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Crowdfunding in Small Business

Basic Introduction to Crowdfunding

The process of collecting a large pool of investors, each contributing or investing a small amount of dollars for a highly focused project is referred to as crowdfunding.  The crowd is financing the project or goal.  This is very similar to how large non-profits address significant events worldwide.  A good example is the American Red Cross addressing disaster relief in the aftermath of a major natural tragedy.  An e-mail goes out to their collective previous donor pool with a link to a website asking for donations in light of the recent catastrophe.  

Crowdfunding uses a similar process by notifying the members of an existing funding request, referred members proceed to the website to invest a small amount of money to meet the goal.  There are several crowdfunding platforms each with a different program.  In some, the members join and register their preference for the types of investments or donation.  As an example, Kickstarter restricts their program to creative types of investments such as film, music, art and dance.  

The person with the idea or project need creates a ‘Campaign’ which is the formal term used in crowdfunding.  Effectively, the project is placed online with a description, purpose, dollar amount needed and the expected outcome. 

The following are some of the larger more prominent players involved in crowdfunding and the ideal form of investments or projects: 

  • Indiagogo technology and technology involved in the film industry
  • GoFundMepersonal projects by zip code, examples include Boy Scout or religious community projects
  • Causes oriented towards nonprofit and social projects; the donor registers for particular types of projects and is notified of a pending campaign
  • GiveForward a site dedicated to raising money for a personal love one’s issue such as medical or a dream 

In business, crowdfunding is used to either help get a business off the ground, thus one name Kickstarter or for a long term investmentLaragh FinanceBusiness based crowdfunding uses several different versions.  The various versions include reward based, equity and credit types of funding.  The following sections explain each of the different forms of crowdfunding in business. 

Reward Based Crowdfunding 

This is the more accepted form of crowdfunding as the donor receives some type of reward such as a gift or the actual product for their respective donation.  The crowdfunding site lists the campaign with the particulars and each donor or investor receives the respective reward once the goal is achieved.  If investment falls short of the stated goal, the investors receive their respective donations back and neither party is obligated to the other.  When the goal is met, the crowdfunding site takes a commission and transfers the money and the information to the campaign.  The campaign is then obligated to deliver the respective reward. 

In most of the campaigns, the particular reward is the actual subject matter for the investment.  In technology, the creator typically delivers a version of the respective software or application to the donor in exchange for the investment.  In most cases, the investor does not receive any form of equity position in the new business entity.  Other examples are where the investors are prepaying for a particular product to help get the business off the ground and moving. 

Some really good examples include: 

  • Reaper Bones was a Kickstarter project that raised $3.4M. The company created a fantasy game using figurines with bone like structures.  This is a part of the board gaming industry.
  • Pepple Watch raised $10.2M to build a line of Android and iPhone watches with customizable faces. 

The most common gift reward is a T-Shirt with the company’s logo or project image on the front.  This form of crowdfunding is legal in the United States but other forms are not fully legal or require compliance with the Securities and Exchange Commission. 

Equity Based Crowdfunding 

The Jumpstart Our Business Startups Act (JOBS Act) of 2012 was enacted to follow up on the crowdfunding craze.  Basically, raising equity funds across state lines requires federal approval via the Securities and Exchange Commission (SEC).  The Act has two core Titles related to raising money via crowdfunding.  Title II addresses raising money online with Accredited Investors (wealthy and knowledgeable individuals) and sometime in 2014 regulations will be available to solicit to non-accredited investors (Title III of the Act).  Be sure to read the basic rules here.

In equity based crowdfunding, the investor receives an equity position with their respective investment.  The most common form of equity is stock.  Under Title III of the Jobs Act, campaigns will be allowed to solicit non-accredited investors contingent on certain rules.  Basically, the investor cannot donate more than 2% of their annual compensation and the campaign can raise no more than $1,000,000 and sell to no more than 1,999 investors.  Final regulations are due out soon.  

As an outsider looking in, I am pretty confident that this form of equity solicitation will cost more than 15% of the total amount raised just to ensure proper compliance and documentation with the respective investors.  Furthermore, the crowdfunding site will assess a fee typically in the 7 – 10% range plus the cost of credit/debit card transactions.  So you can see, total costs will run in the 20 to 30% range.  So equity based crowdfunding in the United States via one of the platforms will only be marginally successful.  The more restrictive Accredited Investor format will be less expensive and more than likely superior to Title III forms of fund raising.

Credit Based Crowdfunding 

The third form of crowdfunding is referred to as credit based (sometimes reference as lending based).  As the name implies, the investment group is lending money to the campaign and there is a requirement to pay interest on the debt.  The risk of default is much greater than traditional forms of loansIn almost every case, the loans have no recourseThere are some positives in this area; when the campaign pays back the loan, subsequent credit based funding campaigns have lower interest rates.  

As in equity based crowdfunding, the administration costs are very high making this form of fund sourcing economically prohibitive to monitor and implement. 

Summary 

In researching this article I discovered a couple of interesting facts.  In general, less than 10% of all campaigns are actually funded.  The costs of funding (fees and administration) make these forms of funding questionable over the long run.  But, if you consider the fees and returns required from Angel or Venture Capitalists, crowdfunding is a viable alternative.  Furthermore, crowdfunding appears to be a nice fit in the capitalization process for most business ventures.  In many cases, it is a significant leap of capitalization going from the family size operation to a regional or national operation.  Venture Capitalists rarely review business requests of less than $5M due to the economy of scale involved.  Therefore, crowdfunding will flourish to fill the void. 

Crowdfunding has three forms of fundraising.  The most common type is rewards based and now with the JOBS Act, equity based crowdfunding will gain momentum in the United States.  Credit based crowdfunding will play a role, but nowhere near the volume of reward or equity based crowdfunding.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article.

 

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About David J Hoare (414 Articles)
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns