Types of Crowdfunding: Choosing the Right Approach for Your Startup

Fuel to drive your venture forward.

Introduction

Crowdfunding is exploding as a viable alternative to conventional early funding sources for startups. In 2021, the global crowdfunding market was valued at $13.64 billion and is expected to double by 2028, according to Statista. U.S. and Canadian markets accounted for the most significant volume of funds raised at 73.9 Billion. During this period, $4.41 billion has been raised globally through equity-based crowdfunding campaigns.

Several factors drive the rapid expansion of crowdfunding globally, including:

1. The emergence of new platforms.

2. The rising popularity of equity-based approaches.

3. An overall increasing global awareness of this viable funding source.

The number of crowdfunding platforms continues to grow. Pitchbook currently lists 979 crowdfunding service providers. The top 10 platforms are Kickstarter, Indiegogo, Crowdcube, Wefunder, Seedrs, EquityNet, StartEngine, Republic, Angel Investment Network, and SeedInvest. In addition, seven of these ten platforms offer equity-based crowdfunding; thus, this type of funding is growing. 

These crowdfunding platforms serve as "network orchestrators." They create the necessary organizational systems and conditions for integrating resources among different communities, thereby replacing traditional intermediaries such as venture capitalists and private equity investors. In addition, these platforms link startups with committed supporters who believe strongly enough in the persons behind the projects to provide monetary support.

Types of Crowdfunding

There are several categories of crowdfunding depending on the stage of your company's development, your ultimate aims, how much funding you seek, and what is legally possible in your environment. Let's look at four primary types:

Reward-Based Crowdfunding

Reward-based crowdfunding remains the most common form as it avoids the regulatory and organizational problems arising from equity-based funding. These platforms work for various purposes, from creative projects such as filmmaking and music production to startup initiatives that offer physical and digital products.

There are two basic models for reward-based crowdfunding campaigns. The "Keep-it-All" allows the entrepreneurial firm to establish a fundraising goal and keep the entire amount raised regardless of whether or not they meet their funding target. The other "All-or-Nothing" model allows the company to set a fundraising goal and keeps nothing unless the campaign achieves its goal. The all-or-nothing campaigns, on average, raise twice the funds as keep-it-all projects. Kickstarter and Indiegogo are the dominant players using this successful model. There are usually multiple levels of pledged amounts, with each group getting extra rewards the more funds committed. Founders can be very creative in their reward offerings. For startups, the reward is usually an initial version of the product. This offer can be desirable to early customers excited to be early adopters of a new product.

For startups, this can be an excellent way to validate the interest in their product in what is essentially a pre-sell approach. Customers are, in effect, pre-ordering your product before production. One of our Columbia Startups, Thursday Boots, successfully applied the pre-order approach via Kickstarter. They offered various donation packages for one or more premium, handcrafted boots. In 33 days, over 1200 people donated $276,610. 

According to Statistica, Indegogo's highest-grossing campaign as of March 2022 was for the MATE X, a foldable eBike, which raised nearly 17.6 million U.S. dollars on the platform. [Consider adding the table on top campaigns.]

The above success stories are an anomaly. The majority of these campaigns never reach their goals. According to Kickstarter, 60 percent of campaigns are not successful. The majority of successful campaigns raise less than $10,000. This form of crowdfunding works well with clearly defined and short-term projects rather than long-term company growth.

If the campaign is successful, you can expect to pay up to 5 percent commission to the platform and a further 3 -5 percent in payment processing fees. Usually, there are no fees to pay if you do not reach your target.

Donation-Based Crowdfunding

Donation-based crowdfunding supports personal matters and social causes such as healthcare costs, educational needs, or charitable activities. Although it is a philanthropic model, campaigns do not provide rewards, and a donor gains no benefit except the personal satisfaction of helping someone in need. GoFundMe is one such platform that caters to both individuals and charities.

This crowdfunding approach is specifically helpful for social enterprises. Crowdfunding campaigns can benefit a cause by spreading awareness to interested parties. While similar to all funding campaigns, these donation-based platforms are storytelling mediums. Fundly is a well-recognized fundraising platform for both individuals and charities. As they say, "Tell your story and connect with donors." The platform helps founders to create visually appealing campaigns to attract donors. This point is critical when choosing the venue. Donors tend to associate themselves with specific causes and will be more motivated to donate to projects that align with their interests and values. Therefore, you want to select a platform that attracts similar causes.

