Crowdfunding campaigns as a means for startup funding have emerged as a potential alternative to angel and venture capital (VC) investments.
What is crowdfunding? Crowdfunding is the use of small amounts of capital contributed by a large number of donors during an online fundraising campaign in order to support the financing of a new venture.
The advent of crowdfunding is linked to the increased importance of social networking in a business context. The success of a crowdfunding campaign often rests on the strength of the new venture’s network.
Some startups have been able to leverage their network to mobilize a large number of donors and fundraise millions of dollars in capital in relatively short amounts of time. For this reason, crowdfunding campaigns have become a significant startup funding mechanism.
Raising funds in the form of equity or debt for a new venture is an activity regulated by law. Many jurisdictions, including Ontario and the US, currently prohibit the use of crowdfunding for that purpose.
However, as of December 2013, the Ontario Security Commission and the US Securities and Exchange Commission (SEC) were considering amending their regulations to allow some form of crowdfunding to be used to raise capital for new ventures. The key factors of concern for security regulators include various forms of investor protection, the use of a middleman (that is, the crowdfunding platform) and the venture’s reporting requirements.
Most regulators recognize that crowdfunding campaigns can help lower the cost and expand the capital pool for startups. At the same time, regulators place a priority on maintaining market trust by providing safeguards against fraudulent activity.
In the United Kingdom, for instance, crowdfunding for equity is permitted. In Saskatchewan, in late 2013, regulators issued rules that allow crowdfunding for projects originating in that province.
If a venture is potentially investment-grade, a successful crowdfunding campaign can reveal whether a project merits serious investor consideration. Beyond the fundraising targets (met or not), campaigns garner significant amounts of publicity and market feedback. These are valuable campaign outcomes that startups might otherwise have difficulty obtaining quickly and at a low cost.
Information learned during a campaign can further the market validation needed for future potential investors, thus helping advance the equity-raising process required to scale the business.
With equity and debt unavailable through crowdfunding in Ontario, campaigns currently focus on fundraising through donations and pre-sales.
Many crowdfunding ventures, especially those in the arts and non-profit sector, are not the type of investment-grade opportunities that attract venture capital and angel investors. For those ventures, as well as niche startups with limited growth potential, donations and pre-sales would always be the crowdfunding practice on which they would rely.
In crowdfunding terms, a donation is a monetary contribution to a crowdfunding campaign given in exchange for a reward.
Rewards can range from a token thank-you tweet for a small contribution to an exclusive meeting with the founder/CEO for a larger one.
The crowdfunding platform Kickstarter operates with three categories of rewards: collaborations, experiences and mementos. Project (campaign) organizers invest a great deal of creativity into designing and describing the rewards of each campaign to make them attractive for supporters and to enable both small and large contributions.
Through a pre-sales campaign, a product or service of the project being funded can be pre-ordered. Often the item itself will be offered in a limited version or bundled into an experience package to increase its attractiveness and generate excitement with the campaign’s supporters.
For startups, the potential reach of pre-sales is particularly attractive for products and services that appeal to a narrow market niche.
Pre-sales is also appealing for startups that manufacture physical items as it helps to:
Nevertheless, there are risks in offering a pre-sales reward. Risks include setting the right price to:
The logistical requirements (for example, cost, packaging, shipping time) and any taxes involved in shipping goods across international and provincial borders can also add complexity to the process. For more information on risks involved with crowdfunding, see Crowdfunding risks.
Crowdfunding may appeal to those startups following the Lean Startup approach and seeking to validate their business model. Keep in mind that a lot of preparation is required to launch a successful crowdfunding campaign.
Also remember that the field of crowdfunding is developing rapidly with new crowdfunding platforms entering the market and regulations in flux. Before you plan your crowdfunding campaign, make sure to research and meet current regulatory requirements.
Crowdfunding now, but interested in learning more about preparing for angel and venture capital investment? We’ve created a free online course to help you get investment-ready. Check out Introduction to Investment Readiness and learn useful tips, tactics and strategies to prepare for your seed fundraising round.