What is crowdfunding and how does it work?
Are you looking for funding for your growing business? Do you have a fantastic product idea you can sell to the public? If so then crowdfunding could be a great way to raise finance for your business. It works by pooling investments from lots of individual investors.
In this guide we explain how using crowdfunding works and the pros and cons of using it. We also answer common questions like “How much money can I raise with crowdfunding?” and “Should I use equity or reward-based crowdfunding?”
Table of Contents
- What is crowdfunding?
- What are the pros & cons of using crowdfunding?
- How to apply for crowdfunding
- Frequently asked questions?
What is crowdfunding?
Crowdfunding is where individual members of the public club together to fund a new business or charity venture. It reverses the usual idea of investing where one individual invests a large sum of money. Instead, with crowdfunding, hundreds of individuals invest small amounts of money.
Here are some key features:
- Business owners use social media or crowdfunding websites to find possible investors
- Investors can contribute small amounts of as little as £10, although some platforms have a £1,000 minimum investment
- Opens up investment to ordinary people rather than wealthy investors and financial institutions
- There are 4 types of crowdfunding: equity-based, debt-based, reward-based and donation-based
- Crowdfunding can raise between £10,000 to £ millions for your business
How does crowdfunding work?
Crowdfunding works by bringing together investors and businesses on a crowdfunding platform. Individual investors use the platform to invest in growing businesses in exchange for shares or a reward (discount, service or product). Some crowdfunding projects simply ask for donations to fund a project.
Businesses use the platform to connect with and pitch to potential investors. They upload a video, photos and information about their plans for the business and how they will use the funding.
What is crowdfunding for?
Crowdfunding is often used by new or small businesses that might struggle to get a business loan with a traditional lender (e.g. a business loan). They may not have a proven track record or established credit record. Businesses can use crowdfunding for all sorts of projects including the following:
- Paying for more staff
- Funding stock purchases
- Developing a new product, website or app
- Funding an expansion
- Renting or renovating a new premises
- Developing property or building a property portfolio
Individuals and charities can also use donation-based fundraising to pay for projects. They may use crowdfunding for a charity campaign or to help with personal costs like medical bills or emergencies.
Different types of crowdfunding
There are several different types of crowdfunding and they include the following:
- Equity-based - investors receive shares in your business.
- Debt-based - sometimes called peer-to-peer lending. This works just like a traditional loan where your business pays back investors in the future.
- Reward-based - investors are given a product or service (tickets to an event, acknowledgment on an album cover or free gifts). It’s actually a type of donation-based funding because investors usually contribute more than the service is worth.
- Donation-based - suitable for charities or individuals with a specific need. This type of crowdfunding can be used for medical bills or disaster relief.
Pros and cons of using crowdfunding?
The pros and cons vary depending on the type of crowdfunding. Here are the main pros and cons using equity crowdfunding:
Pros
- Early stage funding - crowdfunding allows businesses to pitch for investment at an earlier stage than usually possible with traditional finance.
- Easier to access funding - crowdfunding provides investments to businesses that might not be able to access traditional funding.
- Keep control - although you may give away shares to investors, you will have many smaller investors so their influence on the business will be less than an angel investor or venture capitalist.
- Low upfront costs - you won’t have to pay back interest or capital on investments so it’s cheaper than a traditional business loan.
- Unsecured - you won’t risk secured assets if your business venture fails.
Cons
- Marketing expertise - marketing for crowdfunding is more important than traditional lending as you’ll need to create a great pitch to attract investors. That means you’ll need to have great marketing or pay for the crowdfunding platform to help you.
- Professional costs - you will need to draw up terms and conditions so your investors know what to expect.
- Reduced profit share - if you give away shares in the business, you may water down your future earnings.
- Reputation risk - your business venture will be public on social media or a crowdfunding website so there’s a bigger reputation risk if your business venture fails.
How to apply for crowdfunding?
You can apply for crowdfunding by setting up a project on a crowdfunding website. Here’s how the crowdfunding process works for:
- Join a crowdfunding website
- Submit details of your project to the crowdfunding platform
- The platform reviews and approves your application
- Upload details of your project. Tell your story in a way that’s appealing to potential investors (look at other crowdfunding projects for ideas of how to write a great pitch). Some crowdfunding platforms offer to help you with your pitch and provide access to professional writers and designers.
- Upload a photo or video about your business and project (a video is usually better)
- Give details of your fundraising target
- Promote your project on social media to your followers including Facebook, Twitter and Youtube.
- Share your project with team members. Projects with a team supporting them often raise more money than those with an individual backer
- Investors find and invest in your project
- If you are using equity finance, then fund transfers and legal documents are worked out directly offline between the investor and your company.
- reward-based finance is collected directly by the crowdfunding platform. You will receive the funding, minus any admin and processing fees.
Where to get crowdfunding
Crowdfunding websites are probably the easiest place to start. Here are a few options:
Frequently asked questions
There is no UK legal limit on how much you can raise with crowdfunding. In fact one of the largest crowdfunding campaigns raised £42 million for craft brewer Brewdog. According to Crowdcube, the average crowdfunding campaign raises £670,000.
How much crowdfunding can raise depends on the type of crowdfunding and the success of your marketing. Equity crowdfunding is more suitable for larger funding requirements of over £50,000 whereas rewards-based lending is better for smaller projects of under £50,000. Businesses using debt-based crowdfunding or peer-to-peer lending can expect to raise between £10,000 to £250,000.
In general, startup companies can expect to raise less than established businesses. Startups usually raise a maximum of £250,000; early-stage businesses can hope to raise up to £750,000 and established businesses can raise above £750,000.
Crowdfunding is often suggested as a cheap way of raising finance but is not completely free. Here are the common costs:
- Legal and professional fees
- Marketing costs
- Application fee - may be around £2,000
- Platform fee - often 5% of the total raised
- Credit card and processing fees
The tax treatment of crowdfunding depends on the type of funding and the rules are complicated so you should consult your accountant.
There may be some tax reliefs available to investors under the government-backed Enterprise Investment Scheme and Seed Enterprise Investment Scheme.
If you don’t meet your crowdfunding target then what happens next depends on the crowdfunding platform and the terms of your project. Some crowdfunding projects allow you to keep what you have raised so far whereas others are done on an all or nothing basis. This means investors will receive their money back if you don’t hit your target.
Equity and loan-based crowdfunding is regulated by the FCA. Donation-cased and reward-based funding is currently unregulated.
Donation-based and reward-based crowdfunding is cheap and may be almost free. But there are usually some marketing and legal costs, as well as processing and arrangement fees from the crowdfunding platform.
If you arrange equity-based funding, your investors will become part owners of your business. They will expect a return on their investment either through dividends or selling their shares.
If you apply for debt-based crowdfunding, you will need to pay interest and capital payments on the loan.
Equity crowdfunding is often more suitable if you need a large capital injection or you are in the early stages of starting a business and don’t have much to offer as a reward. equity-based crowdfunding has the potential to raise £ millions if you have an attractive offer for investors.
Reward-based lending can be a great option if you have an established customer or fan base and you’re funding a smaller project. For example, bands sometimes use reward-based crowdfunding to fund a tour in exchange for tickets or signed merchandise.
Using crowdfunding to start a business is sometimes called seed funding. Seed funding is designed for start up businesses and funding can start at as little as £10,000.
Many startups choose to use crowdfunding because it can be easier to access than traditional lending. It can also help you get publicity for your new business or product, as long as you have a great marketing campaign.