For startups, crowdfunding is exploding as a viable alternative to more conventional early funding sources. In 2021, the global crowdfunding market was valued at $13.64 billion and is expected to double by 2028, according to Statista. U.S. and Canadian markets accounted for the most significant volume of funds raised at 73.9 Billion. During this period, $4.41 Billion was generated through equity-based crowdfunding campaigns globally.
Several factors drive the rapid expansion of crowdfunding globally, including:
- The emergence of new platforms.
- The rising popularity of equity-based approaches.
- An overall increasing global awareness of this viable funding source.
The number of crowdfunding platforms continues to grow. Pitchbook currently lists 979 crowdfunding service providers. The top 10 platforms are Kickstarter, Indiegogo, Crowdcube, Wefunder, Seedrs, EquityNet, StartEngine, Republic, Angel Investment Network, and SeedInvest. In addition, seven of these ten platforms offer equity-based crowdfunding; thus, this type of funding is growing.
These crowdfunding platforms serve as “network orchestrators.” They create the necessary organizational systems and conditions for integrating resources among different communities, thereby replacing traditional intermediaries such as venture capitalists and private equity investors. In addition, these platforms link startups with committed supporters who believe in the persons behind the projects strongly enough to provide monetary support.
Types of Crowdfunding
There are several categories of crowdfunding depending on the stage of your company’s development, your ultimate aims, how much funding you seek, and what is legally possible in your environment. Let’s look at four primary types:
Reward-based crowdfunding remains the most common form as it avoids the regulatory and organizational problems arising from equity-based funding. These platforms work for various purposes, from creative projects such as filmmaking and music production to startup initiatives that offer physical and digital products.
There are two basic models for reward-based crowdfunding campaigns. The “Keep-it-All” allows the entrepreneurial firm to establish a fundraising goal and keep the entire amount raised regardless of whether or not they meet their funding target. The other “All-or-Nothing” model allows the company to set a fundraising goal and keeps nothing unless the goal is achieved. The all-or-nothing campaigns, on average, raise twice the funds as keep-it-all projects. Kickstarter and Indiegogo are the dominant players using this successful model. There are usually multiple levels of pledged amounts, with each group getting extra rewards the more funds committed. Founders can be very creative in their reward offerings. For startups, the reward is usually an initial version of the product. This offer can be desirable to early customers who are excited to be early adopters of a new product.
For startups, this can be an excellent way to validate the interest in their product in what is essentially a pre-sell approach. Customers are, in effect, pre-ordering your product before production. One of our Columbia Startups, Thursday Boots, successfully applied the pre-order approach via Kickstarter. They offered various donation packages for one or more of their premium, handcrafted boots. In 33 days, over 1200 people donated for a total of $276,610.
According to Statistica, Indegogo’s highest grossing campaign as of March 2022 was for the MATE X, a foldable eBike, which raised nearly 17.6 million U.S. dollars on the platform. [Consider adding the table on top campaigns.]
The above success stories are an anomaly. The majority of these campaigns never reach their goals. According to Kickstarter, 60 percent of campaigns are not successful. The majority of successful campaigns raise less than $10,000USD. This form of crowdfunding works well with clearly defined and short-term projects rather than long-term company growth.
If the campaign is successful, you can expect to pay up to 5 percent commission to the platform and a further 3 -5 percent in payment processing fees. Usually, there are no fees to pay if you do not reach your target.
Donation-based crowdfunding supports personal matters and social causes such as healthcare costs, educational needs, or charitable activities. Although it is a philanthropic model, campaigns do not provide rewards, and a donor gains no benefit except the personal satisfaction of helping someone in need. GoFundMe is one such platform that caters to both individuals and charities.
This crowdfunding approach is specifically helpful for social enterprises. Crowdfunding campaigns can benefit a cause by spreading awareness to interested parties. While similar to all funding campaigns, these donation-based platforms are storytelling mediums. Fundly is a well-recognized fundraising platform for both individuals and charities. As they say, “tell your story and connect with donors.” The platform helps founders to create visually appealing campaigns to attract donors. This point is critical when choosing the venue. Donors tend to associate themselves with specific causes and will be more motivated to donate to projects that align with their interests and values. Therefore, you want to select a platform that attracts similar causes.