Some donation-based platforms focus on individual fundraisers, while others are better for enterprise-level campaigns. For example, DonorDrive serves nonprofits, healthcare, higher education, and corporate social responsibility initiatives. In addition, specific platforms will have experience providing services to particular organizations and expert guidance for your campaigns.

Peer-to-Peer Loan Crowdfunding

Peer-to-peer loan crowdfunding platforms exist to match personal lenders to small companies. Credit-based crowdfunding from non-banks became prominent starting around 2006. Since the inception of these peer-to-peer lending models, there have been many changes to the platform models. Many earlier players have stopped P2P fundraising and focused on intermediaries with institutional lenders instead. Here are three platforms that support entrepreneurs and small business owners.

Kiva is one of the earliest platforms and remains an essential micro-loan source. With Kiva, lenders select projects in developing countries and pledge the amount they want. Kiva's structure has evolved, and the loan process starts with entrepreneurs demonstrating credibility by soliciting funds from their networks. The capacity to provide a percentage of the requested amount from one's network shows the founder's character. The second stage opens the listing up to the public. Once the campaign achieves the targeted funds, the borrower receives the funds through local microfinance institutions. Today, lenders receive the loan principal but do not earn interest. In earlier iterations, lenders had some options for repayment. Separate charitable donations support Kiva, so borrowers are not charged fees as part of the lending process.

Many earlier players, except Kiva, no longer offer traditional P2P loan transactions. For example, Lending Club was part of the second phase of crowdfunding platforms, founded in 2007. Since its inception, it has advanced over US$6 billion in loans via its website, resulting in nearly $600 million in interest payments to lenders. Prospective borrowers of the Lending Club first submit their requirements and are then matched with pools of lenders willing to accept the credit terms. While one of the pioneers of peer-to-peer loans, this platform no longer offers P2P lending.

But a new wave of platforms supports small business owners, which may be suitable for startups. These new platforms offer an expected fixed return on investments. With debt crowdfunding, investors support small businesses expecting a return with interest. These newer platforms work differently than the earlier ones. SMBX connects investors with local companies through a unique "small business bonds" program. These bonds are a fixed debt instrument that yields monthly payouts of principal and interest, with annual rates of return ranging from 6%-10%. For startups and small businesses, the fundraising process is relatively simple. First, SMBX's review team validates that your business qualifies for the program. Then, your loan request goes public, and investors can purchase bonds in the company. Like most platforms, business owners should actively participate in marketing and promoting loan requests. Once the offer closes, the business receives the capital, and loans are repaid in fixed monthly payments. The platform charges the business owner 3.5% of the total loan amount raised.

Another innovative P2P platform is Honeycomb Credit. This platform connects investors to small businesses with profiles listed on its website. Investors do not need to be accredited to invest. In this case, the investment is in the form of a promissory note for repayment. The rate of return varies between 7% and 12%. Businesses make monthly repayments that include interest, assuming no defaults. Honeycomb establishes rates for each project based on a credit analysis of the applicant. Each business repays its loans monthly, and your portion goes into a third-party account. You receive your funds quarterly directly into your bank account. The platform team reviews your financials, credit history, and business plans as a business owner. If accepted, the business works with the platform team to build a campaign. The platform charges an investor fee of 2.85%. The business owner posts $250 for a listing and pays a percentage of the total amount raised for each successful campaign. Fees range from 6% to 8%. 

Equity-Based or Regulation Crowdfunding 

Equity-based or regulation crowdfunding is a mechanism that enables broad groups of investors to fund startups and small businesses in return for ownership participation in the form of shares. Investors provide money to a company and receive ownership of a small business. Research in equity crowdfunding indicates its potential is most significant, with startup businesses seeking smaller investments to achieve establishment. At the same time, follow-on funding (required for rapid growth) may come from other sources.

The United States signed the "Jumpstart Our Business Startups" (JOBS) Act in 2012. The legislation mandates funding portals registered with the SEC and an applicable self-regulatory organization to operate. The JOBS Act enables equity-based crowdfunding by a licensed broker-dealer or via a funding portal registered with the SEC. The Act initially limited the value of securities that an issuer may offer and that individuals can invest through crowdfunding intermediaries at $1.07 Million in 12 months. Investors could invest up to $100,000 in crowdfunding issues yearly, depending on their net worth and income. An independent financial statement review by a CPA firm occurs for raises of $100,000–500,000, and an independent audit by a CPA firm must happen for raises over $500,000.

