What is Crowdfunding for Small Businesses?
In this article, you’ll learn:
Starting a new business, taking over an existing business, or keeping up with an established business venture can be very rewarding, but it can also be difficult to manage financially. Crowdfunding is just one option for entrepreneurs and business owners looking to finance their business needs.
In this article, we define crowdfunding, discuss the pros and cons, and learn what other financing options are out there.
What is crowdfunding
Crowdfunding is a type of financing in which small investments or donations are collected from multiple people. Advances in technology and wi-fi access have made online crowdfunding sites a popular way for entrepreneurs to finance startup ventures. Crowdfunding is also used by established business owners as an alternative to personal loans or business funding through a bank or online lender. The funds can come from strangers, curious investors, friends, family, community members, or other businesses.
Typically fundraising via crowdfunding begins with the entrepreneur or business owner sharing their story, their business goals, and their intentions for the funds received on a crowdfunding platform. Most of the time a monetary goal is set, and the progress towards that goal is made public. Funders may be offered a reward for their investment, which may or may not have any monetary value. Some entrepreneurs offer free products or services, while some crowdfunding allows the funder to get equity in the business in return for their contributions.
Types of crowdfunding
There are many different types of financing that can be considered crowdfunding, but a few have emerged as the most popular among small business owners. Most small businesses that choose crowdfunding as a primary or secondary source of financing use rewards-based crowdfunding, donation-based crowdfunding, or peer-to-peer lending.
In reward-based crowdfunding, people contribute smaller amounts of money to a specific business idea or project with the expectation of receiving something in return. This type of crowdfunding is the most common for startup tech entrepreneurs, artists, and other creative projects. When done through an online platform, the person or business seeking funds lists a monetary goal and gives some background on their project or business plan. The rewards are listed upfront, so the donor knows what to expect in return for their contribution. The reward can be straightforward like, “Every contributor receives a free T-Shirt and Baseball Cap,” or the person seeking funds may offer tiered rewards, like “A $100 contribution receives a portrait, a $1,000 contribution receives early access to shows, and so on.” Most sites that feature this type of funding have an “all or nothing” policy, so the funds are only released to the entrepreneur if the goal is met.
[[Some examples of reward-based crowdfunding platforms include:
Donation crowdfunding is like reward-based crowdfunding because they both involve many contributors giving small amounts of money. The difference is that contributors do not receive anything in return. This type of crowdfunding is a popular source of funding for nonprofits raising money for charitable causes. Individuals also often used donation-based crowdfunding to collect funds for personal expenses, medical costs, or startup businesses. Contributors can be nonprofit organizations, angel investors, corporations, or individuals.
[[The most well-known donation-based crowdfunding website is GoFundMe.]]
Peer-to-peer (P2P) lending, or debt crowdfunding, describes the process of business owners or individuals using an online service to be matched with lenders. Some borrowers prefer P2P loans over traditional bank loans because they offer a quick application process and may have more flexible repayment terms. P2P loans typically have terms of one to five years and are fixed, offering a predictable repayment schedule. Investors interested in lending funds through a P2P transaction evaluate borrowers by annual revenues, credit scores, and business plans.
Other types of crowdfunding
While P2P lending and reward or donation-based crowdfunding are the most popular types of crowdfunding, some businesses are successful in raising capital through equity or real estate crowdfunding as well.
Equity crowdfunding is a type of business financing where backers receive shares in the company for their contribution. This type of funding is attractive to venture capitalists and other interested investors because they can invest in a business idea or company that they are passionate about and believe will be a profitable partnership. Startup businesses that have an advanced business plan and growth strategies in place are often the most successful at equity crowdfunding. Entrepreneurs and business owners that choose this type of funding must understand that the funders will own a portion of the company, which may cause complications down the road, including shared decision-making.
[[Some examples of popular crowdfunding sites that deal with equity crowdfunding:
Real Estate crowdfunding
Real Estate crowdfunding transactions can be arranged via a crowdfunding site or directly from person to person. This type of crowdfunding is similar to real estate investment trusts but involves soliciting funds from individuals or businesses for the purpose of purchasing a building or land. Typically, the purchased asset is commercial real estate that each contributor shares ownership in.
Advantages and disadvantages of crowdfunding a small business
Determining whether crowdfunding is the right financing option for a small business should be based on several factors, including the business owner’s goals and business needs. Just like any other business transaction, there are pros and cons of crowdfunding.
