If you're an individual or a business that needs to raise cash, you might be considering crowdfunding as a viable source of raising them. Indeed, crowdfunding has become one of the most popular ways of raising money online.
What's the difference between crowdfunding and traditional funding ? Crowdfunding involves raising money from a large pool of people contributing small sums. Traditional funding methods involve borrowing money from a single lender or selling equity to an investor or a small group of them.
The exact differences depend on the type of crowdfunding you're looking at carrying out. If you want to fully understand all of the differences, keep reading!
Types of Traditional Funding Methods
Broadly speaking, there are two types of entities that seek funding. The first is individuals and the second is companies.
For individuals looking to raise cash, the most popular option is to borrow money from a lender. This lender could be a bank, your credit card or from an institution such as an advance payday loan outfit.
All of these options work to varying degrees. Personal loans can help you tide over any large emergencies but you'll be stuck with interest payments for a long time.
Credit card debt is the most common form of debt that people around the world carry, apart from mortgages. Another type of debt that a lot of people carry these days is student loan debt.
Payday loans are the most desperate option in this list. The interest rates on them are particularly high and if you borrow enough from such institutions, you'll eventually end up making payments for the rest of your life!
As far as companies go they have two ways in which they can raise cash. These are:
Issuing debt/ borrowing money
Most small businesses prefer to raise loans from banks and this can be a hit or miss thing. A small business loan can help you tide over problems but the thing with banks is that they lend only to businesses that have great track records.
In short, they end up offering money almost always to businesses that don't have the biggest need for them. One can understand the banks' position but there's no denying that the small business owner facing a shortage of cash needs a miracle to keep themselves afloat.
Issuing debt is one method of raising funds but this option isn't the most viable one for small businesses.
You could issue equity in your company by offering shares to an investor.
Most business owners shy away from doing this and rightly so. After all, if you manage to bounce back from your present problems then you've given away a large slice of your business to someone else forever.
While these options seem to have a lot of negatives associated with them there's no denying that there is a large support system in place for them.
This means you're never lacking any legal or professional help when the time comes to put these methods into action.
So now that we've taken a look at the traditional fundraising methods, let's look at how crowdfunding is different.
How Crowdfunding is Different
As a concept, crowdfunding is pretty simple to understand. You put your case in front of millions of people and hope that they donate small amounts of cash to you. These small amounts add up and before you know it, you're raised the amount you need!
As I mentioned earlier, the exact differences between crowdfunding and the more traditional methods depends on the type of crowdfunding campaign you're carrying out.
There are four types of crowdfunding campaigns you'll find. These are:
Debt crowdfunding or P2P lending
Equity crowdfunding has become all the rage since it was legalized in 2012. Companies can now issue shares to the general public as long as they follow the guidelines laid out by the SEC.
Typically, you'll find startups using this option instead of opting for VC or angel funding. There are many benefits to this approach and you'll learn about them shortly.
Rewards based campaigns are usually carried out by individuals launching a product or by companies that are looking to get up and running with a new idea. It's a great way to test the waters before commiting capital to a new product.
Kickstarter and Indiegogo are popular platforms that enable these kinds of campaigns.
Donation based campaigns are usually run by people in need of cash to fund their debts or education. In fact, there's no limit to what you can raise money towards.
There are campaigns to lay legal fees, funeral costs, weddings, honeymoons, you name it! GoFundMe is the most popular platform for this type of fundraising.
Lastly, we have debt based campaigns or P2P lending as it's more popularly known. P2P lending was the first type of crowdfunding that emerged and it has turned into a highly regulated industry.
This is a perfect example of how crowdfunding can benefit both the borrower as well as the creditor while minimizing risk across the board.
All of these types of campaigns offer their own advantages and disadvantages. Choosing the right kind of campaign is important and you should take the time to learn about all of them individually.
However, we're not here to compare them to one another! Instead, let's now move on and look at how each of them compares to the more traditional options that exist to achieve the same ends.
Equity Crowdfunding Versus Traditional Capital Raising Methods
Since equity crowdfunding involves issuing shares in your company, I'm going to focus on the traditional methods that do the same thing.
In other words, how does equity crowdfunding differ from VC funding or angel investing? The following list will make all the differences clear:
Equity crowdfunding success hinges on how well you can convey what your company's business is all about in the simplest of terms.
This means your pitch needs to explain the intricacies of your business and at the same time, be simple enough so that lay investors can understand what you're on about.
This is a challenging balance to pull off and the clarity of your pitch and offering is paramount to your success. You should spend a lot of time designing this or hire the services of a professional who knows how to deliver.
The crowd that you'll be pitching to will not be as sophisticated as the average VC board. Many platforms such as StartEngine have a number of sophisticated investors on board but these people are in the minority.
Further compounding the issue is the fact that you can issue different types of vehicles for you investors.
The average investor in a crowdfunding platform might have issues deciphering the terms of a convertible debt issue and this might reduce your chances of funding.
Generally speaking, equity crowdfunding is more entrepreneur friendly than the VC process is. You won't have to give up seats on your board and neither will you have to agree to covenants that govern the way you run operations.
The flip side is that it can be hard for you to receive honest feedback with regards to the way you're running the business.
Many business, especially startups, could use a helping hand from experienced investors and VC funding is a good way to get it. Equity crowdfunding doesn't bring that mentorship aspect to the table.