The JOBS Act opened new avenues for startups and small companies to raise capital. As discussed in an earlier post, soliciting early funding is not easy. Early ventures rarely have assets or patented intellectual property necessary to procure traditional bank financing or SBA loans. Equity-based sources such as angel groups and venture firms select investments based on criteria these early companies rarely meet. For early ventures, equity crowdfunding presents a unique opportunity to raise capital from investors in return for ownership.

In March 2015, the SEC expanded these rules to allow a startup company to raise $5 million of securities in 12 months, subject to eligibility, disclosure, and reporting requirements. The 2015 rules, often called Regulation A+, provide several stipulations and limitations for companies and investors. As noted above, startup companies can not issue an aggregate amount of securities over $5 Million for 12 months.

Regulation Updates

In 2022, the SEC expanded these rules to allow a startup company to raise $5 million of securities in 12 months, subject to eligibility, disclosure, and reporting requirements. The updated regulations provide several stipulations and limitations for companies and investors. Startup companies can not issue an aggregate amount of securities over $5 Million for 12 months.

• Recently, in 2023, the SEC implemented further changes, including:

• Expanding small- to mid-size companies' 12-month limits to $75 million from $50 million.

• Lifting limits on secondary sales under Reg A to $22.5 million from $15 million.

• Increasing capital-raising limits under "Regulation D" for companies selling up to $10 million of their securities, up from $5 million.

• Removing the dollar amount an accredited investor can contribute to a crowdfunding campaign.

Purchasers of securities that are not accredited investors still have limitations:

• If annual income or net worth is less than $124,000, can invest up to greater than $2,500 or 5% of income/net worth

• If annual income and net worth are $124,000 or more, you can invest up to 10% of income/net worth, capped at $124,000

Remembering the differences between Regulatory Crowdfunding and Regulation Crowdfunding A+ is essential. Regulation Crowdfunding (Reg CF) was created in 2012 with the JOBS Act, while Regulation A+ (Reg A+) came later in 2015 when the SEC signed it into law. Reg CF paved the way, with Reg A+ building on it a few years later with higher fundraising limits.

Reg CF (Regulation Crowdfunding) allows companies to raise to $5 million in a 12-month by selling securities to accredited and non-accredited investors. Reg A+ allows companies to raise $75 million from accredited and non-accredited investors.

Reg CF is more common for early-stage startups and ventures looking to raise smaller amounts of capital. The lower $5 million limit and less stringent disclosure requirements make it better suited for younger companies.

Reg A+ works better for more mature, later-stage ventures looking to raise more substantial amounts, upwards of $75 million. The enhanced reporting requirements make it better for companies with more operational history and financial statements to provide investors.

Bridging Between Funding Stages

Equity crowdfunding offers an effective bridge between non-equity funding sources like loans or grants to eventual venture capital or angel investor equity stakes. For many founders, equity crowdfunding represents a first chance to offer equity while retaining significant control. Compared to VC or angel funding, the dilution is much smaller, with the founder spread across potentially hundreds of investors participating at low ownership percentages. This strategy allows testing equity funding in a more managed way before eventually needing to take on further outside investment with more significant dilution. Plus, having an already established shareholder base can demonstrate market traction and demand to attract VC attention. 

The tradeoff for less dilution now is the management overhead with potentially hundreds of shareholders instead of a few concentrated equity partners. Communication, governance, and execution of shareholder rights become much more complex. For founders less familiar with such dynamics, an equity crowdfunding round can be a valuable learning experience for structuring future VC rounds while securing essential capital infusions. However, equity crowdfunding also comes with some potential drawbacks" would signal the shift.

Perceptions from Later-Stage Investors

Later-stage investors and venture capitalists (VCs) have mixed feelings about startups that have equity from crowdfunding investments. On the one hand, equity views crowdfunding as a positive step that reduces a startup's reliance on subsequent fundraisings and enables later-stage financing. It can also be an appealing route for fast-growing companies to diversify their funding sources.

However, there are also potential drawbacks. One concern is that startups funded through equity crowdfunding may lack the professional guidance often provided by angel investors and VCs. These investors often negotiate seats on the company's board of directors and play an essential role in assisting early-stage companies in executing their business plans. A startup financed through equity crowdfunding may not benefit from this guidance.

