There are four main types of crowdfunding that startups can choose from. Each has unique advantages and is better suited to specific use cases. Here’s an overview of what startups need to know:
1. Reward-based crowdfundingWith reward-based crowdfunding, backers contribute funds to your startup in exchange for a “reward,” usually a product or service your company offers. This model is typically used by startups that are launching a new product or service and need funding for development or production. Examples of reward-based crowdfunding platforms include Kickstarter and Indiegogo.
Reward-based crowdfunding is a popular method for raising funds, especially for creative projects or new product launches. Below are some of the key pros and cons.
Pros of reward-based crowdfunding:No equity sacrificed: Unlike equity-based crowdfunding, reward-based crowdfunding doesn't involve giving up ownership in your company.
Market validation: Reward-based crowdfunding allows you to assess market interest in your product or service. If your campaign succeeds, it’s a good sign that there’s a market for what you’re selling.
Pre-sales and marketing: Crowdfunding campaigns can also act as a pre-sale of the product, generating publicity and providing an initial customer base.
Community building: Crowdfunding platforms provide a way to communicate and engage with backers. This can help build a community of supporters who might help spread the word about your product or service.
Cons of reward-based crowdfunding:All-or-nothing funding: Many crowdfunding platforms, such as Kickstarter and Indiegogo, operate on an all-or-nothing basis, which means if you don’t hit your funding goal, you don’t receive any money. While this isn’t true for all platforms, businesses should be aware before starting the process.
Fulfilling rewards: It’s important to deliver on promised rewards, which could be more time-consuming or costly than anticipated. Failing to fulfill rewards can lead to reputation damage or even give supporters grounds to ask for their funds back.
Unpredictable success: Not all campaigns succeed, even if your idea is good. Success can depend on many factors, including the quality of the campaign, timing, and luck.
Fees: Crowdfunding platforms typically charge a percentage of the funds raised as a fee, and there could be additional processing fees. Successful campaign fees are often around 5% of total funds raised, while payment processing fees range from 3% to 5%.
2. Equity-based crowdfundingWith equity-based crowdfunding, backers receive shares of your company in return for their investment. This form of crowdfunding is used most often by startups with high growth potential, as it allows them to raise larger amounts of money in exchange for a stake in their company’s future profits. SeedInvest and CircleUp are popular platforms for equity-based crowdfunding.
Pros of equity-based crowdfunding:Larger amounts of capital: Since investors are purchasing a stake in the future success of the company, they may be willing to contribute larger amounts than in reward-based crowdfunding. This can allow startups to raise significant funds.
Long-term investor relationships: Unlike reward-based crowdfunding, where the relationship typically ends once the reward is delivered, equity crowdfunding can result in long-term relationships with investors who have a vested interest in the ongoing success of the company.
Access to expertise and networks: Investors often bring their own expertise, experience, and networks, which can be valuable resources for early-stage companies.
Cons of equity-based crowdfunding:Loss of ownership: By offering equity in your company, you are giving away a portion of your ownership, which might mean sharing control and decision-making.
Regulatory complexity: Equity-based crowdfunding is subject to more complex laws and regulations than other forms of crowdfunding. This may require legal counsel and can result in substantial legal costs.
Increased reporting requirements: Companies with many shareholders often have to provide regular updates and financial reports to their investors. This can be time-consuming and require additional administrative resources.
Pressure for returns: Unlike reward-based crowdfunding, where backers are happy to receive the product or service, equity investors seek a financial return on their investment. This can increase the pressure on the company to perform and provide returns.
Potential for dilution: If you raise more equity funding in the future, the percentage of the company owned by earlier investors (including crowdfunding investors) may be diluted. This can lead to dissatisfaction among investors, if it’s not handled correctly.
3. Debt-based crowdfundingAlso known as “peer-to-peer lending” or “P2P lending,” debt-based crowdfunding is similar to a traditional loan. Instead of getting a loan from a bank, you’re getting a loan from a crowd of investors. The startup agrees to pay back the loan with interest over a specified period of time. LendingClub and Prosper are well-known platforms for debt-based crowdfunding.
Pros of debt-based crowdfunding:Retention of ownership: Unlike equity crowdfunding, with debt-based crowdfunding you don't have to give up any ownership stake in your company. Once the loan is repaid, your obligation to your investors ends.
Faster process: The process for securing a loan through debt-based crowdfunding can be faster than through traditional banks. The qualification requirements may also be less strict.
Fixed repayment schedule: You'll have a fixed repayment schedule, which can be easier to plan for than the unpredictable nature of equity investments.
Potentially lower costs: Depending on the interest rate you secure and the length of your loan, debt-based crowdfunding can sometimes be a cheaper form of finance than equity-based crowdfunding or other types of traditional business bank loans.
Cons of debt-based crowdfunding:Obligation to repay: Unlike other forms of crowdfunding, the money you raise through debt-based crowdfunding must be paid back with interest. This is a fixed expense you'll need to plan for, regardless of how well your business is doing.
Interest costs: The cost of the loan includes not just the principal amount you borrow, but also the interest you'll pay over the life of the loan, which can range from 7.5% to 36% APR.
Risk to credit score: If you're unable to make your loan repayments, your credit score may be affected, which can impact your ability to secure financing in the future.
Secured loans risk: Some debt-based crowdfunding might require collateral or a personal guarantee. If the loan isn't repaid, you risk losing the assets you've pledged as collateral.
4. Donation-based crowdfundingThe donation-based crowdfunding model is commonly used by nonprofits, social entrepreneurs, and startups where the “return on investment” is not financial, but a social good or some form of community benefit. Backers donate money to the project because they believe in the cause, not because they're expecting a financial return. GoFundMe is a well-known fundraising platform for donation-based crowdfunding.
Pros of donation-based crowdfunding:No repayment or equity exchange: Backers donate the money to your project or cause, so you don't have to worry about repaying a loan or giving up a share of your business.
Support for social causes: Donation-based crowdfunding is particularly effective for projects or causes that have a social, charitable, or community focus.
Community engagement: This form of crowdfunding can be a good way to build a community of supporters who are emotionally invested in your project or cause.
Cons of donation-based crowdfunding:Limited appeal: Donation-based campaigns often rely on the emotional appeal of the project or cause, which might limit their appeal to a wider audience. These campaigns may be less successful for commercial projects.
Lack of guaranteed funding: As with other forms of crowdfunding, there's no guarantee you'll reach your funding goal. On some platforms, if you don't reach your goal, you won't receive any funds.
Public exposure: As with other forms of crowdfunding, your idea is public, which could lead to someone else replicating it.
Platform fees: While the money you raise doesn't have to be paid back, most platforms charge a fee based on the amount of money you raise.