Entrepreneurs who want to raise funds to launch or expand their businesses have typically turned to bank loans, grants, venture capital, angel investors, or friends and family. However, crowdfunding is a relatively new form of fundraising for entrepreneurs that’s become a legitimate source of financing.
While seasoned entrepreneurs can raise money through crowdfunding, so can new entrepreneurs who may find it beneficial if they don’t have the professional connections, financial resources, collateral, or other assets to qualify for traditional methods of financing. There are numerous crowdfunding platform options, each with its own structure, focus, and specialty. Here’s what you need to know about crowdfunding sites and how to choose the one that best suits your business needs.
- What is crowdfunding?
- What are the 4 main types of crowdfunding?
- 7 advantages of crowdfunding
- 8 disadvantages of crowdfunding
- Crowdfunding advantages and disadvantages FAQ
What is crowdfunding?
Crowdfunding is the process of raising capital from a group of individuals through an online platform of donations or investments. The funds can be used to finance a business idea or particular projects. Crowdfunding has grown in popularity since the first platform for social causes, Kiva, started in 2005, in part thanks to websites like Kickstarter, Indiegogo, and Wefunder. Anyone with internet access and who lives in a country where crowdfunding sites are permitted can create a crowdfunding campaign.
Some business owners start crowdfunding campaigns to raise seed capital for a new business, while others aim to expand their business. Crowdfunding is also popular with creatives to support artistic endeavors and individuals who raise funds for social causes. Crowdfunding is estimated to reach $28.2 billion worldwide by 2028, up from $13.5 billion in 2021, according to Bloomberg.
A key advantage of crowdfunding is it can help a business avoid debt and the interest expense of a bank loan. Nevertheless, it can still pose challenges. It takes time and effort to carefully plan, orchestrate, and execute successful crowdfunding campaigns. The typical campaign lifespan is one to two months, and has a preset financial fundraising goal. Even the most basic campaign page requires developing a marketing and promotional plan, researching platforms to host your campaign, creating a pitch video, and establishing a program to incentivize donations.
What are the 4 main types of crowdfunding?
- Rewards-based crowdfunding
- Equity-based crowdfunding
- Debt-based crowdfunding
- Donation-based crowdfunding
There are four main types of business crowdfunding, but rewards-based and equity-based are used commonly for product launches and business expansions. If you’re considering starting a crowdfunding campaign, familiarize yourself with the different types of crowdfunding and what the platforms offer.
1. Rewards-based crowdfunding
Reward-based crowdfunding is when donors receive gifts from the startup founder in exchange for their contributions. Kickstarter and Indiegogo are two of the most popular rewards-based platforms. Reward-based crowdfunding structures typically offer tiered levels of gifts proportionate to, or on the same level as, the dollar contribution. The larger to pledge, the more valuable the gift. These rewards could be in the form of merchandise, luxury goods, invites to exclusive events like a meet and greet, early access to products, or a launch party.
Most rewards-based crowdfunding platforms take a percentage of the funds raised, often about 5% to 8%. Kickstarter returns all donations to the donors if the financial goal is not met and doesn’t take a fee; the business owner also receives no money. Alternatively, Indiegogo offers an option to reward the business owner with the money that was raised, even if the financial goal isn’t met.
Each crowdfunding site has its specialty and certain niches perform better than others, like gaming projects on Kickstarter or consumer tech gadgets on Indiegogo. Businesses that feature direct-to-consumer (DTC) products and services (as opposed to business-to-business, or B2B) tend to do better on rewards-based crowdfunding sites.
2. Equity-based crowdfunding
Equity-based crowdfunding campaigns are when donors become investors, gaining an ownership stake in the company in exchange for their contribution. Wefunder is a popular equity crowdfunding platform. This type of crowdfunding often is used by founders to launch or expand their business.
