Crowdfunding for Business: How It Works
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Summary:
Crowdfunding for a business has always existed in theory but wasn’t applicable to most businesses until technology made crowdfunding platforms possible. These days, businesses can conduct crowdfunding campaigns by offering equity stakes in the company, gifts, and rewards or by accepting donations. However, once businesses grow, owners might opt to raise money through other means. This can be difficult for businesses and investors who initially crowdfunded the platform, as they may be unsure of where everything fits in the capital stack.
Many would argue that the most breathtaking aspect of the internet is its ability to connect people with like-minded ideas across every corner of the world. One day you can have a chat about Buddhist philosophy with monks in Myanmar, and the next, you can look at business opportunities around the world. You can also foster business connections, including raising capital. One way to raise money is through crowdfunding. The ability to fund a business or its operations through many smaller private investors is an old business concept that has taken off with the advent of crowdfunding platforms. However, business owners and potential investors need to understand how crowdfunding works before investing or receiving crowdfunding capital or using a crowdfunding site.
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Crowdfunding and crowdfunding platforms
Crowdfunding is the process of raising money to finance a project from a large number of people. Although these days, a crowdfunding campaign is almost exclusively associated with the internet, crowdfunding has been around since the creation of modern finance itself. Currently, however, crowdfunding is most associated with internet platforms like these:
- Kickstarter
- Wefunder
- Seed Invest
- RocketHub
How modern crowdfunding works
People typically use crowdfunding to raise money to fund business operations or ventures by offering three options: an equity stake, a gift or reward, or a donation. Alex McIntosh, the founder, and CEO of Thrive Natural Care, as well as a seasoned entrepreneur, has seen crowdfunding take off in the last few years. “Crowdfunding can be a helpful source of cash flow for startup companies, especially in a tough VC market like we have been seeing since 2022,” he says. “If a business wants to get started in crowdfunding, there are really good platforms out there like Wefunder, that can help.”
(Crowdfunding) allows retail investors an opportunity to be 'in on the ground floor' of exciting opportunities in a way that they weren't in the days when Amazon, Facebook, and other giant companies were still getting started. - Alex McIntoshClick to Tweet
This is different than P2P lending — although many people can buy part of a P2P loan, effectively a crow, a P2P loan is a debt instrument. So it is classified differently in the form of future business loans.
Crowdfunding by offering equity
Crowdfunding a business by offering equity is kind of like private equity for the common man. You offer private equity in your business in exchange for capital. Many people will offer equity in two ways.
Direct equity in the company
In this scenario, you offer direct equity in the business. For example, you say that the value of your business is $100,000. You will need to somehow prove to investors how you got this valuation, but you could crowdfund 10% ($10,000), for example. The minimum investment is up to you, but you need to reach $10,000. See how it works below.
| Valuation of the Business | $100,000 |
|---|---|
| Investment Needed (10% Valuation) | $10,000 |
| Crowdfunding Minimum Investment | $500 |
| Crowdfunders Needed | 20 |
A convertible bond
Another way to offer equity in the business through crowdfunding is to offer a convertible bond that will convert to equity on maturity. In some cases, you might need to do this if you don’t have the proper corporate structure set up to receive investments. Or, for example, you are taking crowdfunding capital from abroad, and thus non-resident/citizen shareholders will completely change your tax-filing status. In this case, you will offer a 10% return on a one-year bond that is convertible to a percentage equity based on the company valuation and how much was invested.
What to consider when structuring equity for crowdfunding
If you are a crowdfunding investor or a business owner raising money, you need to consider the following:
- Where is crowdfunding in the capital stack?
- How are the investors exiting the investment?
- What happens if the shares are diluted?
Where is crowdfunding in the capital stack?
A capital stack refers to the various forms of financing a company, also known as “capital,” and how they are structured. Typically, they will be structured with debt and equity, and each form of financing will have a “seniority” or a senior position in the capital stack that allows them to access their money first. Most of the time, these will be further delineated into the following categories:
- common equity,
- preferred equity,
- mezzanine debt,
- and senior debt.
For a business that is crowdfunding by offering equity, a decision needs to be made about whether the crowdfunding will be preferred equity or common equity. In a liquidity event, either good or bad, the senior debt will get paid back first, followed by the mezzanine debt, then the preferred equity, then the common equity. Therefore, if the crowdfunding is through preferred equity, that’s higher on the capital stack and thus better for the crowdfunding investors.
