Has Crowdfunding Become the Best Way for Start-Ups to Raise Funds? Not So Fast!

By Nikkia Knudsen

As founders embark on starting a company or launching a business venture around a new technology, perhaps the biggest consideration is funding. As entrepreneurs’ search for funding resources, many consider crowdfunding. Crowdfunding platforms include Kickstarter, Indigogo, and GoFundMe. Authorized by the Jumpstart Our Business Staratups Act (JOBS)—which became effective in 2016—crowdfunding has grown over the past few years. Sources such as Fundly report that $34 billion were raised through crowdfunding worldwide in 2020 and CrowdCrux reports crowdfunding is projected to be at $300 billion by 2030.

Crowdfunding is a method by which many people—i.e., a crowd—pool money for a specific project, cause, or investment they are interested in. The pooling of small amounts of money result in a large overall funding resource.

There are two general types of crowdfunding. In the first—“exchange-based crowdfunding”—people contribute without receiving an ownership stake in the company, or any expectation for a return on the contribution other than the potential completion of an artistic work, or the advancement of a cause. In the second type of crowdfunding—“equity crowdfunding”—people provide money in exchange for equity, or an ownership stake within the company.

Regardless of the crowdfunding type, the Securities and Exchange Commission requires intermediaries or crowdfunding platforms, to “register with the Securities and Exchange Commission (SEC) as a broker or as a funding portal. The intermediary must become a member of a national securities association (FINRA). The FINRA website provides the names of crowdfunding intermediaries that are registered with the SEC as funding portals.”

Crowdfunding may seem like an easy method for fundraising, but not so fast. Crowdfunding represents a relatively new mechanism for raising funds and should be carefully considered before proceeding. Before launching a crowdfunding campaign, the various requirements for each as well as the advantages and disadvantages of each crowdfunding type should be understood. The regulations are summarized on the SEC website: Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers.

Pros and Cons of Exchange Based Crowdfunding

In the first type of crowdfunding people contribute without expectation or return or for a product sample upon completion. There is no obligation or expectation of financial return or equity share to the contributors.

Advantages of Exchange Based Crowdfunding

The benefits to crowdfunding as a funding source include the following:

  • Crowdfunding is easy and allows entrepreneurs to raise money quickly.
  • Crowdfunding allows entrepreneurs to control messaging that will reach potential contributors and customers. The entrepreneurs are also able to directly communicate with the contributors.
  • As some contributors are likely to become future customers, crowdfunding allows entrepreneurs to build their customer base and receive feedback on the product or business launch.
  • Those that provide money are not traditional “investors” because they will not receive an ownership stake in the company. Rather, contributors can expect a gift in exchange for the contribution, which could be the product they are helping launch, or the advancement of a cause they support. This provides flexibility to entrepreneurs because the contributor does not have an ownership stake and is not involved in the business decisions.
  • Crowdfunding tends to be low risk as entrepreneurs are often not required to pay back contributors if the venture fails.

Disadvantages Exchange Based Crowdfunding

The disadvantages of utilizing non-equity crowdfunding include the following:

  • Crowdfunding, although fairly easy, can be time consuming. There are many ventures participating in crowdfunding, and it can be difficult to develop a campaign that differentiates one business from those of competitors. Thus, it is important for the entrepreneur to strategically market the “ask” of the business venture.
  • Crowdfunds are often, but not always, hosted by various platforms, which have stipulations that entrepreneurs must meet. If not using a crowdfunding platform, a company can establish its own website that seeks investments for special product releases and discounts, or in the example of equity crowdfunding, investors receive dividends or investment appreciation. If using a platform, it is important to consider what the stipulations are and how they impact the ability to fundraise. For example, what are the requirements for an entrepreneur to launch a crowdfund on the selected platform? Are there any compliance issues with the requirements? What does the agreement with the platform stipulate? For example, Investopedia reports that Indiegogo has an additional third-party payment processing fee and Patreon has fees that increase as the crowdfunding campaign is created. Conversely, SeedInvest has a strict vetting process, and not all crowdfunding campaigns are accepted by the company to engage in crowdfunding.
  • It is extremely important to understand the platform fees. Some platforms will not allow campaigns to utilize earned funds until the specified fundraising goal is met. Thus, it is important to consider whether the platform will withhold access to money raised if the financial goal is not met. It is also important to determine how much of the funding will go to pay for platform fees.
  • The information about a venture must be easily accessible and available to potential contributors. This is in part to minimize the risk of scammers taking advantage of crowdfunding. Careful contributors are likely to extensively vet a potential business. Thus, it is important that entrepreneurs take the time to make information on the business readily available to potential contributors and/or be willing to provide requested information. This information includes how the funds will be used, where one is in the development of the business or product, the timeline of the product or business launch, what the product or business aims to accomplish, and what contributors can expect in return for their involvement.

Pros and Cons of Equity Crowdfunding

Equity crowdfunding represents an exception to the previous law that prohibited nonpublic/ non-SEC reporting companies from selling securities unless they met all of the stringent financial disclosure and reporting guidelines applicable to traditional public companies. It creates an exemption under the federal securities laws so that crowdfunding can be used to offer and sell securities to the general public rather than just qualified investors. There are limits on the amount of money companies can raise and investors can invest through this method. If a company would like to offer and sell securities through crowdfunding, they must still comply with federal securities laws.

Advantages of Equity Crowdfunding

The benefits to equity crowdfunding include the following:

  • When raising money with equity crowdfunding, the funds do not have to be paid back to investors. However, because investors have an ownership stake in the company, if the company is sold, the investors would be paid out of the profits.
  • If the venture succeeds, the investor will own part of the successful business.
  • Equity crowdfunding allows average investors, including non-accredited investors, to invest in the company.
  • Regulation Crowdfunding provides an exemption from the registration requirements for securities-based crowdfunding. The exemption allows companies to offer and sell up to $1.07 million of their securities without having to register the offering with the SEC.

Disadvantages of Equity Crowdfunding

Despite the advantages, the potential disadvantages to equity crowdfunding should be considered. These include the following:

  • Equity crowdfunding gives investors an ownership stake in the company, which can result in less flexibility for entrepreneurs.
  • Companies raising money through crowdfunding are required to share some of the profits with the equity funders, unlike exchanged based crowdfunding where the investors receive a product or special discount.
  • Equity crowdfunding is risky for investors because if the business model fails, the investor loses all the money.
  • Equity, or regulation-based crowdfunding must comply with SEC disclosure requirements. These requirements include the reporting of company balance sheets as well as advertising requirements to potential investors.

Overall, the ease and flexibility of securing funding through crowdfunding has resulted in its adoption over the past few years. Although crowdfunding might be a great option for entrepreneurs, it is important to consider the disadvantages and risks before launching a campaign.

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