Equity crowdfunding became legal in 2012 as part of the JOBS (Jumpstart Our Business Startups) Act, which allowed startups to issue securities online. The equity-based platforms that emerged after passage of the JOBS Act are considered funding portals and follow the rules and regulations of the Securities and Exchange Commission (SEC). Entrepreneurs must adhere to a multitude of strict rules, including only being allowed to raise $5 million in a given 12-month period. Equity-based crowdfunding sites are popular with tech startups and brick-and-mortar businesses alike.
3. Debt-based crowdfunding
In a debt-based crowdfunding campaign, the crowd is lending the capital to your business. So in this scenario, you are borrowing money, which you agree to repay to the individual investors—often with interest—for specific projects.
This crowdfunding option can be a quicker and less complex process than borrowing from a bank, especially if you have a low credit score that may hurt your ability to get a traditional loan. The nonprofit Kiva is a well-known debt-based crowdfunding site that facilitates microloans, but doesn’t charge interest.
4. Donation-based crowdfunding
Individuals donate money to a cause in donation-based crowdfunding. This crowdfunding type is often used by business owners and others when funding unforeseen personal and professional hardships—and is rarely used to raise capital. Donation-based crowdfunding doesn’t offer donors any compensation such as rewards, benefits, or equity. One popular donation-based platform is GoFundMe. Funds might go toward expensive medical treatment or the cost of rebuilding after a fire or natural disaster to supplement insurance claims.
7 advantages of crowdfunding
- Credit score not required
- Serves as proof of concept
- Creates an organic customer base
- A form of free marketing
- Funding from multiple sources
- Avoids business loan interest costs
- Fast method of raising capital
There is no easy way to raise capital, but there are seven crowdfunding pros:
1. Credit score not required
When applying for loans at financial institutions, a nonexistent or low personal or business credit score is typically a barrier. But it’s not an issue for most crowdfunding platforms, especially rewards-based platforms, because entrepreneurs are not required to furnish or post their credit score when launching a campaign. Even if you are a so-called “credit invisible” and lack a credit history, crowdfunding can be an alternative to traditional financing to help you start or expand your business.
2. Serves as proof of concept
Proof of concept is the feasibility that the project or business idea can work. The speed and enthusiasm of donors’ contributions to a campaign is usually an indication of a business’s proof of concept and potential market demand. Generally, when a campaign hits its goal before the deadline or the amount of money raised greatly surpasses the original goal, it’s typically a good sign of proof of concept.
3. Creates an organic customer base
Crowdfunding is a way to organically create your customer base and build engagement. Donors to successful campaigns often become loyal customers and brand enthusiasts because they have been on the entrepreneur’s journey from the beginning. This way, you organically build relationships with customers without having to spend on paid advertising and other marketing campaigns to engage customers.
4. A form of free marketing
If the business idea is remarkable and the campaign page is compelling, a successful campaign can be a form of marketing that leads to free publicity on the internet and social media—from viral social media posts to media attention. Buzzy campaigns can also attract investors. Make sure to track data on your campaign’s success, including funding amounts and conversion rates.
5. Funding from multiple sources
Entrepreneurs who complete a successful crowdfunding campaign will typically have hundreds of investors—some could be potential angel investors when you’re ready to scale. Having multiple sources of funding serves as a safety net in case an investor backs out.
6. Avoids bank loan interest costs
Crowdfunding can be a way to avoid taking out costly bank loans and incurring debt. Recent average interest rates on bank business loans range from 5.26% to 11.32%. While many crowdfunding platforms do charge platform fees—in some cases, 5% of funds raised, plus processing fees—costs are often lower than the expense of repaying most bank loans.
7. Fast method of raising capital
Most crowdfunding campaigns last one to two months, with several weeks or months of preparation time. Yet, crowdfunding is a relatively fast method of raising money for entrepreneurs compared to applying for bank loans or pitching to venture capital (VC) firms. Plus, with crowdfunding, you control the length of the campaign.
