What is crowdfunding?
Crowdfunding an umbrella term that refers to a modern way of funding businesses online by means of a public funding campaign. The Merriam-Webster dictionary defines it as “the practice of soliciting financial contributions from a large number of people especially from the online community”. Crowdfunding is a form of crowdsourcing, which refers to obtaining services, ideas or content from the online community.
At the core of crowdfunding are three defining aspects:
Investments come from large numbers of investors (hence the ‘crowd’)
The average investment is relatively low (hundreds to thousands of euros)
The investments and fundraising campaigns take place online
Types of crowdfunding
While all types of crowdfunding share the three aspects listed above, crowdfunding is still a vague term that can refer to several very different types of fundraising. There are four generally recognised types of crowdfunding: equity, debt, rewards and donations.
Equity and debt crowdfunding together make up investment crowdfunding. In these types of crowdfunding, the entity seeking funding is always a company, generally a limited liability company. In exchange for money they give investors shares in the company, in the case of equity crowdfunding, or bonds or IOUs in the case of debt crowdfunding. From the point of view of the person giving the money, these crowdfunding campaigns are investments: they carry a risk of losing the invested capital while also having the potential to make a profit. Equity crowdfunding and debt crowdfunding are suitable for companies who already have revenues and are looking to fund their growth. At Invesdor, we focus solely on equity crowdfunding and debt (bond) crowdfunding.
Rewards-based crowdfunding is most easily compared to pre-sales. In rewards-based crowdfunding, a business or a project group markets a product or service that it is generally looking to launch into the market in the future. Contributors either pre-purchase the product or service or receive other kinds of tangible compensation such as merchandise. The contributors still run the risk of losing their money if the campaign creator is unable to deliver the product or service, but they generally have no way of making money. Therefore, contributions in reward crowdfunding projects are purchases, not investments. Rewards-based crowdfunding is best suited for pre-revenue companies looking to find market validation for their product or service, but a rewards-based crowdfunding project is also often used as a general pre-sales/marketing campaign when launching a new product or service.
Donation crowdfunding involves charitable donations. As these are donations, the contributors receive nothing tangible or financially valuable in exchange for their money. These types of campaigns are typically run by ordinary people to promote noble causes, such as building an animal shelter, or reaching out for help in getting over bumps in their personal lives, such as paying for a costly surgery. Donation-based crowdfuding is most often used by individuals or small charitable organisations.
Non-crowdfunding ‘crowd’ models: Some funding models that tap into the power of the ‘crowd’ but do not utilise the online aspect might sometimes still be called crowdfunding, however this interpretation is misleading. There has always been soliciting of donations or other contributions from the general population in the form of direct mailing campaigns, cold call sales or newspaper ads such as in the case of the building of the pedestal of the Statute of Liberty. What these models lack is the online aspect, which has become a central characteristic in modern crowdfunding because it has made organising of funding campaigns significantly cheaper and more scalable while also enabling people all over the globe to participate in them.
Why choose crowdfunding?
We have identified six main reasons that companies choose to use a crowdfunding platform. The reasons do differ between different types of crowdfunding, and ours have been collected in the context of investment (i.e. equity and debt) crowdfunding.
Reason 1: Raising money
This one is self-explanatory. The number one reason companies choose to use a crowdfunding platform is for raising funding. However, this reason alone doesn’t explain the choice of crowdfunding sites over other forms of financing.
Reason 2: Building brand awareness
This reason is a major differentiator between crowdfunding and for example bank financing. If planned and executed well, a public funding campaign is a strong builder of visibility and thus brand awareness, which is something private funding arrangements or bank lending won’t be able to provide.
Reason 3: Engaging clients
The crowd does not only mean faceless masses unknown to the company raising funding. All companies have a crowd of their own: their clients. If a company’s product and service are excellent, its customers will often be eager to invest in it. Happy customers can recommend a product or service to their networks, but a happy customer that is also a shareholder in the provider of that product or service will be even more likely to do it.
Reason 4: Finding market validation
Market validation is more often relevant in rewards-based crowdfunding, as compared to equity or debt crowdfunding it is a better channel for companies that have yet to launch their products or services to the market. The main logic behind the idea is that crowdfunding websites are marketplaces frequented by donators, consumers or investors, depending on the type of crowdfunding site. Promoting your future offering in such a marketplace will allow the users of the crowdfunding platform to vote with their wallets on whether they find your offering interesting or not. Sometimes the best return on a campaign is feedback from the market.
Reason 5: Getting ready for public listing
Companies looking to list their shares on a stock exchange need to have a fairly large number of existing shareholders. Many marketplaces require that the company have at least 100 shareholders to ensure liquidity for the share once listed. Most private companies that have only raised funding from a closed circle of friends, family and business angels do not have a hundred shareholders. This is where expanding of the shareholder base will become necessary, and a crowdfunding campaign is an efficient way to do it. These types of projects are often called pre-IPO offerings, as they are done to grow the shareholder pool and build awareness in preparation for a public listing in the near future.
Reason 6: Entering new markets
Entering new markets is typically done with sales and marketing efforts. With crowdfunding, a company looking to enter new markets can combine marketing and sales with raising funding for the actual expansion. By targeting a fundraising campaign to the countries that the company wants to expand into it can acquire local shareholders. These shareholders can then act as brand ambassadors, spreading awareness of the company, asking retailers to take their products in stock or connecting the company with valuable local networks because this way the investors are actively growing the value of their investment.
