Everything You Need to Know About Crowdfunding

Ryan is trying to raise money for his startup.

His idea is to build a luxury cooler (yes, the kind you store lunch and drinks in) for the beach or a camping trip, equipped with all the bells and whistles. In short, he wants to build a party on wheels — the world’s coolest cooler.

This cooler would include Bluetooth speakers, which happen to be waterproof in case one of your freshly blended margaritas, made from the rechargeable blender (also included), overflows with too much awesomeness. This cooler would also have built-in storage for plates and utensils, a USB port to keep your cell phone powered all day, sturdy wheels, and every other feature you could ever want in a cooler.

Ryan decides to invest some of his own money and build a prototype. The prototype turns out pretty good, though there are still some tweaks and improvements to be made before he can commercialize his product.

What should he do?

Luckily for Ryan, crowdfunding sites like Kickstarter exist. Crowdfunding allows you to promote your vision for your product online, and take orders and pre-sell inventory before you pay to manufacture it.

Ryan can use the platform to try and pre-sell the world’s “coolest cooler” to gauge demand for the product and raise much needed funding to expand production. He can set a fundraising goal — say, $25,000 in 90 days — and anyone who likes the idea can pledge money or pre-order the cooler. The money raised can exceed the goal, but he’ll only receive the funds if he meets the goal. He can also offer other premiums for larger contributions, from personalized, one-of-a-kind products to naming rights.

Using Kickstarter’s crowdfunding platform and leveraging the site’s popularity allowed Ryan to test out his dream of building and selling the “world’s coolest cooler” virtually risk-free. Considering that at least half of all startups fail, testing the market demand for your vision or idea before investing substantial amounts of capital into research and development, production, and marketing is a smart idea.

But would anyone actually want to pay for the world’s coolest cooler? That was the question Ryan needed to figure out.

The answer?

No. At least, not at first.

The first time Ryan tried Kickstarter, he hoped to raise $125,000 — but not enough people supported the project. Kickerstarter uses an all-or-nothing funding model, which means if you don’t reach your funding goal, no one is charged for their pledge, and you don’t receive any of the money.

However, after some product tweaking, a more seasonally strategic release date (seriously, who drinks margaritas and goes to the beach in the winter?), and a better marketing video, Ryan decided to give Kickstarter’s crowdfunding platform one more try.

And it’s good thing he did. The world’s Coolest Cooler ended up setting the record for the most funding ever since Kickstarter’s inception back in 2009. Ryan’s cooler was viewed nearly 3 million times and raised over $13 million in pledges.

A pledge is a donation toward a project in exchange for a reward. Usually the reward is the product itself (in this case the cooler), but often there are smaller rewards available, like personalized thank-you notes or small branded gifts (such as T-shirts or travel mugs), to attract pledges below the price level for the actual product. (The Coolest Cooler was $185 for pre-orders and is expected to retail for about $299).

Of the 62,642 pledges for the Coolest Cooler campaign, approximately 2,000 of them were small pledges for which the cooler was not a reward. For the other 60,000 pre-orders, Ryan and his staff will use the $13 million raised to build and ship the actual coolers.

Hopefully Ryan’s story will give you a better understanding of one type of crowdfunding.

All About Crowdfunding

Crowdfunding is a method of raising money for a project, company, or business expansion from a large group of people, many of whom you may not know, most often via the Internet. 

There are typically three players in the crowdfunding model:

  1. The project initiator: The inventor, artist, entrepreneur, or startup company looking to raise funds — such as Ryan, in the example above.
  2. The platform: The actual marketplace used to raise money and gauge market demand, such as Kickstarter in the example above.
  3. The crowd: The individuals or groups who support and pledge money to the idea or project.

The initiator selects a platform, sets a fundraising goal and timeframe to raise the money, and then markets the project to as many potential funders as possible using friends, family, connections, and social media.

Make sense?

Instead of hitting up one or two big investors or donors, crowdfunding is about leveraging the power of technology to find many supporters, small and large, who will help raise awareness and money for your project, company, or cause.

In 2013, the crowdfunding industry grew to over $5.1 billion worldwide. And if the early data is any indication, it’s just getting started and poised for major growth in the years to come.

There are a few ways to categorize crowdfunding approaches. In general, they are either donation- or investment-based. For our purposes, we’ll break them up into three groups:

  • Reward
  • Debt
  • Equity

Reward Crowdfunding

Reward-based crowdfunding asks supporters to donate to a project in exchange for tangible, non-monetary rewards, such as getting your name on their website, a handwritten thank-you note, a T-shirt, a cooler, or whatever the finished product will be.