Some donation-based platforms focus on individual fundraisers, while others are better for enterprise-level campaigns. For example, DonorDrive, serves nonprofits, healthcare, higher education, and corporate social responsibility initiatives. In addition, specific platforms will have experience providing services to particular organizations and expert guidance for your campaigns.
Peer-to-Peer loan crowdfunding platforms exist to match personal lenders to small companies. Credit-based crowdfunding from non-banks became prominent starting around 2006. Since the inception of these peer-to-peer lending models, there have been many changes to the platform models. Many earlier players have stopped P2P fundraising and focused on intermediaries with institutional lenders instead. Here are three platforms that support entrepreneurs and small business owners.
Kiva is one of the earliest platforms and remains an essential source of micro-loans. With Kiva, lenders select projects in developing countries and pledge the amount they want. Kiva’s structure has evolved, and the loan process starts with entrepreneurs demonstrating credibility by soliciting funds from their networks. The capacity to provide a percentage of the requested amount from one’s network shows the founder’s character. The second stage opens the listing up to the public. Once the loan is funded, the funds are delivered to the borrower through local microfinance institutions. Today, lenders receive the loan principal but do not earn interest. In earlier iterations, lenders had some options for repayment. Separate charitable donations support Kiva, so borrowers are not charged fees as part of the lending process.
Many earlier players, except for Kiva, no longer offer traditional P2P loan transactions. For example, Lending Club was part of the second phase of crowdfunding platforms, founded in 2007. Since its inception, it has advanced more than US$6 billion in loans via its website resulting in nearly $600 million in interest payments to lenders. Prospective borrowers of the Lending Club first submit their requirements and are then matched with pools of lenders willing to accept the credit terms. While one of the pioneers of peer-to-peer loans, this platform no longer offers P2P lending.
But there is a new wave of platforms that support small business owners, which may be suitable for startups. These new platforms offer an expected fixed return on investments. With debt crowdfunding, investors support small businesses with the expectation of being paid back with interest. These newer platforms work differently than the earlier ones. SMBX connects investors with local companies through a unique “small business bonds” program. These bonds are a fixed debt instrument that yields monthly payouts of principal and interest, with annual rates of return ranging from 6%-10%. For startups and small businesses, the fundraising process is relatively simple. First, SMBX’s review team validates that your business qualifies for the program. Then your loan request goes public, and investors can purchase bonds in the company. As in most platforms, business owners should be active participants in the marketing and promotion of loan request. Once the offer closes, the business receives the capital, and loans are repaid in fixed monthly payments. The platform charges the business owner 3.5% of the total loan amount raised.
Another innovative P2P platform is Honeycomb Credit. This platform connects investors to small businesses with profiles listed on its website. Investors do not need to be accredited to invest. The investment, in this case, is in the form of a promissory note for repayment. The rate of return varies between 7% and 12%. Businesses make monthly repayments that include interest, assuming no defaults. Honeycomb establishes rates for each project based on a credit analysis of the applicant. Each business repays its loans monthly, and your portion goes into a third-party account. You receive your funds quarterly directly into your bank account. The platform team reviews your financials, credit history, and business plans as a business owner. If accepted, the business works with the platform team to build a campaign. The platform charges an investor fee of 2.85%. The business owner posts $250 for a listing and pays a percentage of the total amount raised for each successful campaign. Fees range from ranges from 6% to 8%.
Equity-based or regulation crowdfunding is a mechanism that enables broad groups of investors to fund startups and small businesses in return for ownership participation in the form of shares. Investors provide money to a company and receive ownership of a small business. Research in equity crowdfunding indicates that its potential is most significant, with startup businesses seeking smaller investments to achieve establishment. At the same time, follow-on funding (required for rapid growth) may come from other sources.
The United States signed the “Jumpstart our Business Startups” (JOBS) Act in 2012. The legislation mandates funding portals registered with the SEC and an applicable self-regulatory organization to operate. The JOBS Act enables equity-based crowdfunding when conducted by a licensed broker-dealer or via a funding portal registered with the SEC. The Act initially limited the value of securities that an issuer may offer and that individuals can invest through crowdfunding intermediaries at $1.07 Million in 12 months. Depending upon their net worth and income, investors were permitted to invest up to $100,000 in crowdfunding issues each year. An independent financial statement review by a CPA firm occurs for raises of $100,000–500,000, and an independent audit by a CPA firm must happen for raises over $500,000.