Securing a small business loan might take several months, from preparation to approval and receiving funds. In the best case scenario, pitching a VC firm, receiving an answer, and closing a deal also might take several months. Typically, you have to have a scalable startup and be well-connected to even be introduced to VCs. This excludes many small business owners who often haven’t cultivated the professional network for a colleague referral, or don’t have the capital and resources for scalability. Crowdfunding can help overcome these hurdles.
8 disadvantages of crowdfunding
- Missing funding target
- Time commitment
- May give up equity
- Regulatory paperwork and preparation
- Minimal professional guidance
- Risk of intellectual property theft
- Low success rate
- False positives
There are numerous disadvantages to crowdfunding. Eight crowdfunding cons to be aware of include:
1. Missing funding target
Even the most compelling ideas and beautifully designed crowdfunding campaigns might not reach their funding target. If so, Kickstarter returns the entire amount raised to the donors; while Indiegogo offers the option to give the funds to the entrepreneur even if the funding target isn’t achieved. Check the crowdfunding platform policy before starting your campaign.
2. Time commitment
Despite minimal financial risk and fairly low cost, the crowdfunding process can take a significant amount of time, from planning to execution. It often involves creating new visual content, including photographs and a high-quality, one- or two-minute video, designing a tiered rewards program, and writing engaging social media posts and newsletter updates.
3. May give up equity
Business owners who choose equity-based crowdfunding give up an ownership stake in their business, so they no longer hold 100% of the equity in the business. Each entrepreneur can decide for themselves the percentage stake given up and dividends paid, in accordance with the rules and regulations of a particular platform. If an equity crowdfunded business goes bankrupt, however, investors typically lose their money.
4. Regulatory paperwork and preparation
Equity-based crowdfunding requires business owners to comply with the SEC’s rules and regulations, including filing a Form C offering statement, through the SEC’s online EDGAR portal. Other required forms include progress updates Form C-U and annual report Form C-AR when the funding period ends. Hiring a lawyer can make the filing process smoother.
5. Minimal professional guidance
Startup founders who are raising capital through crowdfunding often must create their own network of mentors and industry connections. They don’t receive the level of support and professional guidance that comes with the expertise within a venture capital firm.
To fill that gap, you can go to industry-related events, join professional groups, and even cold call potential mentors and ask them to coffee.
6. Risk of intellectual property theft
Business ideas laid out on crowdsourcing platforms are exceptionally vulnerable because they are broadcast online to the world. Discuss with a lawyer your concerns to help illuminate any intellectual property (IP) risks you may face and potential protections for your circumstance.
7. Low success rate
Crowdfunding has a fairly low success rate. For example, Kickstarter’s success rate as of May 2023 was 40.62%, meaning only about 40 out of 100 projects have successful campaigns and receive their funding.
8. False positives
Crowdfunding campaigns can lead to false positives: a successful crowdfunding campaign might not translate into a booming business. Alternatively, a failed crowdfunding campaign does not necessarily mean you have a bad business idea; it could simply be the result of a poorly planned and executed campaign.
Crowdfunding advantages and disadvantages FAQ
Are there alternatives to crowdfunding?
Yes, alternatives to fundraising include traditional funding methods. You can apply for small business loans, pitch private investors like venture capitalists, fund through bootstrapping from your personal finances or friends and family members, or ask wealthy individuals and angel backers for investments.
Can I crowdfund after I launch my business?
Yes, many business owners crowdfund while running a successful business to raise capital to purchase equipment, buy property, or rent a larger space.
What are the pitfalls of crowdfunding to avoid?
Crowdfunding pitfalls to avoid include poorly planned and executed campaigns that could damage your business’s reputation and potential (or actual) earnings. If you plan to launch a crowdfunding campaign, take the time to do your research and plan carefully.
What are the legal considerations of crowdfunding to be aware of?
Legal considerations in crowdfunding include issues of intellectual property theft. Equity-based crowdfunding has the most stringent legal considerations due to SEC compliance, so check the platform’s rules and regulations before starting your funding campaign.