Reward-based crowdfunding allows entrepreneurs or project creators to pre-sell a product or service to launch a business, business concept, or new product without incurring debt or sacrificing equity in the company. Sometimes the pledges are donations, where no products are delivered.

The project initiator benefits from the wide marketing reach of the established platform — for instance, Ryan’s cooler was viewed three million times on Kickstarter. In exchange for that exposure and handling the financial transactions, the platforms charge a percentage fee of the funds raised.

In the example above…

Ryan’s Coolest Cooler campaign on Kickstarter was a reward-based crowdfunding case study. He selected a fundraising goal, a window of time to reach his goal, and created a short marketing video to share with his potential donors, which is included on his Kickstarter page. Ryan then did whatever else was humanly possible to market his project to as many eyeballs as possible during his fundraising campaign.

Here’s how the numbers tallied up

  • Ryan’s project raised $13.285 million dollars
  • Kickstarter’s fee (5%) = $664,250
  • Credit card processing fees (5%) = $664,250 (Amazon.com processes credit card transactions for Kickstarter and also charges a 3-5% processing fee.)
  • Net to Ryan = $11.956 million

His next task: Communicate with all the pledgers and get started producing and shipping 60,000 coolers.

Taking the $11.956 million left after subtracting fees and the pledges that didn’t qualify for product leaves Ryan approximately $199 per cooler.

His cost structure per unit must include R&D, product costs, labor costs, customer service, and any other overhead expenses Ryan and his team need to buy materials, manufacture, and deliver finished products to the pledgers/customers. But being able to buy materials in bulk will reduce the marginal cost per unit.

As you can see, the Kickstarter campaign was just the beginning of a lot of work for Ryan and his team.

While there are many reward crowdfunding sites out there, there are two you should start with: Kickstarter and Indiegogo. Keep in mind the crowdfunding world is rapidly changing, and there are dozens of niche crowdfunding sites popping up — so the top two sites may not retain that position for long.

Like any pursuit, there are pros and cons, so we’ll briefly summarize each platform and lay out the pros and cons for you to consider.

Kickstarter

Kickstarter is the largest and most successful crowdfunding site to date. It uses an all-or-nothing model, which means if you reach your fundraising goal, credit cards are charged and the project gets funded. If your project falls short of your fundraising goal — even a dollar short — no cards are charged and your project is not funded.

In general, a Kickstarter campaign must be centered around art, comics, dance, design, fashion, film, food, games, music, photography, technology, or theater to be approved.

Here are a few Kickstarter stats to catch your eye:

  • Funded over 74,000 projects since its inception in 2009
  • $1,419,175,594 in pledges
  • 7,485,461 total backers

Pros:

  • The largest and most successful crowdfunding platform to date.
  • Free to set up and run a campaign, and it costs you nothing in fees unless your project is fully funded.
  • Ability to take advantage of Kickstarter’s marketing engine to share your project with a wider audience.
  • Kickstarter staff members review project submissions and suggest modifications before publishing. They try their best to improve the overall quality of pitches, which leads to more valuable content on the site (and likely more pledges for you).
  • You retain 100% of your company (no equity splits).

Cons: 

  • While over 75% of projects submitted get the green light, not all projects get approval to be listed on the site.
  • Projects must fall within Kickstarter’s accepted categories such as art, fashion, film, music, photography, and video to name a few. While this may be a plus if you’re the creative type, others will find Kickstarter is not the right platform for their crowdfunding.
  • Fees: 5% plus 3-5% in credit card processing fees, so upwards of 10% of the money raised will not be yours.
  • With the all-or-nothing model, you are waiting in limbo to see if your project will get funded, losing what could be valuable production time.
  • Yes, Kickstarter has a well-known platform, but you still must work hard to actively market your campaign or you risk not being fully funded (which means you get nothing).

Indiegogo

Indiegogo is similar to Kickstarter, but it has a number of key differences.  For starters, there is no staff review and filtering of projects for the site. All campaigns created will be listed on the site. Before launching, you will be asked to choose one of their two pricing options: Flexible or Fixed Funding.

If you reach your goal, you’ll keep the funds you raised, but be charged a fee of 4% of your raised funds. (Nonprofits pay a 3% fee, which is a 25% discount.)

What happens if you don’t reach your fundraising goal depends on which option you selected:

  • If you chose a Flexible Funding campaign, you’ll keep the funds you raised, but be charged a fee of 9% of your raised funds.
  • A Fixed Funding campaign is more like an all-or-nothing campaign: You won’t keep the funds you raised, all of your contributors will be refunded, and you won’t be charged any fees.

