by Cynthia Nevels
Crowdfunding is any financing method that involves taking small amounts of money from a large number of individuals.
Key Takeaways
Crowdfunding occurs when an entity seeks small-dollar funding from a large group of individuals.
Crowdfunding is typically facilitated by websites that connect fundraising entities with individuals who are willing to contribute to that entity.
The funders may or may not expect something in return for their funding. It could be viewed as a donation, or they may expect equity, products, or services.
How Does Crowdfunding Work?
Crowdfunding combines the concepts of crowdsourcing and microfinancing, bringing together various individuals who commit small amounts of money to projects and entities they want to support. This is often done through websites that make it easy for entities to find potential funders. Funders could expect something in return for their contributions—such as equity, products, or services—or they may donate the funds.
The people who fund crowdfunding projects and entities may do so without expecting anything in return—they're donations to a cause they support. Others fund projects in exchange for products, services, or equity.
Crowdfunding is a way to raise money for a project or business by asking many people to donate small amounts. There are four main types of crowdfunding:
Donation-based Individuals donate small amounts to a charitable project or social cause without receiving any financial or material return. In return, they may receive token rewards that increase in value with the size of their donation.
Rewards-based Individuals donate to a project or business in exchange for a non-financial reward, such as a product or service at a later date.
Equity-based A business sells a stake in itself to investors in exchange for investment. In return, investors receive equity shares in the company.
Debt-based Businesses share future profits or revenues with the crowd in exchange for funding.
Example of Crowdfunding
One common example of crowdfunding is a creative project a musician you like may use crowdfunding to produce their next album. They make a Kickstarter page for the new album, outlining the basic ideas they have for it. You (along with other fans) contribute $10 to the project. In return, you will receive a digital copy of the album when it's done.
Oftentimes crowdfunding efforts often involve tiered rewards. A $10 donation may earn you a digital copy of the album, whereas a $20 donation gets a vinyl album shipped to your house.
Crowdfunding Methods Explained
Reward-Based Crowdfunding
Perhaps the most popular crowdfunding method comes in the form of rewards-based sites like Kickstarter and Indiegogo. With reward-based crowdfunding, people can pledge money to creative projects, a novel piece of technology, or any other product or service.
Peer-to-Peer Lending
Ever loan small amounts of money to a friend or relative? Platforms like Lending Club and Prosper apply that same concept to crowdfunding. This enables borrowers to get access to funds outside of traditional banking channels. People willing to take a little risk to lend money to other individuals can create whole loan portfolios at the click of a button.
Donation-Based Crowdfunding
Crowdfunding sites are also used by nonprofits seeking donations. Sites like GoFundMe give organizations a free platform to raise funds for their causes. Instead of taking a cut of their donations, GoFundMe asks contributors directly for a donation to help keep the site running.
Note
Contributors who give through sites like GoFundMe don't usually expect anything in return. They're simply contributing to a cause or organization that they support.
Equity Crowdfunding
The smallest slice of the crowdfunding pie, equity crowdfunding nonetheless has the potential to change the way individuals invest their money. Equity crowdfunding enables investors to make real investments in private companies. Sites like AngelList, CircleUp, and OurCrowd offer their own take on equity crowdfunding.
Equity crowdfunding is less regulated than other methods of equity financing. While most businesses need to go through an SEC registration process to issue equity shares, companies can issue up to $1.07 million in securities through crowdfunding methods without going through that process.1
There are limits on how much investors can invest through equity crowdfunding. These limits depend on the investor's income bracket and net worth. If either your net worth or annual income falls below $124,000 you can invest up to $2,500 or 5% of your annual income (whichever is greater) through equity crowdfunding every year. If your annual income or net worth exceeds $124,000, you can invest 10% of the income or net worth (whichever is greater) up to a maximum of $124,000.2
Real Estate Crowdfunding
Real estate crowdfunding sites combine the concepts of crowdfunding and real estate investment trusts. Examples of these sites include RealtyMogul, and CrowdStreet. Contributors kick in small amounts in exchange for equity in real estate (often commercial real estate).
Frequently Asked Questions (FAQs)
What is the most funded Kickstarter ever?
In March 2022, fantasy author Brandon Sanderson launched the most funded Kickstarter project ever. The author raised $41,754,153 from 185,341 backers in exchange for four novels to be released throughout 2023.
Does crowdfunding have to be paid back?
There are a few different kinds of crowdfunding: reward-based, donation-based, peer-to-peer lending, and equity crowdfunding. In donation-based crowdfunding, the project creator is not required to provide anything in return. With rewards-based crowdfunding, those who contribute to the project won't be charged until the project is completely funded.
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