Who is crowdfunding for?
On the company side, different types of crowdfunding can be useful in all stages of the company’s growth. For pre-revenue startups, rewards-based crowdfunding is a good way to test market fit, build awareness and get pre-orders for their products. As the company becomes more established and has solid revenue, it will be time to take a growth leap, which often requires external funding. In this stage, investment-based crowdfunding in the form of equity or debt is generally a better choice. This will often be a ‘series A’ funding round, however many ‘seed’ rounds are also done via equity crowdfunding platforms. Throughout the rest of the lifespan of the company, it can use equity crowdfunding platforms as add-on tools to make its securities (equities or bonds) offerings easier and more efficient.
From the point of view of a member of the ‘crowd’, rewards crowdfunding is pre-purchasing of a product, i.e. consumption, whereas participating in an equity or debt crowdfunding campaign is an investment. Pre-purchases for consumption purposes and investments are of course very different types of transactions, however both involve risk. The risk a buyer faces when pre-purchasing is that the company is unable to deliver the product.
In the case of investments, there is always a risk of losing money. Both equity and debt crowdfunding investments are generally regarded as high-risk investments. The reason for this is that these investments are often in early-stage companies that have a higher bankruptcy risk compared to more established companies, generally do not pay dividends, and the liquidity for the investment is low because the shares or bonds are not listed on a stock exchange. These investment risks are somewhat lowered in the case equity crowdfunding platforms doing IPOs, as listed shares are considered ordinary investment instruments. Investors should always carefully consider what they are investing in and invest responsibly.
Donation-based crowdfunding is generally only suitable for small projects or organisations that are charitable in nature. Businesses should focus on rewards, equity and debt crowdfunding. For members of the crowd looking to make donations into good causes, donation-based crowdfunding sites might be worth looking into.
How crowdfunding works
It is useful to think of a crowdfunding platform as an online marketplace. On the marketplace, there are several products available for shopping. In the case of rewards-based crowdfunding, those products are pre-purchases of actual products, collectible items or other perks. In the case of equity crowdfunding, users of the marketplace are shopping for shares of companies, and in the case of debt crowdfunding they are shopping for bonds or IOUs of issued by companies. A crowdfunding platform pools all these projects and campaigns together on its marketplace and drives traffic to the marketplace by promoting the campaigns and its own services.
Crowdfunding is a numbers game; it’s all about volume. The crowdfunding site itself helps with volume, but more is always better when it comes to traffic and eyeballs on your pitch. This is the reason why a crowdfunding project needs to be thought of and planned as a marketing campaign. When a company is planning its marketing, it should focus on digital channels, because those are the most scalable ones. However, the company’s people should keep in mind that the marketing mix that worked for one campaign might not work for theirs. Some tailoring is always needed, but one thing that all successful crowdfunding campaigns share is a good story, so companies need to focus on telling theirs well.
You can easily find many online guides and articles that will teach you the basics of crowdfunding. Much of the general advice related to rewards-crowdfunding campaigning is transferrable to equity and debt crowdfunding, and vice versa. Companies will need to change their tones and key messages depending on the channel though: what works on consumers might not work on investors.
Most crowdfunding platforms make companies set a minimum and maximum funding target for their campaigns. Once the minimum is reached, the campaign is considered successful, and only then will committed money be transferred to the company. If the minimum is not reached, all commitments and investments are returned to the contributors or investors. This ‘all-or-nothing’ model has become the industry standard in crowdfunding. Furthermore, crowdfunding sites often base most their pricing on a success fee, which means that they only get paid when the campaign succeeds. In addition to the success fee the platforms may charge upfront listing fees and post-campaign closing fees, but these are generally relatively small sums.
All crowdfunding campaigns follow the same basic structure: preparation, campaigning, and closure.
Preparation includes preparing your marketing material (the ‘pitch’) on the platform you’ve chosen, making sure your marketing plan is ironclad and preparing any necessary paperwork such as shareholder decisions when issuing equity (equity crowdfunding platforms will help you with these and provide templates). The preparation phase generally takes one to two months depending on how much marketing material (text, images, videos) you have ready.
Once all the material has been uploaded onto the crowdfunding platform and all necessary documents are in order, the campaigning begins. Often the campaigning phase is split into two: a hidden phase and a public phase. In the hidden phase, the company approaches its closest networks to secure the first investments before anything about the campaign is said publicly.
The reason for having a hidden phase is simple. Just imagine yourself as an aspiring investor browsing through cases on a crowdfunding website, and you see an interesting case with 0% invested. Would you invest? Most likely you wouldn’t, because the case lacks social validation. Nobody else has believed and invested in it yet, so why would you? This is the reason why it is vital to always have a minimum of 30% of your minimum funding target already committed before going public with the campaign – otherwise the inertia will simply be too high to get the ball rolling. On average, the hidden phase takes two weeks.
The public phase of the fundraising campaign is a constant barrage of marketing actions: email newsletters, social media, phone calls, meetings… All channels should be used, because in crowdfunding success doesn’t happen by accident. source