crowdfunding diagram

What is Crowdfunding?

Last Updated on February 16, 2021 by Grey Idol

It is often a struggle for entrepreneurs to find ways to fund their new business ventures. There are plenty of options, from traditional to unique.

A popular and newer idea in business funding is crowdfunding. This method allows you to raise quite a bit of money without asking for a huge risk from those investing due to the set up of the process.

If you don’t know much about crowdfunding but need to find creative ways to fund your business, now is the time to learn about this financing method and see if it may be the solution for you.

Crowdfunding Defined

Crowdfunding is raising money from various people who invest small amounts into the project. It almost always occurs online.

How It Works

Crowdfunding will involve three parties. It starts with you having a need for money and asking for it. Then, you will have a platform upon which you can ask for the money. Finally, you have the investors. There is also often a fourth party, and that is the people who support you and help spread the word about your venture.

You will have to craft a pitch just as you would when soliciting money through any other means. You have to convince people to invest in your idea because there will be many other options available.

The investor will choose how much money to put into your project. Most platforms allow for very small investments, such as $10. The idea is not to get a lot of money from one source. You want to diversify. It helps to reduce the risk to the investor while allowing you to appeal to a wide number of investors.

You should note that the crowdfunding platform will take money from what you earn. This is how these platforms earn revenue.

Crowdfunding vs. Other Business Financing

There are many ways to fund your business, so you may wonder if crowdfunding is the best option for you. It can help to compare it to the other choices you have to see how it stacks up.

Business Loans

One of the most common ways to get business funding is to secure a business loan. Business.com explains that these loans typically come from a bank. There is an application process that often takes some time to get through. Plus, the bank has strict qualification requirements, most notably that you have a good enough credit history.

Crowdfunding is not as complicated. While you may have to qualify through the platform, it is usually a quick process. Plus, credit histories and scores are not part of the process.

On the other hand, once you get through the bank’s application process, you can usually get your money fairly quickly. With crowdfunding, you have to wait for investors to find your project and make their investments.

Perhaps the biggest difference is that you must repay a bank loan. You don’t have to repay money you raise through crowdfunding, but if you make promises to investors, such as a return on the investment, then you do need to fulfill those. Plus, a bank loan comes with interest tacked on, whereas crowdfunding only has a one-time fee.

Credit Cards

Another option for business funding is using a credit card. The biggest issue with this type of funding is the high interest rates. It will cost you a lot of money to fund your business this way.

Other than that, the application process isn’t too difficult, and you can get access to funding very quickly. NerdWallet also explains that by using a credit card for business funding, you will be able to build your business credit, which can make securing funding in the future much easier.

Venture Capitalists

Using venture capitalists to fund your business is somewhat similar to crowdfunding in that you are seeking investors who directly put their money into your business. However, with venture capitalists, the investors will often want some involvement with your business. The U.S. Chamber of Congress explains that this can be a good thing as your investors may assist you as consultants.

They will have more at stake when it comes to the success of your business as well. However, they also can provide continuing funding as you need it whereas crowdfunding is a one-time investment.

Benefits and Drawbacks of Crowdfunding

Entrepreneur explains that crowdfunding, like any type of effort to raise business funding, comes with its good and bad points. You need to weigh these to see if this is the right option for your needs.

Benefits

Crowdfunding gives you the opportunity to try out your idea. It’s kind of a marketing test where you see if anyone finds it interesting. If you start to draw in investors, it can give you some positive market feedback and a good idea that this venture may succeed.

On the other hand, if nobody invests, then it may be a sign your idea isn’t all that great. However, you really don’t lose anything by trying crowdfunding, and the feedback you get is invaluable.

Also, with this type of fundraising, you will discover a great customer base. Many investors will become your first customers because they believe in your business. They also feel like they have some responsibility to help your business grow, so they may tell others about your business and help it to grow via word-of-mouth advertising.

Finally, crowdfunding is a low-cost option. The only real investment is your time to set up the pitch and monitor what is happening. You won’t even pay fees until you reach your goal and collect the money.

Drawbacks

The downside to crowdfunding is that it can be hard to get investments to start rolling in. There is a lot of competition, especially on more well-known platforms. You need to have some type of compelling story to even catch anyone’s eye. Then you must convince them to give you their money instead of some other campaign.

You can waste a lot of time with no return. If you don’t receive any investors or you fail to reach your goal, you end up with nothing.

There is also a risk that comes with delivering on your promises. You will have to offer something to get people to invest, and if you fail to deliver, you could face legal issues.

Types of Crowdfunding

The general idea of crowdfunding is the same in every situation. You receive money from those interested in your business idea. However, Business News Daily explains there are different types of crowdfunding with various methods of how you get those funds.

Reward System

The reward system of crowdfunding provides an immediate return for an investment. You would provide investors with some type of reward for his or her investment. The basic idea is to tie the reward’s value with the amount of money the person gives you to encourage larger investments.

Equity System

You cannot allow investors to buy a portion of your business with their investments, but you can share equity with them. This serves as a big incentive for investors who truly believe in your business idea. They feel strongly you will be a success, which means they will end up reaping the rewards of that through the equity they own in your business. The amount of equality they receive depends on the size of the money they give you.

Donation System

Often with crowdsourcing, you will provide a promise to give investors something in return. With a donation system, there is no return. The people who invest are simply giving you money with no strings attached.

Debt System

A debt system makes the process more like a loan. You will raise money the same way, but you will have to pay the money back. This also usually tacks interest onto the money you receive.

Wrapping Up

Crowdfunding is one alternative financing option for your business. It is not for everyone, though. It has its pros and cons. You have to decide for yourself if it sounds like something that will work for your situation.