What Is Crowdfunding?
Crowdfunding is a method of fundraising typically used to raise money for business ventures, personal projects, nonprofits, etc. through the collection of small amounts of funds from a large number of contributors. It’s a helpful way for entrepreneurs, innovators, and creatives to get their idea on its feet.
It’s likely you’ve heard of Kickstarter, Lending Club, or GoFundMe. If you have, you’re one step closer to understanding what crowdfunding is. From a cooler that doubles as a speaker and blender to a virtual reality headset, the most innovative (and sometimes crazy) ideas have seen success through crowdfunding campaigns.
After all, starting a business often takes a lot of capital, but 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 year 2030. Crowdfunding is completely transforming the way companies raise capital, how consumers behave with their money, and the market as a whole.
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.
Let’s explore the benefits, challenges, and four types of crowdfunding.
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.
A challenge for many entrepreneurs or early startups is validating whether their idea or concept will be successful in the market. While you can always test it out among a close network of coworkers, family, or friends, it’s a good idea to expand beyond this group.
The early stages of a business idea is the best time to conduct testing, gather data, and make changes. From there, you can scale. 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.
By starting a crowdfunding campaign, you have the opportunity to connect and engage with your customers on a direct or personal level. With access to comments, questions, and feedback, you can quickly figure out if something’s missing from your idea.
Individuals have the chance to poke holes in your concept, so you can take the feedback and improve your product or service with ideas you previously hadn’t thought of. This direct feedback and data is truly immeasurable.
A popular crowdfunding platform will have a large community and existing network you can tap into. Kickstarter alone has over 17 million backers on their site. A community like this gives you an engaged group that’s more likely to support your idea and spread the word.
Not only this, but you’re typically vetted before you’re accepted to a platform, so it gives a level of legitimacy to your new business. If you go the more traditional route in raising seed money, you won’t have the advantage of this exposure from the get-go.
Investors in the early stages of your business usually become your most loyal customers. People who contribute money toward getting your idea off the ground often feel more loyal, engaged, and like they have a part in your success. Early investors 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. They require a ton of planning and work before your campaign even launches. You need early traction and attention, along with a variety of great rewards, to get people interested and keep your campaign momentum.
Not only that, but the market is very crowded. Ensure your idea isn’t already being pursued by someone else so you can stand out as unique among the noise. Keep in mind, if you fail to reach your target, it can affect your brand reputation or image and investors may be less likely to support you down the line.
It’s All or Nothing
Raising money is just the first step of many to starting your business or company. Typically, if you don’t reach your funding target, money that’s been pledged will get returned to backers. 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. 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.
Whether you’re launching your crowdfunding campaign on a tight budget or have the savings to help promote it, it’s important to understand that most crowdfunding platforms charge fees of their own. They typically generate a percentage of revenue from campaign funds that are raised. 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
There may be competitors or individuals that can steal your idea and beat you to market. 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.
4 Types of Crowdfunding You Need to Know About
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.
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.
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 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). GoFundMe, Crowdrise, Tilt, and Kiva are all popular donation-based platforms.
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 crowdfunding industry continues to double year over year, proving to be a valuable form of raising capital for new new startups or entrepreneurs. It helps put decision-making power into the hands of individuals and helps to fill the void in the traditional investment world. Any local business or entrepreneur who is willing to work for it has an opportunity to succeed with crowdfunding.
Understanding the benefits and drawbacks of crowdfunding, as well as the types of crowdfunding, can help improve your chances at success, and ultimately guide you toward the next steps of building and growing your own company!
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
- Charitable donation
- Gift tax
If your crowdfunding campaign is dedicated to raising money for some type of business project or venture, then the funds are subject to income tax. Anyone with this type of campaign should receive a 1099-K form from the crowdfunding platform that they are using.
- In short, a 1099-K identifies that the entity running the campaign has either received over $20,000 in funding or has acquired over 200 transactions on their campaign. However, even if you do not receive a 1099-K (i.e. your campaign earns less than $20,000 or less than 200 transactions), you are still responsible for reporting the income.
In the case that the crowdfunding campaign is run by a charitable organization or nonprofit, then the funds that are raised are not subject to taxes. It is important that if you are looking to raise funds under a charity or nonprofit, that the organization is qualified—otherwise, the funds may be subject to taxes. For anyone who donates to a charitable campaign, the donation is seen as tax-deductible in the eyes of the IRS.
Individuals with a crowdfunding campaign that is not associated with a business or charitable organization could be subjected to paying gift taxes on the funds that they raise. However, gift tax is only applicable to total funds of over $15,000. As long as your total gift tax exclusions for the given year do not exceed this limit, then the funds you raise will not be subject to gift tax.