What Is Crowdfunding? Definition, How It Works, Types

While starting a business often takes a lot of capital, startups and other new businesses have a more difficult time qualifying for traditional business loans. That’s where crowdfunding comes in. Crowdfunding is the monetary efforts of a collective of individuals who support a business venture or project. It’s a helpful way for entrepreneurs, innovators, and creatives to get their idea on its feet.

Jump to our infographic for a quick overview of everything you need know to know about crowdfunding, or read through our comprehensive guide for a more in-depth look at what crowdfunding is, types of crowdfunding, and how you can use this strategy to fund your small business.

What Is Crowdfunding?

Crowdfunding is a form of financing a project or business venture by raising small amounts of money from a collective of individuals. There are over 600 different crowdfunding platforms in the world that make it easy for entrepreneurs, investors, and people to connect. Anyone with an idea has the chance to pitch it to available investors. It’s a young, yet popular form of both crowdsourcing and alternative financing.

It’s growing exponentially—so much so that the crowdfunding industry is predicted to grow to $300 billion by 2030. Crowdfunding is completely transforming the way companies raise capital, how consumers behave with their money, and the market as a whole.

How Does Crowdfunding Work?

In order to launch your crowdfunding campaign, you first have to create your campaign—aka what you’re raising money for. Explain who you are, what you hope to achieve, and what you need to get there. Keep in mind that people are more likely to donate to campaigns that tell a story, so spend some time developing your pitch and what visuals (i.e. video, graphics, a product demo) you’ll include. You’ll also need to consider how much money you’re trying to raise and set your goal.

Once you get your campaign out there, it is open for individuals and groups to donate money to help you reach your funding goal. Anyone can contribute to your campaign, which means you have a better chance of reaching your goal quicker. Popular crowdfunding sites have also upped their technology, making it easier for people to browse campaigns, categorize which ones they like to donate to, and promote ones they like. If you’re lucky, your campaign will be one of them.

This can a much better option than peer lending, as you’re limited to your personal network, whereas crowdfunding campaigns (when done well) can be shared to a much wider audience.

How to Use Crowdfunding for Your Business or Startup

The crowdfunding definition may be simple, but using this financing option isn’t always as easy. Crowdfunding is not as simple as posting your project and reaching your goal of $10,000 the next day. It takes strategy, a lot of preparation, and a clear understanding of which crowdfunding type and platform is right for you. Here are some initial steps and general guidelines on how to set up your crowdfunding campaign.

• Choose the right platform for your business. Each crowdfunding platform is unique to a specific type of crowdfunding, niche, or industry. This helps determine which potential customers you will attract.
• Make your idea enticing. Define who your audience is and what they need, and cater your messaging toward them. Keep it simple and digestible, but add compelling visuals or videos to intrigue people and tell your business’s story.
• Offer rewards for people. Provide value for backers to support your crowdfunding venture by offering a valuable reward they’ll love. Just be sure not to break the bank.
• Offer a range of investment levels. Give people options to invest so they can find the level that works for their budget. Offer tiered rewards to pair with each investment level.
• Make it easy for people to share. Use social media to your advantage. Supporters will be more motivated and willing to share with their friends and family if it’s easy to do so.
• Spread the word. Organize your contacts for outreach. Put together a compelling pitch that you can communicate to press, bloggers, or your network. Go offline and throw an event or share your idea with people in person.

4 Types of Crowdfunding 

In what can seem like a complex industry of investment and banking, crowdfunding makes it easy to have the opportunity to grow your idea or business. Depending on your business and goals, you’ll want to choose the type of crowdfunding that’s most relevant for you.

Each type of crowdfunding has its own advantages and each platform is particular for a specific type, niche, industry, or project. Let’s break down the four types of crowdfunding, so you can determine which is the best fit for your business and decide which platform to use when launching your campaign.

Rewards-Based Crowdfunding

The most popular type of crowdfunding is rewards-based, where individuals lend small amounts of money to a project in exchange for a reward or incentive. Funding can range anywhere from $1 to $1,000 and the reward can range from the product or service, perks, or simply recognition.

Crowdfunding was brought into the mainstream by two popular rewards-based crowdfunding platforms: Kickstarter and Indiegogo. These two platforms are more common with creative and newly innovative ideas or projects.

Equity-Based Crowdfunding

With equity-based crowdfunding, investors lend a larger amount of money in exchange for a share, percentage, or, like the title says, equity in the company. They then become stakeholders or part owners. Entrepreneurs can even set investment caps and minimum amounts if they choose. Equity-based campaigns are typically used to launch a startup and last a few months or longer to raise larger funding amounts (up to $100,000 or more).

As with any investment, there’s always a possibility that you can lose a portion or all of your return, so it’s good to keep in mind not just the potential, but also the risks. AngelList, Fundable, and Crowdfunder are popular platforms for equity-based crowdfunding catered more toward venture capitalists.

Donation-Based Crowdfunding

Donation-based crowdfunding is when a large number of individuals donate a small amount of money toward a project. Because it’s based on donations, contributors don’t expect anything in return, other than gratitude from the organization and the satisfaction of supporting a cause they’re passionate about.

