Nov 14, 2022 | Starting a Business

Is crowdfunding a legitimate way to fund my business?

Q. Dear Zenagos, I’ve heard a lot about crowdfunding. Is this a legitimate way for me to fund my business?
–Fatima

Crowdfunding is a legitimate way to fund your business if you work with a reputable platform and you are great at whipping up enthusiasm for your project.

What is crowdfunding?
The term “crowdfunding” describes a way of raising money from a large number of people through an online platform. The founder or entrepreneur (often referred to as a “creator”) explains the business, as well as the rewards that funders will receive for their participation. You might end up with dozens, hundreds, or even thousands of small donations, depending on your approach.

Types of Crowdfunding
The types kinds of crowdfunding differ in the rewards that are offered to funders.

Classic Crowdfunding
The form of crowdfunding that is most popularized by the media is “donation crowdfunding.” In this form, funders provide money for the business, and they expect nothing in return. They do it because they want to support the founder and/or the project.

Rewards Crowdfunding
As with the classic “donation crowdfunding,” in “rewards crowdfunding” the funders do not receive any traditional debt or equity, but they do receive a reward that is explained with the offer. For example, if the founder or creator sought crowdfunding to create a book, the reward for funders might be a signed copy of the book in advance of its general release. Rewards can be very creative and can appeal to funders in a variety of ways.

Debt Crowdfunding
This form of crowdfunding is like a loan. The funders will be paid back on a timeframe that is explained with the offer. This has advantages over other forms of loans, since it typically does not require a credit check or collateral or the other terms that are usually required by banks.

Equity Crowdfunding
Just like traditional equity investing, equity crowdfunding presents funders with shares of stock in the company. This activity falls under a different category of regulations than other forms of crowdfunding, so investors may need to be “accredited” in order to participate. You can learn more about accredited investors in this post.

Is Crowdfunding Legal?
Crowdfunding is legal if it follows the regulations stipulated by the US Securities and Exchange Commission (SEC), which regulates investment activities to protect the public. The key requirements are:

  • The crowdfunding transaction needs to take place online through an SEC-registered platform
  • You cannot raise more than $5 million in a 12-month period
  • If your investors are “non-accredited,” then the amount they can invest is limited
  • The platform needs to send disclosures to investors and file paperwork with the SEC

As long as you work with a registered platform and follow the SEC regulations, it is legal. Some successful crowdfunding sites are Indiegogo, GoFundMe, and Kickstarter.

Pros and Cons of Crowdfunding
Every form of fundraising has strengths and weaknesses. Here are some general pros and cons of crowdfunding:

Crowdfunding Pro: A campaign can be exciting and uplifting
If your idea is appealing, it could go viral, which is very exciting. Certainly, a successful crowdfunding effort proves that there is interest in your idea, which could help you win more funding from traditional sources like banks and formal investors. Finally, and perhaps most importantly, a crowdfunding campaign can help you find and develop a community of like-minded individuals.

Crowdfunding Pro: You can start a company with no money and/or bad credit
Traditional funding methods may not be available to you. If you have no money or no experience, investors may turn you down. If you have bad credit or no credit history for your business, you will most likely not be able to get bank loans. If you have been in prison or have other challenging history, that may also close doors. Depending on the crowdfunding site and how you put your offer together, you may be able to overcome any or all of these obstacles.

Crowdfunding Pro: You may not need to pay anyone back
Depending on the type of crowdfunding, you may be able to keep the funds you acquire without strings attached. This is a significant advantage over most other forms of business funding.

Crowdfunding Pro: You won’t lose control of your company
Most traditional funding arrangements involve risk. Depending on how you perform financially, this risk may involve losing control of your company. In equity arrangements, your investors may acquire enough shares to have a controlling interest in the company and vote you out. In debt arrangements, if you fail to meet loan covenants, the lender may be able to transform your debt into equity and take control of the company. Crowdfunding arrangements rarely involve the risk of losing control of your company.

Crowdfunding Con: Someone can steal your idea
If your idea is unique, posting it on a crowdfunding site can be risky. In most cases, the success or failure of a business is based on its owner’s execution and decision-making, not on the uniqueness of the idea. However, in some cases, the idea itself is important. Clever investors certainly trawl crowdfunding sites looking for ideas to copy, so this is something to consider.

Crowdfunding Con: You will have to pay fees
Whatever platform you choose, that organization will benefit from your campaign. The crowdfunding site usually takes a percentage of what you raise (such as 5-10%), and you will have to pay the fees of any financial processor that is involved, such as 2-5% in credit card transaction fees.

Crowdfunding Con: You may not get the money
You need to read the fine print on your crowdfunding site so you understand the specifics of how that site works. For example, some sites are all-or-nothing: You set a fundraising target, and if you don’t hit it, you don’t get any of the money. So, if you are working with a site like that, you need to set your target carefully.

Crowdfunding Con: You may spend more money marketing than you get in funding
The crowdfunding site will probably feature your offer somewhere on its site, but there will be many, many offers on the site. If you want your campaign to be successful, you will need to market it yourself. People are bombarded with marketing messages, and they are good at ignoring them, so making your offer stand out will take time, effort, and money. In many cases, people who try crowdfunding spend more on their marketing campaign than they receive in funding!

If you already have a strong social media presence and you are a natural self-promoter, crowdfunding may be a terrific option for you. As you continue your research, you may enjoy these earlier posts:

Related Posts on “Ask Zenagos”
I am staring my own business. How does investment work?
I know I need investors to fund my business. Where do I start?
How do you convince potential investors to take you seriously?
Is it better to get an investor or a business loan from a bank?

References

Murphy, K. (2014, January 22). Crowdfunding tips for turning inspiration into reality. New York Times. Retrieved on November 13, 2022 from https://www.nytimes.com/2014/01/23/technology/personaltech/crowdfunding-tips-for-turning-inspiration-into-reality.html

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