What better way to start this Blog than with a discussion of the four (4) general types of crowdfunding.
First, let’s review what “crowdfunding” means. There are various definitions about what constitutes “crowdfunding” but it is essentially just a term to describe a method used by a person or company to get money by seeking small amounts from a large number of people rather than looking for large amounts from one or two people. I like to think of it in terms of throwing a party where, rather than asking just two or three of my best friends to chip in a bunch of money for party supplies, I ask each of my guests to contribute a couple of bucks. The party goes on as planned and everyone in the party “crowd” is happy….
There are four (4) main categories of crowdfunding campaigns based on what (if anything) the person contributing the money can expect to receive in return. The four types of campaigns are: (1) donation based crowdfunding; (2) rewards based crowdfunding; (3) debt based crowdfunding; and (4) equity based crowdfunding.
- Donation Based Crowdfunding.
Donation based crowdfunding is exactly what you might think. It is a type of funding campaign where the person or company running the campaign is not expected to give anything in return to the contributing persons. In a donation based crowdfunding campaign the contributing persons (i.e. the “crowd”) give money or other resources to the person/entity running the campaign simply because they want to support the idea or cause. In my party example these would be the people who give me money for party supplies even though they will not be able to make the party (aww, thank you guys!).
These types of crowdfunding campaigns work well for fostering social causes, community projects, charities etc.
- Rewards Based Crowdfunding.
Rewards based crowdfunding describes a funding campaign where the individuals contributing money can expect to receive varying levels of “rewards” that correspond to the amount of money they contribute. Typically the “reward” is a product or service that that the particular company running the campaign produces or provides (or some discount to acquire the product/service) and there are at least three (3) levels of rewards based on the level of contribution. In my party example, these would be the people who give me money for party supplies because they want the “reward” of coming to my party (I throw great parties).
Reward based crowdfunding has been around a long time. Anyone remember P.B.S. pledge drives??? A $10 dollar contribution may have gotten you a big bird t-shirt but you better dig deep if you wanted that P.B.S. tote bag let alone a lunch with Bob Vila (if you don’t know Bob Vila you better ask somebody). An old example I know, but I only bring it up to show that the concept existed well before we gave it a name. Today rewards based crowdfunding is one of the most popular types of crowdfunding and has been brought into the spotlight by the popularity of sites such as Kickstarter and Indiegogo.
Rewards based crowdfunding campaigns tend to work particularly well for consumer goods and other tangible products.
- Debt Based Crowdfunding.
In a debt based crowdfunding campaign, the person or company running the campaign is essentially looking to borrower money from multiple people. In return, the individuals agreeing to lend money to the company receive the person’s/company’s binding commitment to repay the amount at set time intervals and at a set interest rate. Put simply, the people are giving money to the person/company in exchange for a big I.O.U. In my party example, these are people I invite who won’t just give me money for party supplies but say they would be happy to lend it to me if I agree to pay it back, with interest (these people don’t get invited back, in case you were wondering).
Debt based crowdfunding campaigns are particularly popular with entrepreneurs who don’t want to give up equity in their start-up companies immediately and/or do not have access to more traditional types of loan facilities. They are also growing in popularity as a way for real estate developer to fund a particular real estate project or projects (I call this type of real estate crowdfunding, a “recfund”).
- Equity Based Crowdfunding.
Finally we have equity based crowdfunding. In an equity based campaign, a person contributing money can expect to receive some ownership in the company which is raising the funds. Put another way, the company running the campaign is selling off a piece of its ownership (e.g. shares, membership interest, etc.) to each of the crowd members contributing money. Assuming the company does well, the contributing crowd members may realize a return on their investment by receiving a share of the profits in the form of a dividend, distribution etc. In my example, these would be the people who don’t want to throw the party themselves but want to give me money for supplies so I can throw it and that they can tell everyone that they are a “co-host” of the party. As a co-host they can share in the credit when everyone comments on how awesome the party is (I’d give an example of what happened if a party of mine was bad, but that never happens).
Equity crowdfunding in the U.S. has been on the rise ever since the passing of the Jumpstart Our Business Startups (JOBS) Act in April of 2012 and is expected to be one of the biggest sources of funding for start-ups and small business in the near future. That being said, current legal and regulatory restrictions make this type of funding campaign the most complex and costly to facilitate.
Equity based crowdfunding campaigns are being used more and more by entrepreneurs and start-ups seeking an alternative to traditional venture capital and angel investors when looking for a capital infusion to take their business the next level.