Advantages of crowdfunding
The most obvious advantage to crowdfunding is getting the financing needed to get a business started or keep it running at maximum efficiency. But there are a few advantages that are specific to this type of financing.
An automatic advantage to crowdfunding is that in the process of getting the word out about funding goals through a crowdfunding site, you also get the word out about your new business. Advertising your business idea or new project online through a crowdfunding platform (and then by posting the opportunity on social media) doubles as free advertising for the company, product, or program.
No monthly payments
Unlike a loan from a traditional bank or credit union, there is no obligation to pay back funds collected through crowdfunding. Many financing options leave the borrower with a hefty monthly payment and a significant interest expense, but crowdfunding does not require the business owner to repay the funds.
If crowdfunding is successful, the entrepreneur or business owner will have access to a large amount of capital upfront. These funds can be used to grow the business much faster than traditional financing methods that deplete cash flow with monthly payments.
Disadvantages of crowdfunding
Not unlike other financing options, there are also disadvantages to crowdfunding. Before considering raising funds this way, weigh the pros and cons against your business goals to make an informed decision.
Difficult to secure
Crowdfunding is a great way to raise money for your business, but success is dependent on getting enough people to contribute to the cause. The success rate for crowdfunding is only 22.9% in 2022. While it is simple to set up a crowdfunding project online, it can be very difficult to direct potential investors to your business.
Lack of control
Some types of crowdfunding like, equity-based crowdfunding, require the business owner to relinquish a portion of ownership in the company. Having financial backers in a business also means having partners. Whether it is welcome or not, investors that have equity in the business often have their own ideas about operations.
Setting crowdfunding goal
Many crowdfunding sites operate on an “all or nothing” basis. This means that the initial goal set on the site must be met in order to receive the funds. A goal set too high may result in no funds, and a goal too low may not provide enough capital to meet business needs.
Most crowdfunding websites charge a processing fee, or platform fee, for fundraising on their site to cover marketing and payment processing. The amount of the fee varies depending on the site and the fundraising goal but is usually a percentage of the total funds collected.
Tips for successful crowdfunding
There are steps a small business owner or entrepreneur can take to increase the chance of running a successful crowdfunding campaign. Whether crowdfunding is your main source of capital or supplemental funding, the following tips will help you be successful.
- Create a clear and creative campaign that shows realistic initiatives and forecasts long-term growth.
- Crowdfunding projects that include a personal video raise 150% more than other campaigns.
- Have a thorough business plan prepared before asking for funds to quickly answer the questions of potential investors.
- Sell yourself. Sharing your crowdfunding campaign on social media, with friends, or on podcasts will help get the word out about your cause and your future business.
- Provide regular updates about the progress of crowdfunding and any changes to the business plan or timeline.
- Offer incentives, for reward crowdfunding, that appeal to potential investors but aren’t going to negatively impact cash flow.
- Set a funding goal that provides enough capital for your business needs but is not unreasonable for the specific industry.
Other small business financing options
It is important to understand that crowdfunding doesn’t have to be the only type of financing for your business. Small business loans are a great way to supplement crowdfunding efforts or provide an alternative way to finance your business. The following lending options can provide fast funding to small business owners.
Partially guaranteed by the U.S. Small Business Administration, SBA loan programs provide small business owners with lower interest rates and down payments than traditional types of financing. SBA loans, depending on the type, can be used for large purchases, working capital, or operational expenses, like payroll. The type of SBA loan program also determines the amount of money that a borrower can be approved for.
A business line of credit is a type of revolving credit, like a business credit card. The borrower is approved for a maximum credit limit, and they can then draw on that credit line whenever they need access to fast funding. Interest is only paid on the amount of withdrawn funds and made in a monthly payment according to the repayment terms of the line of credit.
Term loans are a type of small business financing where the borrower receives a lump sum of money upfront and makes regular payments of principal and interest over the term of the loan. The repayment terms depend on the lender, the amount of the loan, and the borrower’s creditworthiness. Term loans provide entrepreneurs with a great opportunity to build good business credit history.
Crowdfunding gives new business owners a great opportunity to raise the funds they need through rewards-based or equity crowdfunding, peer-to-peer financing, real estate financing, and donations. There are many crowdfunding websites in existence for those that are looking for the right platform to raise funds for their small business dreams.
While some entrepreneurs are very successful with crowdfunding, others choose more traditional financing options. Maryam Zadeh turned to Biz2Credit to help her secure small business financing for a New York workout studio after she decided crowdfunding was not for her. Give them a call today to see how they can help you meet your small business goals.