Chapter 11

How crowdfunding works

Crowdfunding can get you money to build a business, and the attention to build a customer base.

A person in construction holds a clipboard and bag of money.

What is crowdfunding?

At a basic level, crowdfunding is lots of people – the crowd – putting in money to support a project. It could be for something as diverse as a trip to a sports competition or to raise money for a bigger taco truck.

There are four different types of crowdfunding and three of them are relevant to small businesses raising finance. They can be especially useful for those who can’t (or don’t want to) get funds through traditional sources.

The different crowdfunding models

Rewards-based crowdfunding

With this method, people give an online contribution in return for a reward. The rewards may differ depending on how much is given – but often include the product or service you’re planning to launch. For some people, this has taken over from going to family and friends to get a project off the ground.

Startups often reward backers with discounts, products, and services. For instance, if the project was a new board game, high-value pledgers might get a copy of the game while lower-value pledgers might get a discount when it’s released.

Rewards-based crowdfunding is great for startups that want to test the market. If their idea fails to attract funds it’s a pretty good sign they’ll fail to attract customers. It’s also a good funding source for businesses with really innovative products or loyal customer bases. It’s easy to build on the enthusiasm of customers to get the funds they need.

The big names in social crowdfunding are:

  • Kickstarter and PledgeMe (rewards)
  • Indiegogo (rewards/donations)
  • GoFundMe and Givealittle (donations)

Equity crowdfunding

This form of crowdfunding lets you raise funds from the public in exchange for unlisted shares (equity) in the business. Unlisted shares aren’t listed or bought or sold on an official stock exchange.

An alternative to giving investors shares is to offer them a convertible note. In this case, the investor lends the business money with the expectation they can convert the debt to shares in future. This method is often used when the business is a startup and its value has still to be figured out.

Equity crowdfunding is better for raising larger amounts than you could get through rewards-based crowdfunding. Because of the large amounts at stake, equity crowdfunding platforms – often called portals – are government regulated. There are rules around how much can be raised, how much can be invested, and how often you use them.

Equity crowdfunding platforms are registered with and regulated by the FMA (Financial Markets Authority)

Some of the big names in equity crowdfunding are:

Snowball Effect and PledgeMe.Equity

Peer-to-peer lending

Sometimes called debt crowdfunding, peer-to-peer lending works in a similar way to a term loan from a bank. But instead of getting the money from an institution, you get the money from individual people. You can learn more in the chapter on peer-to-peer lending.

Four steps to start your own crowdfunding campaign

Got a project you need funds for? Or a plan to expand your business? Perhaps it’s time to turn that taco truck into a fleet of trucks.

1. Select your platform: Start by choosing between a rewards or equity-based platform. Find out how long the different platforms allow campaigns to run. That can be important. What’s the limit on how much you can raise? And find out who will see it. Certain platforms might attract different types of backers.

2. Get accepted by the platform: Fill in the online forms and provide any documentation they need. The platforms need to check you’re legitimate. An offer document or prospectus may be required if you’re looking to use an equity crowdfunder. This sets out the details of the investment, any prescribed risk warnings, and cooling-off periods for investors.

3. Make your pitch: Once accepted by the platform, you have a place to make your pitch. Describe your project or idea, why you want funds, and how much you’re hoping to raise. If it’s a rewards-based platform, list what backers will get. For an equity-based platform you’ll need to state what the equity stake is and the share price – if it can be determined. The pitch phase can require a lot of work. It’s a full-on marketing campaign to promote your project or business and make it attractive to investors. And it may involve frequent updates to keep the interest going. Your business needs to use its customers and fans on social media channels to get the word out. With an equity crowdfunding campaign you’ll need to share your business and financial information with complete strangers. That includes up-to-date company information, financial statements and forecasts, a credible business plan, and – if you’re an existing business – a realistic valuation.

4. Campaign end: With some social crowdfunding platforms you get all the donations raised during the campaign. With others, you have to set a target and only get the cash if you reach it. With equity crowdfunding, you’re given a time frame to attract investors. If you’re successful, the platform arranges the payment of the funds to you and issues share certificates or convertible notes to the investors. If you don’t attract investors, you may be able to extend the deadline. These platforms make their money through fees – for instance a percentage of the amount raised plus transaction fees. Some also take equity. Some won’t charge a fee unless you’re successful. They’re doing a lot of the administration and, in the case of equity platforms, they’re handling the legal compliance that can be complex to do on your own.

Pros and cons of crowdfunding

Rewards based crowdfunding pros and cons

Rewards-based crowdfunding

equity based crowdfunding pros and cons

Equity-based crowdfunding

Did you know?

One of the earliest crowdfunding campaigns was for the Statue of Liberty? The French government gave the Lady with the Lamp to the American people but they were left to raise money for the pedestal to put her on. Joseph Pulitzer, the publisher, launched a fundraising campaign in 1885 through his newspaper, the New York World. In just five months, US$101,091 was raised from over 160,000 donors.

Disclaimer: Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the provided content.

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