It’s kind of like selling shares on the stock market, but on a smaller scale. This model isn’t as popular as donation-based and reward-based fundraising. Equity-based crowdfunding sites must register with the Securities and Exchange Commission (SEC). The Financial Industry Regulatory Authority (FINRA) publishes a list of registered equity crowdfunding sites on their website.

Peer-to-peer lending

Peer-to-peer lending is a type of crowdfunding where entrepreneurs borrow money directly from investors, rather than a bank or credit union. It’s similar to a loan in that the borrower has to pay back its lenders on a set schedule.

Is crowdfunding or funding with angel investors better?

Many startups and companies raise money by seeking angel investors (aka individuals who provide seed money to companies to help them grow in exchange for equity). A company might choose crowdfunding as an alternative to angel investor funding. Both angel investor funding and crowdfunding can help launch or grow a business. Each has its pros and cons. It’s really about which model is right for you.

For example, angel funding may be advantageous if you’re looking for a small pool of funders or an individual to contribute a large investment. Accepting angel funding may come with other upsides, like access to investor advice.

On the other hand, crowdfunding may be preferable for other reasons. First, angel investors typically expect to own equity in your company, which may not fit for entrepreneurs unwilling to do so. Using crowdfunding to raise money for your business venture can also double as a marketing strategy if the crowdfunding campaign gains traction.

Do you pay back crowdfunding?

Whether or not crowdfunding contributors get their money back depends on the type of campaign you’re dealing with, and the success of the company or product. For example, many donation-based campaigns don't pay back their supporters — The contributions are treated like charitable donations.

A typical reward-based crowdfunding campaign tends to promise its backers a different type of return instead of money, like a product, service, or special access. The reward is usually at the discretion of the fundraiser. In peer-to-peer lending, for example, contributors do typically get their money back. When borrowers take out a loan from peers through a lending crowdfunding site, they’re usually responsible for paying back the debt with interest, just as they would for a bank loan.

Finally, in equity-based crowdfunding, getting your money back is usually a possibility, though not guaranteed. The idea is similar to purchasing equity in a public corporation by buying stocks — You hope to see a return on your investment. And like investing, equity-based crowdfunding comes with some inherent level of risk. You might see a return that’s higher than your initial investment, but you also might lose your money if the business doesn’t succeed.

How do crowdfunding websites make money?

Crowdfunding platforms typically make money by taking a fee — Often in the form of a percentage of each contribution or of the total amount of funds you raise.

For example, the crowdfunding platform Kickstarter only applies a fee to campaigns that meet its funding goal. In those cases, the company takes a platform fee of 5% of the total funds raised. In addition, they take a processing fee of 3% and $0.20 per transaction. If a campaign doesn’t meet its goal, however, it doesn’t pay any fees or receive any money.

Another crowdfunding site, GoFundMe, works a bit differently. Rather than charging a platform fee as a percentage of the total funds raised, GoFundMe’s revenue relies primarily on donations and tips. (When donors give money to a GoFundMe campaign, they have the option to leave a tip for the site to help with operational costs.) The company does charge a payment processing fee of 2.9% plus $0.30 on all transactions.

What are the top crowdfunding websites?

There are a lot of crowdfunding sites out there — Some specialize in reward and equity-based funding for entrepreneurs, while others focus on donation-based funding for charitable and personal causes. Here are a few examples of the biggest websites in each category.

Business fundraising

Kickstarter: This crowdfunding site helps creative entrepreneurs raise capital to fund their projects (think of a new board game or a comic book). Kickstarter is a reward-based crowdfunding site, meaning those who contribute usually receive a reward from the company raising money, like a first edition of the campaign’s product. Kickstarter operates on an all-or-nothing policy, meaning entrepreneurs only receive the money from supporters if they reach their goal.

CircleUp: CircleUp is a crowdfunding site that offers equity-based fundraising, where those who contribute to a campaign purchase equity in the fundraising company. Unlike other business crowdfunding sites, CircleUp is usually not for companies just getting started, as they tend to partner with companies that have an existing revenue of $1M to $15M. Both companies and investors must go through a screening process to join the site.

LendingClub: This peer-to-peer lending site allows companies and entrepreneurs to borrow up to $500,000 for their business. A company can be eligible for a loan if it’s been in business for at least one year and has $50,000 in annual revenue. On the other side of the equation, investors can put their money into a LendingClub account. The site then lends that money to borrowers. Investors earn interest on their investments — LendingClub says their returns average between 4% and 7% annually.

Nonprofit organizations and personal fundraising

GoFundMe: This crowdfunding site allows individuals and organizations to raise money for personal and charitable causes. GoFundMe facilitates donation-based fundraising, meaning those contributing money don’t get a return of any kind. Instead, people often use the site to raise funds for a charitable cause (like supporting victims of a natural disaster), or a personal one (like help paying for an uninsured medical procedure).

Causes: This donation-based site is a crowdfunding platform for campaigns related to social and political issues. People can start a campaign about a cause and use the page to raise money and awareness about it.

What are the pros and cons of crowdfunding?

For individuals, crowdfunding offers a new way to access donors. For businesses and entrepreneurs, it can provide benefits that may not exist in more traditional means of fundraising. There can be downsides as well. Here are some of the pros and cons:

Pros

Crowdfunding allows entrepreneurs and small business owners to raise money in a way that previously was often only available to larger companies with access to the more traditional methods of fundraising, like venture capital. Crowdfunding may also allow a company to validate their product before taking it to a larger market. For example, many Kickstarter campaigns involve someone selling a product they haven’t yet created. If the campaign is successful, they use the funds to develop the product. A company might also choose crowdfunding over a more traditional funding source in order to raise money without having to give up ownership or decision-making power in their business (with the exception of equity-based crowdfunding).

Unlike the more traditional funding models, crowdfunding also allows a wider group of people to contribute smaller amounts of money (think $20) to a project or campaign. While contributors usually don’t see a financial return, they may receive other perks. In peer-to-peer lending, investors have an opportunity to see a financial return even with a relatively small investment.

Cons

Crowdfunding does not guarantee that a campaign will succeed. Because crowdfunding campaigns are often supported by a large number of small donors, as opposed to a small pool of big investors, success can be difficult. For example, Kickstarter reports that fewer than half of campaigns on their site reach their fundraising goal. A new campaign may face intense competition and face challenges when attracting a larger audience. Another downside to crowdfunding is that fees can eat into profit. Keep in mind that there’s also plenty of room for fraud in crowdfunding campaigns. It’s possible for a scam artist to set up a GoFundMe account and raise money under a false premise. Like any investment, it’s a good idea to research the project or company before supporting its campaign.

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