The JOBS Act opened new avenues for startups and small companies to raise capital. As we have discussed in an earlier post, soliciting early funding is not easy. Early ventures rarely have assets or patented intellectual property necessary to procure traditional bank financing or SBA loans. Equity-based sources such as angel groups and venture firms select investments based on criteria these early companies rarely meet. For early ventures, equity crowdfunding presents a unique opportunity to raise capital from investors in return for ownership.
In March 2015, these SEC rules were expanded to allow a startup company to raise $5 million of securities in 12 months, subject to eligibility, disclosure, and reporting requirements. The 2015 rules, often referred to as Regulation A+, provide several stipulations and limitations for companies and investors. As noted above, startup companies can not issue an aggregate amount of securities over $5 Million for 12 months.
With current regulation changes, small- to mid-size companies had their 12-month limits expanded to $75 million from $50 million. In addition, limits on secondary sales under Reg A were lifted to $22.5 million from $15 million. Finally, capital-raising limits under “Regulation D”—a registration exemption for companies selling up to $5 million of their securities—now sit at $10 million.
The recent regulatory changes removed the dollar amount an accredited investor can contribute to a crowdfunding campaign. Purchasers of securities that are not considered accredited investors have limitations on how much they can invest. Currently, the SEC rules state that:
Where the purchaser is not an accredited investor, the aggregate amount of securities sold to such an investor during the 12 months preceding the date of said transaction shall not exceed:
(i) The greater of $2,500, or 5 percent of the greater of the investor’s annual income or net worth, if either the investor’s annual income or net worth is less than $124,000;
(ii) Ten percent of the greater of the investor’s annual income or net worth, not to exceed an amount sold of $124,000, if both the investor’s annual income and net worth are equal to or more than $124,000.
Several regulatory agencies around the world responding to the growth of crowdfunding are creating legislation to cover equity-based crowdfunding. For example, the United Kingdom established regulations for equity crowdfunding early. According to recent Pitchbook data, Crowdcube is one of the top equity-based platforms, funding 262 deals and achieving £297 million in investments in 2021.
The regulations around equity-based crowdfunding will continue to evolve. Therefore, I recommend you monitor SEC regulations and consult a legal professional before deciding whether this approach is right for you and your startup.
Dual option crowdfunding is an extension of the above four categories. However, the usual combination is reward-based, leading to equity-based crowdfunding as the needs for the new company change. The dual option model offers a one-stop platform to take the young company through the different stages of cash needs. The rewards phase enables the development of the first product, and then growth can be funded using equity. Still, the company’s value will be higher and easier to establish, thus reducing the risks for investors and making investment more attractive. The entrepreneur will therefore suffer less dilution of their ownership. One such dual-option platform is fundable, which offers the opportunity to start with a reward-based program and then use the same platform for follow-on equity funding. $179/month is charged to create a fundraising campaign. Advisory services may add on extra costs. A reward-based campaign has similar fees to the other platforms in this category.
Benefits and Risks for a Startup
As with any funding source, there are benefits and risks to be considered when deciding on the best fundraising strategy. On the plus side, crowdfunding campaigns allow founders to create initial awareness through the large audiences attracted by these platforms. Selecting the right venue is essential for generating awareness. Founders should look at the platform’s audience for projects similar to your cause or offering. Specific platforms tend to attract a different segment of backers in the larger, more generalized platforms. For example, I work with many founders who start “Green Businesses.” Some platforms cater to sustainable products more than others. For instance, Indiegogo has an “energy and green tech” category that attracts projects that focus on products that support awareness and protection of the environment.
A significant benefit for founders is the ability to solicit feedback on early prototypes. Campaign response can provide valuable feedback from the market and validate that you are on the right track with your target customer. Founders can share campaigns with their networks and ask them to share with them. This promotional activity provides insights into potential market channels for future customer acquisition efforts. Additionally, most established platforms offer a good deal of structure and guidance to founders as they design their campaigns. With recent changes in regulations, some platforms provide an opportunity to launch a “test the waters” campaign to gauge interest in your offering. A startup can launch a campaign page and market the offering to see if its network is interested in investing in them. The company can go through the associated time and costs of preparing the campaign if they get sufficient interest.