Another concern is the potential for a crowded cap table, which can complicate future fundraising rounds and exit strategies. Many small investors can make it more challenging to manage investor relations and potentially deter later-stage investors and VCs.

While equity crowdfunding can provide valuable early-stage funding, it may also present challenges that could impact the perception and involvement of later-stage investors and VCs.

Startups need to consider these factors when deciding on their fundraising strategies. Evaluating these advantages and drawbacks allows founders to choose whether equity crowdfunding offers them the right bridging option from other funding sources into the equity funding realm toward high growth.

Emerging Trends and Landscape

As equity crowdfunding gains mainstream traction, new developments are shaping the future landscape that startups should monitor closely. The rapid changes in this arena mean emerging trends that allow companies to capitalize and potential pitfalls to navigate. Tracking fundamental shifts will empower founders to leverage opportunities and avoid risks.

Globalization represents a major accelerating trend. With crowdfunding's growth, regulatory agencies worldwide are establishing legislation to enable equity models. The United Kingdom implemented early robust equity crowdfunding regulations. PitchBook data shows one UK portal, Crowdcube, funded 262 deals totaling £297 million in 2021 investments.

Other vital trends demonstrate the dynamic shifts in equity crowdfunding:

• Expanding Global Platforms & Investors: Equity crowdfunding increasingly moves beyond US-centric investor bases to allow broader international participation.

• Evolving Accredited Investor Standards: Ongoing discussions around relaxing income and net worth requirements may grant more comprehensive investor access.

• Rising Offering Limits: Momentum points toward continually elevating regulated offering caps under vehicles like Regulation A+.

Keeping pace with such trends will allow startups to capitalize on updated rules, exemptions, and investor networks. It also equips them to avoid potential pitfalls as the landscape develops. With regulations in flux, monitoring changes and consulting professionals remain essential to determine if equity crowdfunding fits a venture's needs. 

Dual Option Crowdfunding

Dual-option crowdfunding is an extension of the above four categories. However, the usual combination is reward-based, leading to equity-based crowdfunding as the needs of the new company change. The dual option model offers a one-stop platform to take the young company through the different stages of cash needs. The rewards phase enables the development of the first product, and then growth can be funded using equity. Still, the company's value will be higher and easier to establish, thus reducing the risks for investors and making investment more attractive. The entrepreneur will, therefore, suffer less dilution of their ownership. One such dual-option platform is fundable, which offers the opportunity to start with a reward-based program and then use the same platform for follow-on equity funding. Fundable charges $179/month to create a fundraising campaign. Advisory services may add on extra costs. A reward-based campaign has similar fees to the other platforms in this category.

Benefits and Risks for a Startup

As with any funding source, you must consider the benefits and risks when deciding on the best fundraising strategy. Conversely, crowdfunding campaigns allow founders to create initial awareness through the large audiences these platforms attract. Selecting the right venue is essential for generating awareness. Founders should look at the platform's audience for projects similar to their cause or offering. Specific platforms tend to attract a different segment of backers in the larger, more generalized platforms. For example, I work with many founders who started "Green Businesses." Some platforms cater to sustainable products more than others. For instance, Indiegogo has an "energy and green tech" category that attracts projects that focus on products that support awareness and protection of the environment.

A significant benefit for founders is the ability to solicit feedback on early prototypes. Campaign response can provide valuable feedback from the market and validate that you are on the right track with your target customer. Founders can share campaigns with their networks and ask them to share with them. This promotional activity provides insights into potential market channels for future customer acquisition efforts. Additionally, most established platforms offer founders a lot of structure and guidance as they design their campaigns. With recent regulation changes, some platforms provide an opportunity to launch a "test the waters" campaign to gauge interest in your offering. A startup can launch a campaign page and market the offering to see if its network is interested in investing. The company can go through the associated time and costs of preparing the campaign if it gets sufficient interest. 

Of course, a key benefit of crowdfunding is providing access to early capital at the early stages of venture development. This vehicle can be a primary funding source for developing your prototype, selling your product pre-production, and transitioning your startup to early growth. I have observed many examples of all these outcomes. For example, the founders of Sotro, a collapsible hair steamer, generated funds to complete the product's industrial design and began soliciting manufacturers for future production. As mentioned earlier, Thursday Boots is a prime example of using their campaign to pre-sell their product before production. In this scenario, it is vital to have all the manufacturing and supply chain partners in place with clear timing expectations. You don't want to make promises to your customers that you can't keep.

