Crowdfunding is all the rage, with new platforms popping up ever more frequently. Many consider it to be the future of investing, others warn that its risks are often underestimated. And then there are the different types of crowdfunding: reward-based, equity-based, debt-based, flexible, fixed and so on. It can all seem bewildering, but like most things the underlying logic is simple.
The most important benefit to crowdfunding is that it makes investment in small companies and startups accessible to everybody. For this reason, it is more important than ever for people to fully understand this new world, as most of the negative publicity around crowdfunding is largely bitcoin roulette focused on misuse and misunderstanding of the platforms. In this article I will cover the different types of crowdfunding platform, along with the main incumbents in each category, and explain some of the primary pitfalls that ensnare many newcomers.
But first, a definition.
What is the crowd?
Ordinary, everyday people. And that’s what the “crowd” in crowdfunding refers to. You see, raising money is not really about business plans or market traction or financial forecasts: it’s ultimately about trust. And in life, the higher the risk of being hurt, the more important trust becomes. For this reason, most people don’t mind putting a few pounds towards sponsoring a charity run or lending a friend a few pounds; there’s a general acceptance that you shouldn’t expect to see that money again, and as such the level of trust in the person to whom you are giving the money doesn’t need to be particularly high. But if somebody asks you to invest several thousand pounds, the situation is radically different. For most people, this is not an amount of money that they can afford to lose. Therefore, most people have been locked out of the investment world where small businesses need thousands of pounds to be invested.
It’s therefore logical that the traditional routes for founders financing a business have been channels like loans from banks, high net worth individuals and friends and family. A founder’s ability to raise money has depended largely on their collateral in the case of a bank loan, or their personal network in the case of investments from individuals, and consisted of big chunks of money from a small handful of people who trust them and/or have thoroughly vetted them. The alternative – raising small chunks of money from a large number of people – has been largely impossible unless the founder happens to know hundreds of people and is both willing and able to deal with the enormous administrative overhead of dealing with so many people.
Enter the internet, with its well-established history of both removing administrative headaches and connecting large groups of people together. Crowdfunding essentially facilitates the matchmaking between ordinary people who are interested in investing in things and ordinary founders who don’t happen to have access to collateral or large networks of wealthy individuals. The software running the crowdfunding platform handles all of the administration, while the internet itself provides a vast potential pool of people for the founder to market to, at scale.
In short, crowdfunding makes it possible to raise small amounts of money from a large amount of total strangers. For that reason, it’s great.
The main types of crowdfunding platform
There are four main types of crowdfunding platform, all with different advantages and risks. Below are the main ones, with links to the largest or most well known incumbents.
Main players: Kickstarter, Indiegogo
The closest sibling to the traditional charity fundraiser, reward-based platforms take money in the form of pledges or donations, and in return you get some kind of kick back or perk from the business. For example, you might get a discounted unit of the product being funded once it’s manufactured, or for a higher donation amount you might get a personalised version of the same product as a thank you for supporting it. This is the “reward” in question, and usually the higher the pledge amount the better the reward.
For obvious reasons you tend to find mostly physical products on reward-based sites, where the money is used to take a concept prototype to first production. They also tend to be popular with creative projects such as movies, games or music albums, where fans can support their favourite artists and get perks like a credit at the end of the movie in return.
The downside to reward-based sites is that they are vulnerable to scams and fraud. There is usually very little or no due diligence on the companies or individuals raising money, and with the minimum pledge amount starting at as little as £1, the barrier to entry on the investor side is minimal too. Scammers will often present fake product prototypes in a video featuring concept art and renders, only to disappear with the money once the campaign is over. The investors, in this case, have little recourse except to complain to the crowdfunding platform itself to get a refund, but the lines of responsibility around risk are somewhat hazy.