Crowdfunding - what is it?

Traditional fundraising is being disrupted and founders are looking for alternatives.

In the old days, entrepreneurs needed to prepare their company materials to go pitch to a limited pool of wealthy individuals or institutions, or take on debt from a loan, to fund themselves. Some of the more traditional funding sources include angel investors, venture capital firms, banks, or even family and friends. Many entrepreneurs would even save up as much as possible to “bootstrap” or fund the project themselves. However, in industries such as Space where the capital requirements are far above what they are for software, for example, this becomes an almost impossible mission. But thanks to the recent popularity of crowdfunding, now there are many more financial options.

 Crowdfunding is the use of small amounts of capital from a large pool of investors to finance a new business venture or even just an idea. Crowdfunding makes use of the easy accessibility of vast networks of people through mostly social media and websites to bring investors and entrepreneurs together, with the potential to increase entrepreneurship by expanding the pool of investors beyond the traditional circle of owners, relatives, and venture capitalists. 

If you’ve ever read Rich Dad Poor Dad by Robert Kiyosaki you’ll understand the concept exceptionally well. His rich entrepreneurial dad had battled up the hill to become an accredited investor. This opened up endless investment opportunities that otherwise he would not have, like buying equity before an IPO. Crowdfunding has opened the doors for retail investors to do just that.

Types of Crowdfunding

There are four main types of crowdfunding and each function is a little different. Take a look.

Donation

No strings attached charity causes.  

Allows people to donate money to campaigns, no strings attached. Donation-based campaigns are driven out of support for a project and nothing else (e.g. a student’s personal fundraiser for a semester abroad). This is commonly used by nonprofits mainly because the platform does not charge a fee for the raise but asks the contributors to make donations to keep the platform going. 

Rewards

Upfront payment for cool stuff - maybe. 

Perhaps the most common of the four, it offers donors a reward or perks in exchange for contributions. Rewards can vary by how much money donors give to a campaign, with those who contribute more receiving more or better (higher quality, exclusive) rewards. Common rewards include T-shirts, early access to the product or service a company provides and public recognition. So I tried this a  few years ago. Here’s my tale of woe.  I invested in a company called Cooler Master, an ice chest with a bluetooth speaker built-in! I know, I know, you want to get one now - but hold on. Although they raised $13M, there was very little in the way of a system to scale so quickly. Tens of thousands of backers, including me, never got the cooler and some even ended up waiting 8 years to get it. That’s just cold.

Equity

Purchase shares of a company pre-IPO. 

According to Mordor Intelligence, the fastest-growing type of crowdfunding which allows startups to sell a portion of their business. Investors receive shares in the businesses they fund, based on how much money they contribute to each capital raising campaign (e.g. a software engineer investing $500 into an edge computing company in exchange for 100 non-voting shares). There are limits on how much investors can invest through equity crowdfunding. These limits depend on the investor's income bracket and net worth. On the lower end, if either your net worth or annual income falls below $107,000, you can invest up to $2,200 or 5% of your annual income (whichever is greater) through equity crowdfunding every year. 

Investors should review the terms and conditions of every offering and fully understand the risks of equity investing before investing, such as the risk of loss, liquidity risk and more. Investors should not invest more than they can afford to lose. 

Debt

Loan money and earn interest - only. 

Sometimes referred to as peer-peer lending, it allows companies to pledge that they will repay their contributors (lenders) with interest by a certain deadline (e.g. a doctor’s patients loaning her clinic money to expand and open a new branch). This enables borrowers to get access to funds outside of traditional banking channels. People willing to take a risk to lend money to other individuals can create whole loan portfolios. Personally, this seems like the riskiest of the four since both will likely require some sort of collateral to be attached to the loan.

There are many online crowdfunding platforms built around different niches and types of crowdfunding. On the other hand, most equity crowdfunding platforms are industry agnostic, which means you may find campaigns looking to fund everything from mom-and-pop ice cream parlors to biotechnology research and even real estate developments all listed right next to each other. 

A few niche crowdfunding sites have begun to emerge in recent years. These single-focus platforms offer an entirely new level of expertise to the crowdfunding space. For example, Spaced Ventures is the first crowdfunding site for early and mid-stage aerospace startups and those interested in funding cutting-edge space-related technologies.