Crowdfunding: Funding On Steroids
A lot of buzz has come out recently about crowdfunding (it’s also called peer-to-peer funding). I expect it will get even more in the coming year as new laws go into effect and more success stories emerge.
Now, before I go into explaining what Crowdfunding is, let me wet your appetite by telling you that a few companies so far have raised over $1 million through crowdfunding. A media darling example is the 26 year old Eric Migicovsky who had an idea to make a smartwatch that works with smartphones (i.e. iPhone and Android). Working out of his apartment, he was running out of money and investors were turning him away. He put up a campaign on kickstarter.com to raise $100,000 for the Pebble smartwatch, which eventually raised $10.2 million from 69,000 people. There are other success stories.
I included at the end of this post a two-minute video that explains crowdsourcing using whiteboard animation. In a nutshell, crowdfunding is when someone raises money from multiple people through a single campaign (i.e. 1-to-many). This is different from the “traditional” way of raising money pitching to banks or investors one at a time (i.e. 1-to-1). Some call it funding on steroids.
THREE TYPES OF CROWDFUNDING FORMULAS:
1- Debt: People (funders) extend loans to a the fundraiser. For example, someone in Germany can give a $10 loan to a woman in Ecuador to expand her family farm.
2- Equity: Funders give money in exchange for ownership in the company (equity), which makes them investors. This act is expected to increase the activity in this segment when the JOBS act goes into effect in January 2013 and removes legal barriers in the U.S.
3- Contribution: Funders contribute money without taking equity or repayment (i.e. not an investment or loan). Some are pure donations while others offer gifts to the contributors.
a) Donation: This formula is similar to charity where people donate for a cause with no tangible rewards for the contributor. GiveForward.com helps people raise money to pay for medical expenses.
b) Gift (pre-order): Funders contribute to a campaign and receive promised rewards in exchange (tiered rewards for different levels of contributions). So if people contribute to an artist’s campaign to produce an album, they get a copy of the album, autographed poster/t-shirt, dinner with the artist, etc. Kickstarter.com and indiegogo.com are the most notable players in this category.
DIFFERENT FUNDING MODELS:
A) “All or Nothing” model: The fundraiser only gets the funds if they reach the desired cutoff point (set by the fundraiser). So if the pebble watch raised less than its $100,000 target, the funders would have kept their money and campaign would have ended as unsuccessful.
B) “Take What You Get” model: The fundraiser takes whatever money is raised even if it falls below the target amount.
HOW DO CROWDFUNDING SITES MAKE MONEY?
Crowdfunding sites take a commission (typically 4% to 10%) off the money raised through their platform. The payment processing fees charged by third parties like Paypal (2%) are usually included in that commission.
ADVANTAGES AND DISADVANTAGES
Crowdfunding brings a lot of advantages for the fundraisers and funders. These include:
- Provide small businesses access money when other sources don’t
- Provide access for the “average” individual to access a new stream of investments or early access to rewards (e.g. pebble watch funders receive a watch before it’s out on the market)
- Taps into the average individual’s pockets, which makes more funding money available to businesses
- Serves as a great demand testing tool, especially the gift based category. If the response is poor, the entrepreneur can make adjustments or abandon the idea with minimal investment of money and effort. If the campaign is successful, the entrepreneur will have the money available up front and can focus on operations
The most common criticism of crowdfunding is that it fuels the “rise of the amateurs” on both sides of the fence (fundraisers and contributors). This comes with a lot of baggage such as:
- Some funders make their funding decisions based on emotion, which leads to unreasonable expectations
- Late or no delivery by less experienced fundraisers who underestimate the operations
- More complicated for fundraisers to deal with a larger pool or funders
- Others can copy the idea once revealed
- Higher possibility for fraud
Enjoy the whiteboard animation video explaining how crowdfunding works.