What is Crowdfunding and How Does it Work?

What is Crowdfunding?

Crowdfunding, as the name suggests, is a method of business financing that relies on donations from interested individuals across the world, rather than traditional forms of equity and debt financing. Equity financing offers investors a stake in your business in return for their upfront investment and debt financing provides upfront capital in return for future interest payments. Crowdfunding, on the other hand, allows you to exchange your own services or personal gifts for early investment in your small business.

Instead of splitting control of your company with investors, or entering into long term contracts with traditional lenders, you may, through crowdfunding, garner investment capital by offering discounts on popular services, free merchandise, or something as simple as a handwritten card.

For those starting a business, crowdfunding provides a low-cost method of reaching out to investors, as well as a growing social media platform for brand profiles and promotion. Depending on the essentials of your business, one of several crowdfunding options may fit your needs.

How Does Crowdfunding Work?

Crowdfunding generally begins within your own social media circles, but can quickly expand if marketed correctly. Typically, business owners seeking crowdfunding will create a profile on a crowdfunding platform that not only advertises their business but sets a goal for fundraising and explains their needs in detail.

For example, you might create a profile on Indiegogo to attract investors for your Cross Fit Gym. Here, you could explain that you opened just before the pandemic, and hope to raise $15,000 to cover the next three months’ rent. As your listing gets shared on social platforms by friends and family, and as it circulates on the crowdfunding site, more and more users will not only be presented with the opportunity to invest but to become familiar with your brand.

Types of Crowdfunding Campaigns

Crowdfunding provides small businesses with a number of advantages compared with traditional investment or alternative financing options. However, the particularities of your operation and your expected path forward impact which crowdfunding options are best suited for you and your investors.

There are four main types of crowdfunding, each of which provides different perks for owners and investors. Rewards-based crowdfunding, equity crowdfunding, donation crowdfunding, and peer-to-peer lending are all viable forms of crowdfunding, each fit for different fundraising needs.

Rewards-Based Crowdfunding

Rewards-Based Crowdfunding is a common avenue for small businesses that hope to kickstart growth without committing to debt financing or giving up ownership to shareholders. Under this format, investors are “rewarded” for their investment in a business by receiving some sort of gift for their donation, with the reward typically increasing with the size of the donation.

For example, a $25 donation may earn investors a free virtual fitness training session, while a $500 donation could result in a gift of company merchandise plus a one-year membership for online classes. Rewards-based crowdfunding is particularly effective for owners that hope to grow their business without dealing with shareholder control or loan repayments and is especially effective for those that hope to promote their business and attract investors without costing their business significantly.

Equity Crowdfunding

Equity crowdfunding, in contrast to Reward-Based efforts, is a good fit for small business owners with a defined growth plan, and confidence in their ability to sustain profits. Like equity financing, equity crowdfunding offers investors a stake in a business, in exchange for a cash contribution to the firm. Equity financing typically involves so-called Angel Investors who purchase large quantities of stock in your company in exchange for a significant say in its operations. Conversely, equity crowdfunding allows you to reach out to a global audience of small-dollar investors with a single post. These “small fish” can offer their financial support for your growing brand, but may not expect the full extent of privileges offered to traditional investors.

Equity Crowdfunding provides owners with upfront financing without adding to their owed debts. However, it does require their accountability to shareholders going forward. Further, as the shareholders in your company increase in number, your business will be under greater pressure from investors and regulators to maintain your obligations. Pursue equity crowdfunding if you have a defined plan for the future, and are willing to take in outside investors.

Donation Crowdfunding

Donation Crowdfunding is the most straightforward form of crowdfunding, and simply refers to crowdfunding efforts driven by a large number of individual donors from across the globe. These investors may contribute any amount of money, and don’t necessarily receive any product or service in return. With a strong social media presence and a large virtual network, donation crowdfunding campaigns can go a long way to increase your fundraising and brand awareness. Donation crowdfunding is also a primary tool for those hoping to raise money for charitable causes, social impact initiatives or other world-changing ideas.

Debt Crowdfunding

If you have the confidence to pursue equity-based crowdfunding, but don’t want to bring shareholders into your company, debt crowdfunding may be a suitable option. Debt crowdfunding, and specifically peer-to-peer crowdfunding, allows individuals to invest in your business without going through a middleman. Debt crowdfunding typically involves making interest payments on loans from investors; however, the terms of your agreement are likely to be more flexible and favorable than they would be if you’d accepted a traditional bank loan.

Best Crowdfunding Websites

Just as each small business may require a different method of crowdfunding, various crowdfunding websites and apps each have their own strengths and may suit some businesses better than others.

Kickstarter

Kickstarter is one of the most popular rewards-based crowdfunding websites for entrepreneurs. Owners create listings on Kickstarter for things ranging from product launches to creative projects to brand expansion efforts, and investors may contribute to whichever causes they choose. Because Kickstarter is a rewards-based platform, investors expect gifts or some other benefit in return for their donations; if you plan to use Kickstarter, have a clear idea of what you plan to offer investors for their financial backing.

Indiegogo

Indiegogo is another rewards-based crowdfunding site that caters to “creative, entrepreneurial” businesses and projects hoping to launch products or services. Like Kickstarter, Indiegogo requires that your business or project offer some sort of gift to your backers, and will assist in the movement of your products during that stage of crowdfunding. Indiegogo also offers to connect entrepreneurs with manufacturing and shipping companies, as well as other young startups for collaborations.

GoFundMe

GoFundMe is one of the most popular donation-based crowdfunding platforms and has seen great success on social media in recent years. Business owners may create listings for things ranging from rent relief to brand expansion on GoFundMe and share their efforts with social media circles around the world.

Unlike Kickstarter or IndieGoGo, GoFundMe does not require rewards-based crowdfunding efforts, and therefore may best serve businesses and individuals that are starting from scratch or don’t have the stability to immediately offer rewards to their donors.

Lending Club

Lending Club may be the right place for you if you hope to receive debt-based, peer-to-peer financing. Lending Club has connected business owners with hopeful investors since 2007 and continues to do so through their website, which allows borrowers and lenders to create personal profiles and connect with potential financing partners from the comfort of their own home.

Peer lenders, in return, are given access to a marketplace where they can independently choose which businesses to invest in for financial gain, still from the comfort of their own home.

Benefits of Crowdfunding

Crowdfunding can be a complicated process, but if you pursue the correct donation process, choose the right service and use your social media brand to your advantage, there are some significant benefits to crowdfunding versus other forms of financing, especially for young startups.

1. Raises Capital Without Interest

Crowdfunding, for one, allows your business to raise capital without the burden of interest payments. Aside from peer-to-peer lending, Crowdfunding options give your small business a valuable chance to grow your operation without taking on debt.

2. Allows for Market Validation

Aside from fundraising, Crowdfunding apps and websites can give your business a vital platform for Market Validation, without wasting capital. Rather than spending money on focus groups and market research, you may be able to gauge consumer interest and predict future growth by operating a well-organized Crowdfunding profile.

3. Attracts Potential Customer Base

Within your efforts to attract investors and gauge interest in your business, it’s very possible that your Crowdfunding efforts may help attract loyal customers to your brand. If your product, service, or initiative is well-represented, if you argue your case to investors and consumers alike on Crowdfunding sites, the options above can be both a vital source of financing and a valuable platform for advertising your product and getting in touch with consumers.

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Certain business loan products are made available through Retail Capital LLC, a licensed California Finance Lender.

What is Crowdfunding and How Does it Work?