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Crowdfunding

Updated on April 12, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Crowdfunding Meaning

Crowdfunding refers to how the business can raise capital from many individuals beyond friends, family, relatives, and customers by posting the project details on websites and other social media platforms. It is the source of finance that does not involve banks or other financial institutions.

Crowdfunding

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In this method, small contributions come from different sources other than the traditional banks or financial institutions. It may be a donation, equity exchange or funding in exchange of a reward. This is useful for those who have a good business idea but are unable to gather funds to start it. If it is planned properly, a new startup can raise good amount from it.

Key Takeaways

  • Crowdfunding is raising capital from multiple individuals outside of traditional sources such as friends, family, and banks. It involves posting project details on various websites and social media platforms to attract potential investors.
  • Crowdfunding typically doesn’t involve banks or financial institutions and instead relies on individuals to provide funding.
  • There are several types of crowdfunding, including donation-based crowdfunding, reward-based crowdfunding, debt crowdfunding, real estate crowdfunding, and equity crowdfunding.
  • The Securities and Exchange Commission (SEC) sets yearly limits on the funds raised through crowdfunding and the maximum amount that individual investors can contribute. 

How Does It Work?

The crowdfunding platforms is a source of raising funds from sources other than banks or financial institutions. It includes friends, relatives or family and communication about fundraising is made either directly or online through social media or websites. However, there is a particular way in which it is done.

The entrepreneur who wants to raise funds through crowdfunding and the small investors interested in funding new businesses and business ideas must register at the official crowdfunding websites. These websites are the medium between investors and entrepreneurs.

The entrepreneur has to put the concept and projections of the business through the investment crowdfunding website so potential investors can decide whether to invest. Along with the idea and forecasts, the entrepreneur has to quote the minimum amount the investor can invest. The minimum amount can be as low as $10.

The potential investor needs to show interest in investing, the minimum amount it can sponsor, and the procedure and details of the investments. If overapplications are received, they will repay the excess money to the investors. Once the funds are raised and received, the entrepreneur pays fees to the crowdfunding campaign. The cost is based on the percentage of fundraising.

The profit generated from the business needs to be shared with the investors by return on investment.

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Crowdfunding Explained in Video

 

Types

There different types of crowdfunding platforms as mentioned below.

Crowdfunding Types

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  1. Donation-Based Crowdfunding: Through this, funds for social projects are raised. It might be through awareness on social media platforms etc.
  2. Reward-Based Crowdfunding: In reward-based crowdfunding, the investors get rewards to correspond to the money invested by them. Most new start-ups prefer reward-based crowdfunding campaign, where their rewards can be gifts, coupons, goods, services, etc.
  3. Equity Crowdfunding: The investors get equity against the investment in the company. Therefore, in this case, the investors become the company’s owners.
  4. Debt Crowdfunding: In this, the company promises to repay the amount invested and interest.
  5. Real Estate Crowdfunding: The company supports the fund raised in the real estate sector and pledges to provide heavy returns once it starts earning.

Examples

Let us understand the concept of crowdfunding for business with the help of an example.

Animoodles is one of the companies which raised funds through the idea of crowdfunding. It started a business of manufacturing and supplying advanced toys with the character of animals and famous cartoons and the sound on them through the magnet on the back of toys. The company put the idea and collected the funds through crowdfunding within 11 hours. They raised around $1.5 million in the campaign of raising $1 million.

The entrepreneur can present the idea so effectively that it would attract many investors. Thus, the above example makes the concept very clear.

Rules

Here are some of the rules that a business should follow while try to raise funds form this source.

  • All the transactions from the fund raised from crowdfunding need to be registered with the security exchange commission unless it meets the exemption criteria defined by the commission.
  • Projects must be displayed on the website and registered with the security exchange commission, and the business for which funds are to be raised needs to be legal.
  • Transparent accounts and movement of fund statements are to be displayed on the website so that the investors can get information about the application of their funds.
  • The Security Exchange Commission needs to put a yearly limit on the amount raised in aggregate and by individual investors.
  • One must file all disclosures and information with the security exchange commission.

