How does crowdfunding works? Know everything about this digital and innovative way of fundraising

Crowdfunding is an innovative approach to raise funds for your business and projects. In this blog post, you are going to know how does crowdfunding work. The concept of crowdfunding is new compared to its peers in the field of business financing. Crowdfunding enables the entrepreneurs to raise funds from the public through online contributions, mostly for a new project. The funds raised through this method usually act as the startup capital for new ventures.

The beginning of the modern-day crowdfunding happened in 1997 when a British rock band raised money from its fans through online donations for their reunion tour. Inspired by this financing method, ArtistShare started the first crowdfunding platform in 2000. In a short period, the world witnessed the birth of several crowdfunding sites. Soon crowdfunding emerged as a popular financing option. Today, it’s an alternative to angel investment and VC financing for start-ups, early-stage businesses, and growth companies.

The transaction value (the donations and pledges made to crowdfunding campaigns) of crowdfunding grew steadily over the years. In 2019, the total transaction value was USD6.92 billion. Transaction value is expected to grow at a CAGR of about 6% between 2020 and 2024 after adjusting the anticipated impact of COVID-19.

Models/Types of Crowdfunding

There are four different models of crowdfunding. The purposes for which the capital raised is the base of this classification. Different models of crowdfunding are donation-based, reward-based, lending-based, and equity-based. Most of the platforms fall under these categories. At the same time, there are certain variations like hybrid models, and platforms that define themselves in a sectorial vertical rather than the type of finance they provide.

• Donation-Based: Funds raised for social or charitable projects come under this category. Here the funder donates the money without expecting any return. People contribute money to such campaigns as they support the idea/ cause. Usually, only small organizations use crowdfunding platforms for donation-based fundraising, while big establishments raise through their websites. 
• Reward-based: Here, the funder contributes money with the expectation of a reward, mostly non-financial benefits. The reward can be in the form of a gift or an early/exclusive access to products or services of the fundraising company. This model works best for consumer goods companies and creative projects. 
• Lending-Based: In this crowdfunding model, the funders lend money to the companies or individuals and receive interest in return. The lender-based model helps the fund-seekers to borrow money at a lower cost than that offered by banks and NBFCs. It’s one of the most popular crowdfunding models that allow business owners to raise funds without losing control of the business. This model is most suitable for business with a track record of revenue.
• Equity-based: It’s the youngest model of crowdfunding. Here the funder gets the shares of the company in return to the invested money, i.e., fractional ownership in the company. If the company does well, then the funders get a part of the profit in as dividends. Equity-based model is the best fundraising option for companies with high growth potential and those start-ups seeking an alternative for VCs and angel investors. The flip side of this model is that legal and regulatory restrictions make the campaign complicated as well as costly. 

How Does Crowdfunding Work?

Crowdfunding is the process of collecting funds from numerous investors, often referred to as a crowd, via an internet-based platform. Crowdfunding platforms allow business owners to pitch ideas straight to potential investors. These platforms enable the fund-seekers to create web pages that host information, photos, and promotional videos on products, services, or projects that they want to get funded. The funders get rewards in the form of equity/shares, dividends, advance access to new releases/merchandise, or some personal incentives. In short, crowdfunding platforms help the business owners to connect with hundreds of thousands of potential investors. 

Fundraising through crowdfunding is not as easy as it sounds. It demands a lot of time in the pre-launch as well as post-launch phases. Careful planning, clever resource allocation, and consistent execution are the three core elements of a successful campaign. 

Pre-launch Planning

The pre-launch stage is critical, as the decisions made in this stage can make or break your project. Hence, do your research and plan your campaign with care. The following points are of foremost importance at this stage.

1. Study other successful campaigns, how they worked, and at the same time, the failed ones also. Try to access your idea, whether it works well in a crowdfunding platform or not, how much funds you need to implement the idea, are the rewards sufficient enough to attract investors, etc.
2. Prepare appropriate marketing materials. Check if your visuals and videos are giving precise and quick messages about your project. Are they highlighting the upside of the project? Usually, you get only a few seconds to capture the attention of the viewers. So, the marketing materials should give a clear idea of what the project is all about.
3. Calculate the manufacturing and distribution costs of your products or the operating costs associated with your services. Estimate the project completion time/ cycle time and then prepare the project budget. Also, determine the minimum amount needed to run the project and set your funding target according to it. Never make high financial goals. It may open a window for failure. Plan the rewards that suit your goods/services. 
4. Decide the optimum length of time to run the campaign. It varies from project to project. 
5. Before putting the idea in front of the public, try it among your friends and contacts. It gives a sense of the success of your campaign. You can improve the marketing strategy at this level if required. If you have a strong fan base or supporters in social media, then engage them as well.
6. Take a pause and do a final system check. Carefully review everything you’ve done so far. 

