What Is Crowdfunding: Risks, Benefits, Guide, & Examples


What is crowdfunding?

Crowdfunding means that a large group of individuals with small sums helps to finance a business, instead of one or a few investors contributing a larger sum. The collection takes place via crowdfunding websites and many times the investors are unknown to the entrepreneur.

How does crowdfunding work?

You present your business idea on a crowdfunding website and at the same time you seek financial support from individuals and companies.

The website presents many business ideas at the same time and it looks a bit like a bulletin board. And crowdfunding has been used to fund everything from museums and mini-robots to computer games, movies and books.

There are different types of crowdfunding:

  • Donation-based crowdfunding are pure gifts without the financier getting anything back.
  • Classic crowfunding can be seen as a loan where you get back either through money or that you instead get access to the final product.
  • Equity crowdfunding is based on those who want to support the business idea making an investment and becoming shareholders.

Typically, a project receives about 25-40% of its revenue from its first, second and third hand contacts. It can be about friends, family, colleagues or other people with whom the owner has contact.

When the business idea has received some traction in that way, it often begins to attract unknown investors.

Why do companies want crowdfunding?

There are more reasons why a company chooses to finance projects through crowdfunding than, for example, through stock exchange listings or traditional financing rounds.

  • Being a listed company means greater demands on transparency, which can be administratively demanding and cost money – which not all companies want to spend time and money on
  • A crowdfunding round can be completed much easier and faster than a traditional financing round where investors must be hunted down and convinced
  • A loan or investment from individuals can be cheaper, easier and less demanding than a loan from traditional lenders

What are the risks of crowdfunding?

As with all types of investments, there are risks with crowdfunding. Companies may not succeed, they may not be able to repay the loan or projects may be forced to close.

To manage the risks that exist, it is important – as always – not to put all eggs in the same basket.

Do not tie up all your savings in crowdfunding and the money you invest is spread out over several different companies in order to spread the risks.

No deposit guarantee

Common to the platforms where you issue direct corporate loans is that they make a solid risk assessment of the companies.

Then the companies are classified in different risk classes where higher risk means higher interest rates on the loans, but of course more uncertain repayment fulfillment.

You can thus choose what risk you are willing to take when you lend the money.

What you should be aware of, however, is that corporate loans are not covered by the deposit guarantee.

There is thus no guarantee that you will get back the money you have invested.

No refund guarantee

There are safety nets in the Swedish economy (not sure about the rest of the world), where different types of collateral such as guarantees and mortgage deeds can be used. However, there is no guarantee that your loans will be paid or that the interest will be paid on time.

Therefore, be very careful to read about which rules apply.

Risk that the marketplace will close down

Crowdfunding in its current form is, after all, a relatively new phenomenon. There is thus a risk that the platforms that provide the services themselves will be forced to close down.

It can then be very cumbersome to get the money you have invested.

What is required of you?

When you raise capital through crowdfunding, there is really no requirement that you give something back. But it is common for entrepreneurs to offer various benefits in exchange for capital.

It can be anything from offering a shirt for a small amount to giving the donor access to the finished product, or offering a certain percentage of the investment back as an exit.

But what is important to remember is that all arrangements can look different, some want pure donations and others offer benefits in exchange for a fixed investment amount.

When is crowdfunding appropriate?

Crowdfunding has proven particularly suitable for certain industries. It is required that your idea and your offer is interesting enough to get people to invest.

If you have the idea to start a construction company, the interest in crowdfunding is probably small.

If you are going to build a fantastic (or horrible) art installation instead, the interest in crowdfunding will probably be greater.

Crowdfunding is therefore suitable when you have an idea that appeals to many, it can be aesthetic, entertaining, cultural, technical or in some other way interesting for the investor.

Crowdfunding at all stages?

Yes, in principle. Of course, you need to have an idea that appeals to investors. But both start-ups and growth companies can attract investors through crowdfunding.

How to attract investors?

Well, by having an interesting idea! Of course, you must also be able to present your idea in a good way. It is common to present your idea through a short film, so have a good pitch ready and make sure to give investors the information they need.

Among other things, you need to provide information on expected returns, financial information and expected sales to those who are looking for a pure investment and who expect a monetary value back.

Anyone who instead expects another value back needs to know what value you are creating, so let them provide input on your idea.

For example, if you are creating a game, let them be part of the development and provide feedback on what you are developing. For them, it is often a sufficient reward to play your cool game and to have a say.

Being passionate and believing in your idea can go a long way, make sure you can communicate it as well.

That’s how crowdfunding started

The concept of crowdfunding was coined in the USA in 2006 and had a big impact through sites such as Kickstarter and Indiegogo.

After the financial crisis made it more difficult to seek capital – and the rise of social media – the crowdfunding movement gained further momentum.

In 2010, various platforms are estimated to have raised around 899 million dollars and this year the figure had risen to 33,9 billion dollars.

Big and small crowdfunding projects

Crowdfunding projects can look very different. Those seeking capital can be both established companies and a completely new player in the market.

It can be anything from a new invention that benefits the whole community to a feature film or a personal art project.

The big advantage of crowdfunding is that a large group of individuals can help with small sums – instead of one or a few investors contributing a larger sum.

More benefits of crowdfunding

Crowdfunding can also serve as a tool to control the potential of a product or service. By crowdfunding your idea, you can test it on a larger target group and get an early rating on whether you are on the right track.

Through the investors, the entrepreneur gets ambassadors who can tell others about the product or service – long before it is launched.

Investors may have different reasons for applying to crowdfunding projects. Some projects may appeal to the investor on a personal or professional level, which makes them want to see it realized.

Some are mainly interested in the process itself, and find it exciting to gain insight into how a project is created.

However, it is common for financiers to give something back to investors. Some of those seeking capital offer investors some influence in the development of the product or service.

Some allow investors to become partners in the company.

It is common for the contractor to give investors the opportunity to pre-order the product or service against advance payment or to use the service at a discounted price.

Conclusion

Examples of platforms for crowdfunding

  • Kickstarter – The world’s most famous platform for crowdfunding
  • Indiegogo – A large platform used globally
  • Startnext – For those who want to reach the German market
  • Crowdfunder – For those who want to reach the British market
  • Verkami – For you who want to reach the Spanish market
  • StartSomethingGood – Crowdfunding for social entrepreneurs

Sources

https://www.sciencedirect.com/science/article/pii/S088390261300058X

https://www.journals.uchicago.edu/doi/full/10.1086/674021

https://www.tandfonline.com/doi/abs/10.1080/13691066.2013.785151

https://www.nber.org/papers/w16820

https://www.econstor.eu/handle/10419/52302

https://www.proquest.com/openview/a956a38633042217cb0389ba9b36f0b3/1?pq-origsite=gscholar&cbl=2046130

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.416.4643&rep=rep1&type=pdf

https://www.fundraisingschool.it/wp-content/uploads/2013/02/European-Crowdfunding-Framework-Oct-2012.pdf

https://www.sciencedirect.com/science/article/abs/pii/S0167624515000463

https://dl.acm.org/doi/abs/10.1145/2530540

Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

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