crowdfunding has become a viable financing mechanism for individual entrepreneurs and businesses alike. But how does crowdfunding work exactly? In this article, we will guide you through the basics of how crowdfunding works. We will also share some important insights along the way.

In this article:

  •       An introduction to crowdfunding;
  •       How does crowdfunding work;
  •       Different types of crowdfunding campaigns and their corresponding platforms – from GoFundMe, through IndieGoGo to Crowdcube;
  •       The benefits of crowdfunding
  •       Crowdfunding risks

How Does Crowdfunding Work - An Introduction

Traditionally, the options for capital building available to startups were few. It comprised mainly of the founder’s personal network, business angels, venture capital firms and seed funding. However, in the past decade, there has been a surge in alternative financing methods with crowdfunding becoming more popular by the minute. Back in 2010, crowdfunding was a relatively small industry, valued at around $880mln. worldwide. Today, estimates put the global crowdfunding market at more than $70 billion. The forecasts are even more impressive. The sector is expected to reach $114 billion by 2022.

Crowdfunding, is the act of seeking financial support for a project from a large number of people. The aforementioned traditional means of financing characterise with entrepreneurs seeking large sums from a small number of people or institutions. In contrast, the “crowd” in a crowdfunding campaign can comprise of tens, hundreds or thousands of individual backers. The prime purpose of crowdfunding is not just that it enables individuals to raise funds, but also the opportunity to test the market and find an engaged following for an idea or a working product.

Without further ado, let’s explore how crowdfunding works.

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How Does Crowdfunding Work – The Process In A Nutshell

  • A creator has a unique idea/ solution and needs additional funding to launch a product off the ground, complete its production or take the business to the next level;
  • The creator has to define which crowdfunding platform is best suited for the needs of the business. The crowdfunding platform serves as a mediator, which brings together two parties and gets them to exchange ideas and funds. The platforms tend to use web-based payment systems to facilitate the trade of resources between the creator and the investor;
  • If the crowdfunding campaign is executed properly, the creator spends time and resources to raise awareness and generate leads months prior to the official launch of the funding round;
  • The campaign eventually goes live. This period is followed by additional efforts to reach the target audience through social media, PR, events and face-to-face conversations;
  • Funds are provided by backers highly invested in the business and what it has to offer.

How Does Crowdfunding Work – Different Types Of Crowdfunding Campaigns

To fully understand how crowdfunding works, one must explore the four main types of funding. Over the years, different types of crowdfunding have been proposed, all depending on the type of reward offered to the supporters in exchange for their contribution – equity shares (equity-based), a product, service or other non-monetary rewards that are more or less symbolic (reward- and donation-based), a particular interest rate (lending-based).

Here is a brief insight into what each campaign type means:

Crowdfunding Typology

  • Donation-Based Campaigns: Donation campaigns assist charity projects to find their funding, offering no tangible return for the contribution. Apart from the satisfaction of donating to a worthy cause, of course. Among such platforms are GoFundMe and JustGiving. According to a 2015 industry report, the donation-based generates the second-largest funding volume globally (NCFA, 2015).
  • Rewards-based Campaign: This is the most popular type of crowdfunding. In reward-based campaigns, donations are sought in return for a special reward (usually with a non-monetary one). Through these campaigns, creators are able to test the ground for a new product and find the right audience before launching it on the market. On the other hand, the crowd has the opportunity to be early adopters of unique products and get them at a low price. The most famous platforms supporting such campaigns are Kickstarter and IndieGoGo.
  • Lending-Based Campaigns (a.k.a. Peer-to-business (P2B) or peer-to-peer (P2P) crowdfunding): Imagine that a large group of investors collectively decide to make a small contribution to an individual or business looking to raise funds. In return, the loan is paid back with interest over time. That’s what the typical lending crowdfunding campaign looks like. Traditional examples of platforms supporting such campaigns are FundingCircle and Lending Club. Data from 2015 positions lending crowdfunding as the largest crowdfunding type by funding volume (NCFA, 2015). We could partially attribute that to the fact that, according to some classifications, Kickstarter falls under the category “presales lending crowdfunding”, which offers a finished product in return for the supporter’s pledge.
  • Equity-based Campaign (a.k.a. investment crowdfunding): Equity campaigns offer investors equity (a share) of the business, thus encouraging individuals to invest knowing they will benefit from it in the future. Investment crowdfunding is the fastest growing crowdfunding category. Crowdcube and Seedrs are the most prominent equity platforms in the UK.
How does crowdfunding work - crowdfunding benefits

How Does Crowdfunding Work - The Benefits

Crowdfunding works well for many startups and the benefits from it are not just financial.

Although we will get into more detail in another article, we decided to scratch the surface here and briefly mention the non-monetary value of crowdfunding.

  • First of all, crowdfunding works really well in terms of validating a business idea;
  • Crowdfunding campaigns are also a great source for getting customer feedback and better understanding customers’ preferences;
  • Furthermore, crowdfunding helps creators get an insight of how the product will perform before officially launching it on the marker;
  • Finally, crowdfunding is an amazing tool to establish a loyal community around your brand.

Crowdfunding is not without advantages to the other side of the equation as well – the backers. To mention a few, supporters often find attractive the fresh investment options, the opportunity to become early adopters of highly innovative products, the significant price discounts and additional perks, typical for most campaigns.

How Does Crowdfunding Work - The Risks

Having discussed the benefits of crowdfunding, light must be shed on the risks, associated with this type of financing.

  • One of the biggest problems for founders are the disclosure risks. Sharing that much product/ business details might lead to patent problems. In rare cases, it might also lead to concepts being stolen by businesses with enough resources to launch them quickly;
  • Unlike business angels and venture capitalists, who often bring plenty of industry knowledge, business relationships and status to the table, a big part of the crowdfunding investors don’t offer more benefits – apart from the money invested;
  • Having a big crowd might lead to harder investor management. Creators often struggle with the different visions of the many, many investors;
  • On the other hand, funders might face the challenges of working with incompetent creators, fraud and lack of information.

How Does Crowdfunding Work - Conclusion

In recent years, crowdfunding has become a dynamically growing alternative financing method. This article offers brief insights into how crowdfunding works by focusing on the process itself, the  different types of crowdfunding and the benefits and risks, associated with this venture.

Do you need advice on how to create your crowdfunding campaign?

We can help. Drop The Crowdfunding Studio are proud partners of Crowdcube and Indiegogo. We assist ambitious businesses in communicating their ideas, products and services with outstanding crowdfunding video production, campaign design and crowdfunding marketing.

To learn more about us and our services, visit our website: drop.studio

Or book a free phone workshop today and ask us anything: how to create a successful crowdfunding campaign or how to accelerate your business from zero to fully funded.