How Crowdfunding Works: Pros And Cons Of Each Model

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As the SEC deadline approaches, it seems everyone is talking about crowdfunding and the JOBS act. Here at SprinkleBit, we're certainly excited about the possibilities that crowdfunding opens for retail investors, so to understand just how crowdfunding works, I want to compare the different models and discuss the potential upsides and downsides of each.

Donation-Based Crowdfunding

I'll start with the most well-known of the crowdfunding models: donation-based crowdfunding. In the donation/pledging category there are multiple different incentives for the individual who pledges capital to a company. The most common are gifts, prizes, rewards, and product pre-orders. This is great for B2C companies or art projects, especially for those with low fixed expenses, fairly low marginal costs, and easily manufactured products.
Kickstarter | Crowdfunding | SprinkleBit

A look at which projects reach completion on Kickstarter (Photo Credit: Mashable)

It’s no coincidence that the top three segments with highest success rates on Kickstarter are Dance (75%), Theater (71%), and Music (68%). They have low fixed expenses with no big upfront costs to get started, once you produce an album or show the marginal cost is very low, and it does not take hundreds of individuals to produce it. However, there are examples of successful projects where the individual backer had no personal interaction or engagement with the end product other than the bragging rights. A good example of this is the Washington Monument, the construction of which was crowdfunded after being halted between 1854 and 1877.
Benefits Of Donation-Based Crowdfunding
Despite Kickstarter's much publicized 41% fail rate, there are plenty of great projects that reach their funding goals and attest to the benefits of this model. Aside from the obvious ability to seek funds from a broad base, you can build up a client base even before you start production. Good examples of this are art projects and product pre orders. Additionally, you don’t have to pay any interest rates in the future and you don’t have to give up any equity
Downsides Of Donation-Based Crowdfunding
If you set you’re expectations too high and budget too low you will encounter problems with delivery and customer management. You have pressure to deliver what you promised on time. Lack of preparation can bury you.
Players
Kickstarter, Indigogo, rockethub,

Investment-Based Crowdfunding

Investment-based crowdfunding is very different from the well-known donation-based crowdfunding just discussed. It's important that we distinguish the two. Investment-based crowdfunding is divided into two sections; debt and equity. The individuals who take part in this type crowdfunding have a slightly different incentive -- here they can actually earn a return on investment (ROI) in the form of interest payments. This opens the door for any company to crowdfund, including B2B companies.

Debt-Based Crowdfunding

Debt is already a plausible way to crowdfund your startup in the US. Lending Club generates about Million in new loans each month and it’s growing at about 100% a year.
Benefits Of Debt-Based Crowdfunding
  1. You can raise capital without giving away part of your company.
  2. You know what the cost basis for the crowdfunding is as you have your set interest rate and the amount of money you want to raise.
This type of crowdfunding would be ideal for a company with a steady revenue stream that can afford to pay off the interest. And as previously mentioned, it doesn’t matter if it is a B2B or a B2C company.
Downsides Of Debt-Based Crowdfunding
The negative aspect of debt-based crowdfunding is that you won’t get the same involvement as in equity-based crowdfunding nor will you get the potential pre-sale/audience building element as you get in donation-based crowdfunding.
Players
Prosper, Lendesk, GreenNote, Loanio, Zopa, 51Give, Pertuity

Equity-Based Crowdfunding

Currently, this is not possible in the US except for tight-knit networks of accredited investors (i.e. wealthy folks). However, this will change when the JOBS Act (“Jumpstart Our Business Startups Act”) goes in to effect January 1st, 2013. It's interesting to note that in the UK, there are already multiple equity-based crowdfunding platforms. (Here's a great funding infographic from one of the UK players, CrowdCube.) Equity-based crowdfunding is the most complex of all the crowdfunding models but it could also become one of the most powerful. Here are a few key details: Through the JOBS Act there are limits to how much an individual can invest through an equity-based crowdfunding round each year. For example, someone who makes between $40k - $90k can only invest 5% of their annual income. The company raising capital also needs audited financial statements if they intend to raise more than $500k. Lastly, the regulation on these types of crowdfunding platforms is also much more complex and they need to be channeled through a registered broker/dealer.
Benefits Of Equity-Based Crowdfunding
This is a real chance for entrepreneurs with great ambitions and creative ideas to get funded at an earlier stage than the traditional venture capital route. As an individual investor I would be more keen to invest $200 in a risky business than $200k, but for the entrepreneur, 1,000 individuals like me makes up for the $200k he or she might need to get his or her company off the ground. Equity-based crowdfunding also provides a new type of investment for retail investors. Now Main Street folks have a chance to get in on the bottom floor before angels and VC firms. It’s much riskier but the payoff can be incredible. Facebook | Crowdfunding | SprinkleBit Let's take a recent example, pretending the JOBS act existed back then: let's say Facebook initiated an equity-based crowdfunding round of $500k back in 2004 instead of taking Peter Theil’s money and you invested a meager $100, how would your investment have fared? Well, if you had sold your investment at $40/share during the IPO, you would have made $1.4 Million. $100 to $1.4 Million? Not a bad investment. Moreover, equity-based crowdfunding will spur innovation in a completely new way. Each crowdfunded company will now have hundreds of ambassadors across the country helping them bring in business or source great talent. Had I invested $100 in our hypothetical Facebook example above, you bet I'd be telling all my friends and family about the company. My $100 earned me a stake, part ownership, and it's in my best interest for it to succeed. With equity-based crowdfunding, multiply this aspiration by the thousands and you now have a powerful word-of-mouth marketing network supporting your company.
Downsides Of Equity-Based Crowdfunding
As an entrepreneur it will be a real challenge to have proper investor relations with the crowd of investors. Here is where the platforms needs to step in and simplify this task. For investors, due diligence is key. A VC firm spends roughly $50k in due diligence before an investment. This expenditure is often not possible for companies seeking $200k in funding, as in the example above. This makes it harder to detect fraud, but here is where the crowd itself can be used to aid in due diligence. Finally, even if the company is amazing and their intentions are good, it might fail to execute. There are multiple examples of this but they rarely are mentioned in the news.
Players
CrowdCube and other European-based firms. Have questions about crowdfunding? Leave a comment and Alexander will answer them for you.

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Alexander

Author: Alexander

Alexander Wallin is the founder and CEO of SprinkleBit. An experienced investor and licensed principal (series 7, 63, 24), he has a passion for startups and making the financial markets more accessible to retail investors. You can follow him on Quora here.

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