Many charities, social causes, and nonprofits lean toward donation-based crowdfunding to raise money so funding targets are generally lower (typically $10,000 or less). Crowdrise, GoFundMe, Tilt, and Kiva are all popular donation-based platforms.

Debt-Based Crowdfunding

Debt-based crowdfunding is somewhat similar to getting a loan from a bank, except that a large amount of individuals lend you a small amount, with the expectation that they will be paid back the principal along with interest. Contributors don’t receive a reward or equity in exchange for their investment.

Many entrepreneurs, startups, or small businesses use this as an alternative to a traditional bank loan since they have more flexibility and options to get funds and resources. It’s most helpful to give a company the financial start they need to go on and continue fundraising.

The Benefits of Crowdfunding

Crowdfunding allows individuals to support the projects or companies that they believe in. On the entrepreneur side, you have the opportunity to test your idea and get valuable feedback from potential customers before going to market. Let’s dive into four key benefits of crowdfunding.

• Market Validation: The early stages of a business idea is the best time to conduct testing, gather data, and make changes. While you can always test out an idea or concept among a close network of coworkers, family, or friends to see if it will be successful in the market, it’s a good idea to expand beyond this group. Determine whether a stranger is willing to spend money on your product, and if not, it may be time to go back to the drawing board.
• Valuable Insights: You have the opportunity to connect and engage with your customers on a direct or personal level when you start a crowdfunding campaign and can quickly figure out any shortcomings through comments, questions, and feedback. Based on that feedback, you can improve your product or service with ideas you previously hadn’t thought of.
• Free Exposure: A popular crowdfunding platform will have a large community and existing, engaged network you can tap into for support and to spread your idea through word of mouth. Kickstarter alone has over 17 million backers on their site.^[1] Additionally, you’re typically vetted before acceptance to a platform, so it gives a level of legitimacy to your new business, as opposed to going a more traditional route for raising seed money.
• Early Adopters: Investors in the early stages of your business usually become your most loyal customers and often feel more loyal, engaged, and like they have a part in your success. They are also more likely to become brand advocates, spread the word, and get other people in their network involved.

The Challenges of Crowdfunding

There’s no question that launching a crowdfunding campaign takes a lot of work. You have to put in the time and effort to build interest and buzz around your idea, which may require additional resources like a team and money. Here are four key challenges to crowdfunding.

• Many Campaigns Fail: The average success rate of crowdfunding campaigns is 22.4%—which means that while this can be a viable solution for funding your startup, many campaigns fail. A successful campaign requires early traction and attention,  along with a variety of great rewards to get people interested and keep your campaign momentum. Conduct market research ahead of time to ensure your idea isn’t already being pursued by someone else.
• It’s All or Nothing: Strategize before you launch your campaign, build in all potential expenses, and set a realistic goal and timeline for your project to improve your chances of success. If you don’t reach your funding target, money that’s been pledged will get returned to backers, but the good news is if you hit the 20% mark, it’s likely you’ll reach your final goal. Almost 80% of Kickstarter campaigns that raised more than 20% ended up being successful.
• Platform Fees: It’s important to understand that most crowdfunding platforms charge fees of their own. Kickstarter and IndieGoGo, for example, both charge a 5% fee of total funds you raise, on top of a 3% to 4% card processing fee.
• Fraud Can Happen: Always keep in mind that with crowdfunding you’re exposing your idea on an open platform, so you may want to monitor who’s involved. Take advantage of private chats with investors to discuss not just your project but potential non-disclosure agreements. Consider talking with a business attorney to ensure your idea is patented and legally protected.

Paying Taxes on Crowdfunding Income

Once you successfully raise money through crowdfunding, it may be easy to forget that you still may need to pay taxes on this money. Depending on the purpose of the campaign, the IRS still may consider those funds taxable. 

There are three categories that your crowdfunding campaign funds may fall into:

• Taxable Income: The funds you raise for your business venture through crowdfunding are subject to income tax. If you have this type of campaign, you will receive a 1099-K form (identifies that you, as the entity running the campaign, has either received $20,000 in funding or has acquired over 200 transactions) from the crowdfunding platform you used. It’s important to know that even if you don’t receive a 1099-K, you are still responsible for reporting the income.
• Charitable Donation: If a crowdfunding campaign is run by a charitable organization or nonprofit, the funds raised are not subject to taxes. If you are raising funds under a charity or nonprofit, the organization must be qualified, or else the funds will be subject to taxes. The IRS recognizes donations to a charitable campaign as tax-deductible.
• Gift Tax: Running a crowdfunding campaign that isn’t associated with a business or charitable organization could be subject to paying gift taxes. However, the gift tax only applies to total funds of over $15,000, so as long as the funds you raise don’t exceed that amount, they will not be subject to gift tax.

Infographic Sources:

Entrepreneur | Fundable | Fundly | Kickstarter

Article Sources:

1. Kickstarter.com. “Stats“