What is Crowdfunding & How Does It Work?

In recent years, more and more entrepreneurs are considering raising investment through crowdfunding. So what exactly is crowdfunding and how does it work?

What is crowdfunding?

Crowdfunding is a method of raising finance for projects, campaigns, charities, and businesses from a large number of individual investors, typically using an online platform.

The following parties are normally involved in crowdfunding:

Project initiator

This is the individual, business, or organisation which is seeking finance for a specified project.

For the purposes of business start-ups, the project initiator will be looking for funding to set up their business or design, build and get a product to market.

They will create an online crowdfunding page on their chosen platform, outlining the nature of the business venture and specifying the level of funding required.

They will also detail how the finance is intended to be used and what the investors can expect to receive in return for providing funding (if anything).

Investors

These are the individuals or businesses who provide funding for the crowdfunded projects.

They will decide how much money to contribute to the campaign. This is then added to the overall pot of crowdfunded investment. Often, the level of funding of each particular investor will entitle them to a specific expected return, with larger donations normally resulting in extra benefits.

Crowdfunding platform

This is the cloud-based software, normally managed by a crowdfunding company, which acts as the primary interface for project initiators and investors.

Crowdfunding pages will usually be hosted on the platform and it will collect donations from investors, providing them with online accounts and visibility of the whole process. In turn, the platform will pay the monies collected from the investors to the project initiator, generally taking a small percentage as their service fee.

One of the key features of crowdfunding is that it seeks to persuade a large number of individual investors to donate money. This is in contrast to other forms of investment, where finance is sought from one primary source such as a bank or angel investor.

Platform providers

There are thousands of different crowdfunding platforms with a wide array of goals and returns for investors. They tend to fall into specific categories, including:

Reward-based

This is the main type of crowdfunding platform used by business start-ups. Investors will normally expect some kind of reward for their money, which often takes the form of early access to the service being developed, or a free product once it has been built.

The production of many computer games is funded in this way. People investing higher amounts will normally be provided with extra features, or possibly have their names featured in credits, etc. Examples of reward-based crowdfunding platforms are Kickstarter and Indiegogo.

Charitable

These platforms normally host crowdfunding pages for individuals or organisations seeking finance for charitable causes (GoFundMe), social activism (Avaaz), or legal justice (CrowdJustice).

There tends to be no return for investors for these types of campaigns. However, they will instead be updated with the progress of the campaign and how donations have helped a cause, etc.

Debt crowdfunding

This is more similar to a traditional loan, in that the investors generally seek a return on their initial investment in addition to a certain rate of interest.

However, in this case, the loans do not involve a bank or a single large investor but instead are made up of a collection of micro-investors.

Equity crowdfunding

This is more like selling shares in a company, as a certain amount of equity in the business is exchanged for a level of investment.

Although it can help start-ups to obtain an alternative form of finance, giving away equity can result in control of the company being diluted, and this can lead to future disputes.

Litigation crowdfunding

This focuses on specifically funding legal action (e.g. AxiaFunder). Investors will typically receive a return if the party whom they are funding wins the case.

How do I set up a crowdfunding page?

Each platform will have a slightly different method of setting up a crowdfunding page. But the key elements are generally as follows:

A detailed description of the project or business idea is presented on a crowdfunding page, using both written and audio-visual communication, as appropriate.
Background to the project should be outlined, including as much information as possible about the history and inspiration for the idea, etc.
Comprehensive details of the project initiators are crucial, highlighting any relevant skills and previous experience.
The timeline for the project, any planned milestones, and the budget should be clearly set out.
Defined reward details, which will typically be a free product or subscription to a service. It is important to explain any different levels of rewards that depend upon the level of investment.

As well as setting up a comprehensive crowdfunding page, it is important to provide regular updates to investors to ensure they know how the project is progressing.

Benefits of crowdfunding over traditional means of raising capital

Let’s consider the reward-based form of crowdfunding (as opposed to debt or equity-based). One of the main advantages compared to raising investment through a loan or via an investor, is that the funding does not need to be repaid. And there is no interest involved.

Crowdfunding also provides an alternative source of finance to businesses that are unable to secure investment through the more traditional channels.

Many products simply would never have come to fruition in the absence of online crowdfunding. This is particularly the case for relatively niche products that may be overlooked by a traditional investor.

One of the downsides is that some crowdfunding platforms do not release the funds if a predefined funding target is not reached. In this case, funds are normally returned to investors and the project is unable to go ahead.

Promoting your crowdfunding campaign

Because crowdfunding involves a large number of small investors, it is crucial that the business understands its target market.

Once a crowdfunding page has been set up, this needs to be marketed to the relevant audience. Some of the methods include:

Social media

The sheer reach of Facebook, coupled with extremely detailed profiling of its user base, makes it a very attractive advertising platform. This is ideal for crowdfunding initiators looking to target a specific demographic.

Facebook adverts appear automatically in the news feeds of their intended audience, based upon factors such as:

location
age
gender
profession
level of education
and other demographics gleaned from users’ profiles

Links to the crowdfunding page can be placed in the adverts, and analytics software can show how many visitors were redirected from Facebook.

Other social media platforms may be more suited to different types of crowdfunding projects.

Services aimed at businesses rather than consumers could have a better response if they are advertised on LinkedIn. And design-led products may fare better on Instagram.

Website

If you have an existing website that gets a reasonable amount of traffic, consider adding a link to your campaign on the home page.

Email list

Compiling an email list to share updates on your campaign with interested parties is an essential part of promotion.

Many low-cost or free email marketing tools are available, such as Mailchimp.

Blogs

Find niche blog sites that cater to the audience for your campaign. Offer to write a guest post for their blog in exchange for a link to your campaign.

Forums

Check out the various forums which relate to your product. Get involved in the discussions and mention your campaign.

Also, make sure you join the Crowdfunding Forum to gain tips and advice from other crowdfunders.

Influencers

Consider reaching out to a social media ‘influencer’ or their agent to ask them to help with the promotion of your campaign.

Google AdWords

This can be highly effective for getting a new product to show up in search results.

So this could potentially work very well for crowdfunding projects which need to get their campaign on the first page of Google. However, this can be very expensive, especially for certain high-value search phrases.

Shops and exhibition spaces

Printing out some flyers and posting them in appropriate locations can be another way of getting the message out.

Bank account for receiving funds

Many of the crowdfunding platforms will have specific requirements regarding the types of bank accounts that can be used by project initiators to receive funds.

For example, UK businesses that set up a crowdfunding page will often need a UK-based business bank account that supports direct deposits.

1st Formations can aid with limited company formation and setting up your business account. We can also help if you want to set up a new company for your crowdfunding venture.

Examples of successful crowdfunding

There have been countless successful crowdfunding campaigns over the years, but here are a couple of examples:

Oculus Rift

This is a virtual reality headset used primarily for gaming. $2,437,429 was raised in just 30 days with over 9,000 backers.

The Rift went through various pre-production models since the Kickstarter campaign in 2012. Around five of which were demonstrated to the public before reaching its commercial release. In March 2014, Oculus was purchased by Facebook for $2 billion.

The Rift has gone through various product iterations since then and has now been superseded by the Oculus Quest 2.

Pebble watch

This was one of the first smartwatches produced. It was designed to be connected to Android and iOS devices and could show various notifications and messages.

The crowdfunding campaign on Kickstarter ran from April 11, 2012, to May 18, 2012, raising a total of $10.3 million.

Although the initial product was eventually discontinued and the company shut down, its intellectual property was purchased by Fitbit, which is still going strong to this day.

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What is crowdfunding and how does it work?