Every entrepreneur with a business idea that they think will work has a vision. Some see the business as a way of providing a better lifestyle for themselves. Others see their product or service disrupting an industry and reaching millions. Whatever the dream may be, they all need to answer this question:
“How am I going to pay for all this?”
In the past, funding a business venture involved banks, venture capitalists, or using personal funds. But there is another way startups have successfully raised capital. They utilized the crowdfunding finance model. While most people are familiar with the crowdfunding model as a way to raise money for a charitable cause, it has become a way for startups to get the funding they need. This type of business model has also proven to provide entrepreneurs and businesses with a boost in exposure.
Many think that the crowdfunding model is an easy, risk-free way to raise capital. And although it may be a great way to do so, it’s not without its challenges. In this article, we’ll explain how the crowdfunding business model works. We’ll also look at the pros and cons of this model for both the fundraiser and the backer.
What is the Crowdfunding Business Model?
Crowdfunding can take various forms, but its essential concept involves raising funds for a venture by collecting money from many individuals. Pooling small amounts of money from multiple organizations and people to finance a project or cause, would be a crowdfunding campaign. These are often hosted on platforms or websites like GoFundMe or Change.org. These platforms allow creators to showcase their ideas and solicit funds from a broad audience.
There are several types of crowdfunding associated with this business model. Here are the main types:
- Donation-based crowdfunding: This is the simplest form of crowdfunding where people contribute money without expecting any type of financial return. This type of crowdfunding is often used for charitable causes, such as disaster relief, medical expenses, or community projects.
- Reward-based crowdfunding: In this type of crowdfunding, backers receive a reward or perk for their contribution. The reward could be anything from a personalized thank-you note to a product or service related to the project. This type of crowdfunding is often used for creative projects, such as music albums, films, and video games.
- Equity-based crowdfunding: This type of crowdfunding allows investors to buy shares in a company or project in exchange for their contribution. Equity crowdfunding is often used by startups and small businesses to raise capital as an alternative to traditional forms of financing.
- Debt-based: In this type of crowdfunding, contributors are providing monetary loans to the project creators. Unlike donation-based crowding, contributors expect repayment in the future plus interest.
- Hybrid crowdfunding: This is a combination of multiple crowdfunding models. For example, a hybrid campaign could offer both rewards and equity to backers. This type of crowdfunding is usually used for more complex projects that require different types of funding.
How the Crowdfunding Business Model Makes Money
Every type of crowdfunding involves backers contributing money to a cause. However, the major difference lies in the payout. This is essentially how businesses make money using this model. Many crowdfunding business models will offer the promise of future profits for initial investment. Whether that’s selling stakes or shares in your business for investors to make money if you were to sell or go public. Or, even offering contributors a future return on investment on a product for an initial loan towards licensing or royalty agreements.
Both of these methods would make both the proponent of the campaign and the contributor, money. However, the legal and financial considerations involved bring risks for both project creators and contributors.
With the popularity of the crowdfunding model, many platforms have emerged in the past 10 years to help creators, startups, non-profits, and individuals raise money for their cause. The platforms themselves are compensated by charging platform and other fees for campaigns. Here are 9 of the most popular and the fees associated with running a campaign. Note that some of these platforms also have processing and other fees that may not be listed below.
- StartEngine: 7.5% commission on the funds raised plus another 2% of what you raised in equity.
- Indiegogo: 5% platform fee. For campaigns that do not reach their funding goal, Indiegogo charges an 8% platform fee with a 15% (total) fee on any funds driven by Indiegogo’s platform channels.
- Kickstarter: 5% platform fee.
- Fundable: Flat-rate plans starting at $179.
- SeedInvest: 7.5% placement fee.
- CircleUp: 5% commission on the funds raised.
- Patreon: Plans from 5%-12% depending on which plan a creator chooses.
- GoFundMe:2.9% payment processing fee (non-business related fundraising).