With either approach, if you receive funding, there is an additional payment processing fee of 3-5%, depending on your selected payment options.

Pros:

  • Free to set up a campaign.
  • No approval process, so all projects created appear on the site.
  • The option to select flexible or fixed funding.
  • Keep 100% of your company.

Cons:

  • All projects get approved and appear on the site, which may lead to lower quality of projects — making donors more skeptical of projects.
  • Indiegogo doesn’t publicly share many stats and has been known to delist campaigns that raise less than $500 (presumably to try and improve their metrics).
  • The risk of paying 12-14% in total fees (including credit card fees) if your project doesn’t reach its funding goal and you selected flexible funding.

I’ve used both Kickstarter and Indiegogo for fundraising campaigns and both have been successful. The one piece of advice I would give myself if I were to do it all over again would be to use every possible marketing strategy you can think of, both online and offline, to help get the word out for your project.

Debt Crowdfunding

Debt-based crowdfunding is asking a crowd or group of peers to lend you money for your wedding, help you pay off debt, fund a new business, or help expand your business project. In return, you promise to pay them an agreed-upon interest rate in exchange for the money.

Your interest rate and ability to get funded is based on your story, credit history, and ability to repay the loan.

Lending Club

Lending Club is one of the first and most popular peer-to-peer lending sites. (Prosper is another established peer-to-peer lender that operates in a similar way.)

There are of course pros and cons for both the lender and the borrower. Overall, I think the scale is tilted in favor of the lender in most peer-to-peer lending agreements, based on adverse selection — meaning those who are unable to get good interest rates through traditional methods may be more likely to pursue alternative funding options like peer-to-peer borrowing. This holds true for Lending Club as we take a closer look at the pros and cons (from the borrower’s perspective):

Pros:

  • Ability to get approved for a loan without ever leaving your house.
  • Avoiding the long traditional loan process through banks.
  • Access to capital and loans traditional banks would not underwrite.
  • Website is easy to navigate.
  • Your story can persuade and influence peer lenders who are not subject to strict underwriting guidelines.

Cons:

  • Interest rates may not be any better than bank loans, especially for those with good FICO scores.
  • Pre-approval or listing your loan does not guarantee you will receive funding.

I haven’t used Lending Club before, but it appears to be a much more attractive option for me as an investor/lender than as a borrower.

If you have a very unique story and a strong peer-to-peer network, there could be opportunities for better than market interest rate or getting a loan funded in ways traditional lenders would not; however, the average borrower should be able to get more favorable rates through traditional lending channels.

If you have some experience with debt crowdfunding, please leave a comment, we’d love to hear your story.

Equity Crowdfunding

The success of Kickstarter and Indiegogo has proven there is a strong demand for crowdfunding and the trend will only continue. Pre-ordering a new album or luxury cooler is one thing — but what about investors who want to get in on the ground floor of a great new idea?

Equity crowdfunding is a way for entrepreneurs and small businesses to attract capital for their business in exchange for equity in the company — an ownership stake. In equity-based crowdfunding, the supporter/investor receives shares of the company, usually in its early stages, in exchange for the money pledged.

The future of equity crowdfunding is in the hands of the JOBS Act. The Jumpstart Our Business Startups Act was signed in April 2012 by President Obama and intended to ease the regulations on funding small businesses. Title 3 of the JOBS Act specifically relates to crowdfunding and is supposed to allow non-accredited investors the opportunity to use crowdfunding to invest in companies. The exact rules, guidelines, and limits were not established at the time of the bill’s approval.

It’s two years later (and counting) and we are still awaiting the final rules and guidelines for Title 3.

Companies like SeedInvest and Rock the Post (now part of Onevest) have not waited for the final guidelines to launch, choosing instead to target only accredited investors who meet income and net worth criteria and operate within investment limitations.

The goal for the JOBS Act is to open the gates of crowdfunding to not just accredited investors (the rich and wealthy), but to the average investor, much like reward-based crowdfunding has.

Stay tuned on this trend, as we are in the very early stages of equity crowdfunding… and we anticipate big things to come.

While reward-based crowdfunding has dominated the market up until now, we expect equity based crowdfunding to grow exponentially once Title 3 of the JOBS Act is finalized. If you want to see what the SEC is reviewing in greater detail, there is a 600-page document that covers the ins and outs and proposed legislation available here.

Comments are closed.