This concern leads to one of the most significant risks: losing brand reputation if you cannot meet your campaign promises. Unfortunately, many stories about crowdfunding campaigns do not deliver the products or services promised. The reasons vary from overestimation of operational capacity to potential fraud. Platforms work hard to minimize the latter, but the former can occur readily. According to Kickstarter, approximately 9% of their projects fail to deliver. The reasons include low pricing and inability to produce the goods, manufacturing problems or supply chain issues, infeasible technology, and fraud.

Another risk to consider is that most campaigns fail to achieve their goals. Generally, statistics show that as many as 85% of crowdfunding campaigns fail. The reality is that these campaigns are labor-intensive. From creating the campaign to obsessively promoting it to your networks, many founders have an unrealistic perception that raising funds in this manner is easy. Well, raising funds is never easy! Every platform has several steps to validate that you are a good candidate. The vetting process alone can be time-consuming. I recently spoke with someone engaging Republic, an equity-based crowdfunding platform. The founder highlighted the importance of showing a working, repeatable, scalable business model. The vetting team wants to know your "burn" and runway. They want at least three months of capital to manage that burn. Reason? It will take about three months to launch and finish a crowdfunding raise.

One final risk area to note. You don't want to jeopardize your intellectual property when participating in a crowdfunding raise. In a campaign, founders share specifics of their idea and its novelty. In the crowdfunding scenario, it is a public disclosure. Depending on the jurisdiction, such public disclosures start the "patent clock" and may sometimes prevent the founder from being granted a patent. If you plan on applying for a patent, you must file for patent protection before publicly disclosing your product on a crowdfunding site. Apply the same strategy to your brand. Seriously, consider registering a trademark before you start a visible campaign. Read more about the trademark process here.

Is Crowdfunding Right for Your Startup?

When considering whether crowdfunding is the right funding option for your startup, it is essential to consider several factors. As a starting point, if your goal is to reach a specific target with a clear project plan and you do not plan on building a high-growth company, it may be beneficial to consider using either a reward-based or donation-based crowdfunding method. Equity funding is not an appropriate choice in these circumstances.

On the other hand, if you plan to grow a small company and eventually sell it to another company to create a liquidity event, equity-based funding might be more suitable. In this case, choosing a crowdfunding platform that complies with all regulatory requirements governing such transactions is crucial. Consulting with a lawyer ensures all commitments align with your long-term fundraising goals. For equity-based crowdfunding, investors typically look for companies that demonstrate traction with early products and have audited financial data. If your company is not in a favorable position to meet these requirements, it may be wise to explore other financing methods first.

Secondly, researching and identifying a crowdfunding platform that has a proven track record of success with similar companies or projects is crucial. Seeking advice from fellow entrepreneurs who have used these platforms can provide valuable insights and recommendations.

Before launching your crowdfunding campaign, it is essential to note that approximately 25 percent of the funding is typically already verbally committed within your network. This commitment highlights the significance of "pre-seeding" the campaign to create early momentum. Some crowdfunding platforms may also require evidence of successful fundraising, and in some cases, they may only accept your company if you bring in a lead investor.

Thirdly, Have contingency plans if you do not reach your funding target. Crowdfunding campaigns can be time-consuming, so you should be prepared to seek capital from alternative sources if needed. Similarly, it is crucial to have plans in place if you exceed your funding needs significantly. Additionally, it is essential not to underestimate the time and effort required to attract the crowd and effectively communicate with your followers. Active marketing campaigns and regular company updates throughout the fundraising period are necessary to engage potential backers.

Finally, before investing substantial time and resources into preparing a crowdfunding campaign, ensure you can meet the screening rules established by your chosen platform. Compliance with these rules is necessary to ensure your campaign's eligibility and success.

Summary

Consider several factors before deciding whether crowdfunding is the right funding source for your startup. If you have a specific goal and project plan but don't anticipate high growth, reward- or donation-based crowdfunding may be suitable. Equity-based crowdfunding can be an option for those aiming to grow and sell a small company, but consulting with a lawyer is crucial to navigating regulations. Choose a platform that aligns with your goals and has a track record of success with similar projects. Pre-seeding the campaign by securing verbal commitments from your network beforehand is essential, and be prepared with contingency plans if you don't reach your target. Additionally, be aware of the time and effort required for marketing and engaging with potential backers. Finally, ensure that you meet the screening criteria set by your chosen platform before investing significant resources in a crowdfunding campaign.