- Mightycause (for non-profits): Plans start at $69.
Crowdfunding Model Advantages
The crowdfunding business model provides a variety of opportunities for customers and entrepreneurs alike. For entrepreneurs and startups, these opportunities can help drive their business vision. For customers and investors, they get the benefit of returns or a product that suits their needs. Here are just some of the advantages of this model for everyone involved.
1. Raising Capital
The first and most obvious advantage is the capital crowdfunding produces. Crowdfunding can provide access to capital for entrepreneurs and startups who may have difficulty obtaining traditional financing from banks or investors. While some of the same things involved in raising capital such as pitching and valuation are involved, many of the challenges are avoided. For example, to obtain a business loan, many banks require the business to be operational for 2 years. The crowdfunding model would allow startups the chance to avoid this requirement.
2. Market Building
Another benefit of crowdfunding for businesses is the building of a market. As you gain awareness of your business and attract investors, you are also attracting those who see value in your offering. This means that you are either attracting potential customers.
Most platforms also feature campaigns on their homepage, newsletters, and social media feeds. This means the businesses raising capital would get exposure as their campaigns become more successful. Think of it as free advertising. All of these are extremely beneficial once a campaign has reached its goal.
3. Market Validation
Crowdfunding also serves as a form of market validation. When a project receives funding from a large number of backers, it indicates that there is demand for the product or service being offered. This can help entrepreneurs gauge the market demand and refine their business strategies accordingly.
4. Customer Engagement
Crowdfunding additionally fosters customer engagement. Platforms allow entrepreneurs to engage directly with their backers. This helps create a community of supporters who are emotionally invested in the success of the project. This can lead to valuable feedback. For example, a backer may let you know what they’d like to see in the product before they contribute funds. You’ll also be building customer loyalty. All of which are beneficial for future product iterations or business expansions.
Crowdfunding Model Disadvantages
However, with great rewards also comes the potential for great risks. And crowd-funding is not immune to that. Here are some of the disadvantages of using the crowdfunding model as a primary source for raising capital.
1. Unsuccessful Campaigns
The first risk that everyone thinks of when it comes to discussing this business model is the risk of failure. Simply, crowdfunding campaigns are not guaranteed to succeed. If a campaign does not reach its funding goal, the project may not receive any funds at all. This can be a devastating emotional blow to the fundraisers. Imagine the feeling. All the time, effort, and resources that were invested in the campaign. All may go to waste because a goal was not reached.
2. Risk of IP Property for Idea-Stage Businesses
There’s also a higher risk of copycats and disputes over intellectual property. When entrepreneurs showcase their ideas or products on crowdfunding platforms, there is a risk of others copying their concepts or designs. If an idea is not fully protected, it may cause trouble in the future. Having an idea copied can cause a loss of competitive advantage.
As crowdfunding has grown in popularity, the number of projects seeking funding has increased significantly. This means that campaigns are competing for attention and support from a limited pool of potential backers. There is only so much money to go around. And things like comparative companies, products, and campaigns eat away at the potential one campaign has.
The level of competition also raises the bar of what is considered a good investment opportunity for backers. High-quality projects with well-developed prototypes, engaging marketing materials, and a strong team often attract more attention and support. This raises the bar for all projects as they strive to stand out from the competition.
4. You Still Need to Find Investors
As good as crowdfunding is at giving an entrepreneur or startup some exposure, it won’t do all of the work for them. Those looking to raise capital still need to market their campaign to find investors. Startups looking for investors by utilizing the crowdfunding model must get creative.
This could mean creating promotional videos and sharing them across social media channels. It may also mean networking to find possible investors. Although using online methods is effective, those looking to raise money shouldn’t limit themselves.
The crowdfunding business model allows entrepreneurs, innovators, and social activists to access capital and bring their ideas to life. It also allows backers to support projects they believe in and potentially earn a financial return. However, it’s important to note that crowdfunding also involves risks. This model can also be a lot of work.