Of course, a key benefit of crowdfunding is providing access to early capital at the early stages of venture development. This vehicle can be a primary funding source for developing your prototype, selling your product pre-production, and transitioning your startup to early growth. I have observed many examples of all these outcomes. For example, the founders of Sotro, a collapsible hair steamer, generated funds to complete the product’s industrial design and began soliciting manufacturers for future production. As mentioned earlier, Thursday Boots is a prime example of using their campaign to pre-sell their product before its production. In this scenario, it is vital to have all the manufacturing and supply chain partners in place with clear timing expectations. You don’t want to make promises to your customers that you can’t keep.
This concern leads to one of the most significant risks, losing brand reputation if you cannot meet your campaign promises. Unfortunately, many stories about crowdfunding campaigns not delivering the products or services promised. The reasons vary from overestimation of operational capacity to potential fraud. Platforms work hard to minimize the latter, but the former can occur readily. According to Kickstarter, approximately 9% of their projects fail to deliver. The reasons include low pricing and inability to produce the goods, manufacturing problems or supply chain issues, infeasible technology, and fraud.
Another risk to consider is that most campaigns fail to achieve their goals. Generally, statistics show that as many as 85% of crowdfunding campaigns fail. The reality is that these campaigns are labor-intensive. From creating the campaign to obsessively promoting it to your networks, many founders have an unrealistic perception that raising funds in this manner is easy. Well, raising funds is never easy! Every platform has several steps you must complete to validate that you are a good candidate. The vetting process alone can be time-consuming. I recently spoke with someone engaging Republic, an equity-based crowdfunding platform. The founder highlighted the importance of showing a working, repeatable, scalable business model. The vetting team wants to know your “burn” and runway. They want at least three months of capital to manage that burn. Reason? It will take about three months to launch and finish a crowdfunding raise.
One final risk area to note. You don’t want to jeopardize your intellectual property when participating in a crowdfunding raise. In a campaign, founders share specifics of their idea and its novelty. In the crowdfunding scenario is a public disclosure. Depending on the jurisdiction, such public disclosures start the “patent clock” and may sometimes prevent the founder from being granted a patent. If you plan on applying for a patent, you must file for patent protection before publicly disclosing your product on a crowdfunding site. Apply the same strategy to your brand. Seriously consider registering a trademark before you start a visible campaign. Read more about the trademark process here.
Is Crowdfunding Right for Your Startup?
Before deciding whether to use crowdfunding as a source of money for your company, consider the following factors:
- If you have a goal to reach a specific target with a clear project plan and do not plan a high-growth company, consider using either a reward- or donation-based method. Avoid equity funding at this phase.
- Consider equity-based funding if you plan to grow a small company and then sell it to another company to create a liquidity event. In this case, choose a platform that meets all regulatory requirements governing such transactions. For equity-based crowdfunding, it is essential to consult with a lawyer to make sure that all commitments align with your long-term fundraising goals.
- For equity-based crowdfunding, investors look for companies that show traction with early products certified via audited financial data. You will want to hold off and use other financing methods until you are in a better position.
- If several funding rounds are required, consider using a reward-based platform to fund a short-term focused project. If a single funding round can get you to positive cash flow, you may consider equity-based funding, but the risks, in this case, are high.
- Identify the platform that has performed well for similar companies or projects. Talk to fellow entrepreneurs that have used them.
- About 25 percent of the funding is already verbally committed within your network before starting the campaign. It is crucial to “pre-seed” the campaign, creating momentum in the early days. Additionally, for equity crowdfunding, most platforms look for evidence of past successful fundraising. Sometimes, these platforms will only accept your company if you bring in a lead investor from the start.
- Have contingency plans if you do not reach your funding target. Campaigns take considerable time, so you must be ready to solicit capital from other sources.
- Have plans on what you will do should you exceed your funding needs significantly.
- Don’t underestimate the time you will have to allot to attract the crowd and communicate with your followers. You must wage an active marketing campaign, providing company updates throughout the fundraising period.
- Before investing the considerable time and resources needed to prepare a crowdfunding campaign, check that you can pass the screening rules defined by your chosen platform.
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