Such rules should be strictly followed while raising money using the method of crowdfunding so that the system remains transparent, clear and easy, along with a proper method to identify any mismanagement or diversion from what should be done.

Advantages

Crowdfunding has helped many individuals and budding entrepreneurs to start their business and flourish. Let us look at the advantages that it provides for the same.

  • One can raise these funds without any security. For traditional sources, it is necessary to keep a collateral with the banks for the purpose of getting the loan, which is not the case with this.
  • Crowdfunding for business is an easy and valuable way of raising funds. This is because there is no need for extra documentation or verification meeting credit rating and income level criteria. Funds are usually taken from people who already know the borrower very well.
  • Through this, one can raise funds within a short period. Since there is no need for meeting the procedures of traditional fundraising system, a lot of time is saved.
  • It is an effective way of promoting an attractive business idea and talent. Internet has penetrated every part of the society within a very short period and it is easy to access people easily using this method. Within a very short period, the online facilities help borrowers and lenders come together for mutual interest and help a business idea to flourish easily, which might be very useful to the society as a whole.
  • It can attract many small investors as the minimum investment is low and affordable. Thus, it is useful for these investors who can earn return from very low investment and also the business which needs immediate money for its operations.

Disadvantages

There are some disadvantages of the system also that needs to be considered while using it for fundraising. They are as follows:

  • Attracting potential investors is difficult as the company needs to earn trust through convincing projects. This requires good image in the market if the business is already operating and it it is a new project then the owners should have good background. It is also important to have a convincing business plan.
  • More transparency and registration of transactions with the security exchange commission may lead to no secrecy as the business needs secrecy regarding important matters.
  • The targets and deadlines defined in the project need to be fulfilled on time and realistically. Otherwise it may lead to loss in revenue and the business will lose its place in the market.
  • Timely returns are the biggest challenge because if the returns are low or there no returns, then the ratings will come down, and the organization’s reputation will suffer.

Risks

There are some serious risk factors that process may face while using it for funding business.

  • The major risk involved in crowdfunding is the risk of fraud or loss of investment. If the company does misutilizes the money then the investor will lose the investment without any return,
  • The company’s risk might not fulfill the commitments due to unfavorable business conditions or other reasons.
  • Risk of failure of the projected plan and dealing with it it should be kept in mind while using investment crowdfunding because it is not necessary that every business idea will be able to attract customers and gain a good market. May small companies are not able to sustain due to lack of good management strategy, lack of or costly raw materials, weak marketing, tough competition, etc.
  • There is also the risk of payment of a return on investment on a timely basis. The company may earn well but may not pay the investor regular returns.

Frequently Asked Questions (FAQs)

1. What is meant by crowdfunding apps?

Crowdfunding apps refer to online platforms that allow individuals, businesses, or organizations to raise money from many people, often through small contributions from each individual. These apps typically provide a way for people to create and share their fundraising campaigns, track their progress, and receive contributions from supporters.

2. What is meant by crowdfunding scams?

Crowdfunding scams refer to fraudulent or deceptive crowdfunding campaigns that seek to defraud investors or donors. These scams can take many forms, such as fake charitable causes, nonexistent products or services, or fraudulent investment opportunities. 

3. What is crowdsourcing vs. crowdfunding?

Crowdsourcing and crowdfunding are related concepts but refer to different things. Crowdsourcing involves using a large group of people, often from diverse backgrounds, to perform a task or solve a problem. This can include gathering ideas, solving puzzles, or completing surveys. Conversely, crowdfunding involves raising money from many people to fund a specific project or venture.

Recommended Articles

This article is a guide to Crowdfunding and its meaning. We explain its types, with example, advantages, disadvantages, rules and risks. You can learn more about it from the following articles: –