How to exit the investment?
Whether you are an investor or you’re raising money via crowdfunding, there should be a well-defined strategy for how investors exit the investment. This isn’t required, however, as investors can take a share of the crowdfunding, regardless of whether or not there is an exit strategy. Here are some exit strategies you can offer.
Buyback based on the pre-agreed-upon amount
You offer to buy back the shares for a fixed amount after a period of time. This allows the investors to have a defined exit strategy.
Buyback based on valuation
You offer to buy back the shares based on a new valuation of the business. You will now agree to pay market value, whatever that may be, for an equity stake.
Acquisition
You agree that the investors will be paid market value on their equity stake in the case of an acquisition. In this case, you will typically have to prove you have a plan to get your company acquired.
IPO
Although rare on Internet equity crowdfunding platforms, an IPO is another way to exit a crowdfunding position. Once the IPO occurs, shares can be sold on the open market if those shares are converted to public equity.
What happens if shares are diluted?
In many cases, a business is going to raise money via crowdfunding at a very early stage. However, in the future, they might take equity investment through other routes, such as institutional investors. In this case, to be able to take in new investments, the business might be required to offer new equity, which will result in the dissolution of shareholders.
If the company is growing substantially, then the dissolution might not matter. Even though the equity position has been diluted, as the company is worth more, those shares are worth more than the initial crowdfunding investment. However, if a company issues too much new equity and things stall out, you could see the crowdfunding portion decline. Whether you are an investor or you are raising money, you might need to consider what the investment terms look like and what the protections are for dissolution, if any.
Crowdfunding by offering gifts or rewards
Another common way to crowdfund a business is to offer a gift or reward instead of an equity stake. Many times, a company that creates a new product will offer that completed product once finished in exchange for money from crowdfunding. The company might need to consider whether it should:
- Offer a gift immediately in exchange for crowdfunding
- Offer a gift in the future based on a successful crowdfunding campaign
If you are already an established business, you might be able to offer a gift right away. Lover’s Lane, for example, is a top adult and mature goods store with 38 retail locations in the U.S. and a thriving eCommerce business. Lover’s Lane might want to offer one of its most popular products in exchange for a crowdfunding investment.
On the other hand, a startup company offering AI-infused skateboards could offer an AI-infused skateboard once it has developed the end product on the back of successful crowdfunding campaigns. The liability for the future product can be tricky, so it’s best to check with the crowdfunding platform and with your investors or consult an attorney.
Crowdfunding with donations
The last way to crowdfund a platform is via donations. The investor does not receive anything in return and instead donates money. Patreon is a popular platform that allows people to solicit money and engage in raising funds in the form of donations.
That being said, many businesses using Patreon or another crowdfunding donation platform will offer exclusive content or something similar as a thank-you for the donation. From the business perspective, a donation is a really easy concept to handle. From an investor’s perspective, there might even be a tax write-off, depending on what the donation is for. When you think about it, the Catholic Church and the Church of Scientology have been crowdfunding for years, and those donations are tax-deductible.
FAQ
Can I crowdfund for a business?
Yes, crowdfunding has been used for businesses since the Dutch East India Company sent ships worldwide. These days, most people will use crowdfunding sites, which take advantage of technology and the internet.
Can you actually make money from crowdfunding?
Yes, for a business, you can use crowdfunding to raise funds and thus grow the business, which ideally will make you money. If you are an investor, you can get a return via an equity position. If it’s a small amount, however, make sure you pay attention to tangential costs, such as payment processing fees.
How much does it cost to start a crowdfunding business?
The cost depends on what you are trying to do. For example, a business using an equity crowdfunding platform to release a substantial equity stake might need to pay for attorneys and admin costs before releasing it. A person using a fundraising platform that offers rewards for crowdfunding opportunities can probably set it up for minimal cost.
Key takeaways
- Crowdfunding to raise money for a business has always existed in theory but wasn’t used for most businesses until the advent of crowdfunding platforms.
- The most common crowdfunding methods are: offering an equity stake, offering a gift or reward, or soliciting donations.
- For those offering equity stakes via crowdfunding, it’s best to be mindful of the exit strategy, where the crowdfunding is in the capital stack, and what happens in a share dilution event.
- Once crowdfunding is over, a traditional business loan or institutional equity stake might be a better next step, so it’s best to have a plan.
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