What Is Crowdfunding? The Clear and Simple Guide

"Crowdfunding will befome the future of how most small businesses are going to be financed." - Duncan Niederauer, Former NYSE CEO

Crowdfunding leverages the power of online social networks (the “crowd”) to help people, businesses and charities raise money (the “funding”) for a variety of purposes. As with other types of funding, there is a wide range of who’s, what’s and why’s when it comes to this space, along with a number of risks. Here is some valuable information to help you get started on learning about this popular topic.




A brief history of crowdfunding


While it may come as a surprise to some, Crowdfunding has been around for hundreds of years. In the 1700s author Jonathan Swift founded the Irish Loan Fund, a crowd-funded source of loans to low-income families in rural Ireland. By the 1800s, 20% of all Irish households used at least one of the 300 crowdfunding programs to gain access to small sums of cash.

Fast forward to 1997 when British rock band Marillion funded their reunion tour 100% through online donations from fans - modern-day crowdfunding was truly born. Inspired by Marillion’s innovative method of financing, more crowdfunding platforms began to emerge in the early 2000’s and by 2011 crowdfunding platforms raised more than $1.5billion worldwide.

As a response to this rapid growth, in 2012 President Barack Obama signed the JOBS Act, also known as the “crowdfunding bill”, into law. Amongst other provisions aimed at helping small businesses, the bill legalized equity crowdfunding in the U.S., making crowdfunding an official part of the traditional fundraising landscape.




Types of crowdfunding


There are various types of crowdfunding that currently exist in the marketplace:

Rewards (“Non-equity”)

In reward-based crowdfunding (also called non-equity crowdfunding), the fundraiser offers a reward, typically in the form of a service or physical good, in exchange for funding. This type of crowdfunding is used for a wide range of purposes including scientific research, development of inventions, civic projects and so on.

Equity

In equity-based crowdfunding, the fundraiser offers an equity stake in a business in return for a potential return on investment. Like most equity investments, donors are relying on the fundraiser to utilize the funding they receive to build and grow a profitable business, of which they will share in the profits through a small ownership. For more info on investing, read our Investment Rules of Thumb.

Donation

In donation-based crowdfunding, the fundraiser seeks funding for a charitable cause with no obligation to give donors anything in return for their contributions. This is the most common type of crowdfunding and is used for a wide range of typically pro-social or pro-environmental purposes. Due to the popularity in this type of crowdfunding, risks surrounding fraudulent campaigns and privacy issues are a concern.

Software value token

In software value token-based crowdfunding, the fundraiser offers a digital or software-based value token in exchange for funding (or an initial coin offering “ICO”). This type of crowdfunding may be used to fund tokens that already exist, or tokens that do not exist and therefore still require substantial development efforts before the token is live. Although ICO’s have grown in popularity over the years, there has been many cases of fraudulent campaigns, so risks remain high. Learn a little about Blockchain here.




Advantages of crowdfunding


Online crowdfunding removes the traditional barriers that often exist when raising money for a worthy cause. With modest (sometimes free) platform fees, if a campaign is successful, fundraisers will typically receive the majority (if not all) of funds they set out to raise. Successfully campaigns can also receive a lot of attention on social media and elsewhere which can help grow awareness for the business, charity or project being funded.

Crowdfunding is a great way for unique and interesting ideas to get funded that wouldn’t have access to financing using more traditional channels. Donors also gain access unique altruistic-based or investment-based opportunities otherwise not available.




Risks of crowdfunding


Unlike traditional methods of raising finance, crowdfunding can involve a unique set of risks that should be considered by fundraisers and donors alike. For example, an unwelcome side effect of greater attention are the risks that others can copy unique ideas before these ideas have realized any rewards. Reward-based campaigns focused on new inventions could run the risk that too many people have access to valuable intellectual capital before the inventor has seen it through to fruition.

Businesses that choose to use equity-based crowdfunding to raise funds risk selling ownership in their company to investors that expect to have a say in how the business is run. While this can sometimes result in valuable guidance and advice from experts, it could also have a negative effect if investors hold up progress or demand the business go in a different direction than the founders intended.

Finally, like all areas of finance, crowdfunding is not immune to fraud or unethical behavior. Fake companies, fraudulent charities, and poorly run platforms remain an unfortunate part of the crowdfunding ecosystem. Whether you’re a fundraiser or donor, it is important to check the credibility of the crowdfunding platform and do your due diligence before entering this space.




Conclusion


Crowdfunding has come a far way since its humble roots back in the 1700s. With over 6 million worldwide campaigns raising billions of dollars last year alone, crowdfunding is rapidly becoming a significant player in the global financing marketplace. While it comes with a unique set of risks to consider, the advantages can be plentiful for those who can navigate the terrain well-informed.