Post-launch Phase

Clicking the launch button is just the beginning of the journey. If you have prepared well in advance, then you may see a rush in the response from friends and fans in the initial hours. They also help to promote your campaign through social media and traditional contacts. 

Now don’t sit idle and watch the rush. Instead, nurture that buzz and make it more significant by updating, tweeting, posting news, calling on prospective backers, and handing out promotional cards. Find ways to keep your campaign alive among the audience. If you’ve kept some exclusive rewards under the wrap while launching, then it’s time to uncover them. Release these rewards at regular intervals and update your page with this news.

Acknowledge your supporters and maintain a running dialogue with them either through direct message or mass updates. Don’t forget to answer the queries immediately and address the concerns as well as problems raised by your patrons. Stay connected with your contributors. Take inputs from the contributors to make your campaign more successful. 

Post-campaign Phase

No matter how successful your campaign was. But don’t walk away from your supporters. It’s time to thank all your supporters. Send then personal messages, if possible. After the completion of the campaign, migrate all the communication to a dedicated website or blog.

Also, fulfill the reward promises you made. If you can’t meet it immediately and are planning to do it later, then communicate it to your backers. 

Stay connected with your supporters and update them about the project with an ongoing blog with regular updates. It shows your gratitude towards them.

Don’t forget to consult a certified tax expert to know when taxes must be paid on the investments raised through crowdfunding and how to allocate funds appropriately. The ideal time to approach the tax expert is before the launch of the campaign.

Running Costs of Crowdfunding Campaigns

• Platform Fees: Usually, it ranges between 3% and 8% of the raised capital depending on the platform and crowdfunding type. While there are a few platforms that do not charge any commercial fees but ask for a cost-recovery contribution to cover their operational costs.
• Equity Fees / Additional Fees: Equity investees need to pay additional fees that include accounting, legal, and security costs. It does not apply to other models of crowdfunding.
• Marketing Costs: These are the costs associated with communication, IT, design, and video production. A well-defined strategy is often required for the success of the campaign. Hence, the assistance of a professional service provider is inevitable.
• Project Specific Costs: Certain crowdfunding campaigns need to invest in prototypes as proof of concept. An innovative product based campaign is an example of this. This cost largely depends upon the type of product, and it ranges from a few thousand to hundreds of thousands of dollars.

Pros and Cons of Crowdfunding

Pros

• Financing via crowdfunding is a cost-effective option. Equity crowdfunding is a long-term and sustainable funding option for start-ups.
• Crowdfunding platforms help individual investors and donors to navigate smoothly through complex foreign legal frameworks and allow them to invest abroad at an affordable rate.
• Crowdfunding promotes entrepreneurship and serves business owners who have no access to traditional or commercial fundraising.
• Crowdfunding enables project owners to test and prove the popularity of their model. It also helps to test elements of the product’s marketing approach and how well the targeted customers will respond to it.
• Successful campaigns can easily raise funds more than their targets. Many campaigns have raised 4x-8x of their original funding goals.
• If the campaign fails to meet the goals, then the project owner doesn’t lose much. Most crowdfunding platforms allow rebooting of the campaign with an improved plan and presentation.
• Often patrons act as the built-in marketing team of the project. They help to promote the project among their friends and contacts. 

Cons

• Running a campaign is a tiring job. When compared to traditional fundraising, it needs a lot of preparation. In crowdfunding, the fund seeker is not reaching out to a professional investor. Instead, the fund seeker is pitching to a totally different and diverse audience called end customers. Thus, consumer marketing, social networks, and social marketing techniques are imperative to converse with investors. 
• The emotional roller coaster is an integral part of the crowdfunding campaign, even if it’s a super success at the end. Usually, the journey is full of unexpected ups and downs. Thus crowdfunding isn’t for the faint of heart.
• Business owners need to disclose valuable commercial information while launching their campaign, i.e., putting your ideas directly to the public. Hence, the competitors may take advantage of this and try to capitalize on your ideas.
• There are no standards for investors to monitor the project status and success after the resource mobilization phase.
• No matter how appealing your idea is and how much effort you put before launching the campaign, the chances of success are still very slim. Here, you will be competing with many other projects with the same set of targeted audiences.
• The need for internet technology in crowdfunding can be a barrier for many developing countries.
• The chances of scams are very high in crowdfunding. Money laundering lobby uses crowdfunding platforms to trap people. 

Conclusion

Crowdfunding is one of the most exciting fundraising methods available today. Year after year, it’s getting more and more public recognition due to its unique features. No traditional fundraising method connects the business owners directly to the end-users. But the investors should be careful and mustn’t get too swept away by the hype.