This is changing though. A number of crowdfunding platforms are looking to bring institutional investors on board to act as mentors.
Besides, having institutional presence in an investment offering boosts the chances of a company being funded.
Equity crowdfunding backers tend to be less business minded about their investment than traditional VCs or angel investors do.
One reason for this is that crowdfunding backers usually aren't investing large sums of money. If they invest $50 and get to back a company that can have a large social impact, this is a great trade off.
This means your pitch should be tailored accordingly. Crowdfunding was initially seen as a way for an entire online community to back cool ideas.
This ethos is still present in equity crowdfunding. So don't assume your backers are solely looking for a financial return. Focus on the social and environment impact as well.
Equity crowdfunding evens the playing field tremendously in terms of allowing entrepreneurs to reach potential investors all around the world. It depends on how well you can run your advertising campaigns and leverage word of mouth online.
A typical equity crowdfunding campaign begins at least three to six months before the campaign is launched.
You'll need to identify and rally your audience and inbound marketing plays a huge role in this. Using social media to expand your reach is crucial during this phase.
In contrast, traditional VC funding is more about networking through business contacts. Any company that isn't in a traditional VC hub such as New York or San Francisco is going to struggle to generate any leads.
Thus, equity crowdfunding might have a longer timeline but it certainly opens up far more options than traditional VC financing does.
A lot of VC funding is heavily dependent on the existing portfolio of the investor. As long as you tick certain boxes and present them with an opportunity to reduce their risk, you stand a good chance of getting funded.
This is a problem for companies that operate in new fields or in lines of business that are less than traditional.
What's more, a lot of VCs have internal rules regarding allocation of funds to one particular company in their portfolio. They also have qualitative measures such as requiring their funded companies to have a co-founder instead of a solitary founder and so on.
These criteria have nothing to do with your business and it can be frustrating to see your company get rejected.
Equity crowdfunding doesn't have any such restrictions and levels the playing field quite a lot.
Equity crowdfunding allows companies to generate a larger media profile. There have been instances where equity crowdfunded startups have a made a big splash and have gone on to bigger things.
Oculus, the VR headset manufacturer, is one of the most famous examples of this. The fact that it was crowdfunded within four hours played a large part in boosting its valuation to the $2 billion mark that Facebook eventually paid for it.
Rewards Based Crowdfunding for Companies Versus Traditional Methods
Companies are some of the biggest beneficiaries of crowdfunding. You've just read about how equity crowdfunding helps them.
Giving up equity in your company doesn't have to be the only option for you. If you have an idea for a great product, then rewards based crowdfunding campaigns might be your best choice.
The traditional method to funding a new product would be to seek a loan from a bank or seek equity funding from a VC or an angel investor. Rewards based crowdfunding changes all of that.
Product launches are risky. You could do all the research in the world but there's no guarantee that people will like your product, much less but it from you.
This typically results in money wasted in inventory and setting up supply chains. Instead, rewards based crowdfunding allows you to run a live test of your product's viability before you ever launch it!
If your crowdfunding campaign is successful, you have solid proof that your product is a hit.
What's more, your backers will effectively pre-order the product from you. Thus, your manufacturing and working capital costs are taken care of before you ever have to place an order with your manufacturer.
Many businesses have used this tactic to grow their brands. It doesn't matter if you're a startup or an established small business.
Rewards based crowdfunding can help you grow your brand immensely.
When you place your order up for sale on a website or on a traditional sales outlet, your customers expect it to be delivered to them within a few weeks at most. These days, it's probably within a few days!
If you fail to deliver, you're going to have them breathing down your neck and all of this is going to hurt your working capital levels. After all, irate customers are going to get on the phone and demand refunds.
This in turn places immense pressure on your cash flow if you've financed operations with a working capital loan. It's a situation that a lot of small business face, especially when times get rough.
Rewards based crowdfunding offers you a little more breathing room in this regard. First off, people have backed you because they believe in your product vision. In essence, they're your biggest fans.
This naturally makes them a bit more patient. Second, when you crowdfund a product you're putting a human face to it. People aren't just investing in an inanimate product, it's you they're backing.
All of this results in entrepreneurs receiving more breathing room to address issues. This doesn't mean you can get away with breaking what you promised.
However, the environment is a lot less hostile than what you will face with a traditional lender.
Rewards based crowdfunding is a great way quickly zero in on your greatest fans. You don't need to guess with Facebook ads or with any other form of PPC advertising once you've launched your product.
Sure, you will need to market your product at first to drive people to your campaign page. This will result in money being spent on ad campaigns.
However, once you've found this group of people you know you can always get back in touch with them to pitch them your new product.
The best part is that your ad costs come before you devote any money to producing your product and this releases a lot of financial pressure from the situation.
Contrast this to the traditional product launch process where manufacturing and logistics are paid for first and then advertising takes place.
This places significant cash flow burdens on a business.
Debt and Donation Based Crowdfunding for Individuals Versus Traditional Funding Sources
One of the first ever uses of the concept of crowdfunding occurred in the personal debt industry.
With the launch of platforms such as Prosper, people could crowdfund debt and raise money towards clearing credit card and other forms of debt.
Once crowdfunding really caught on, donation based campaigns provided a means for people to raise money towards virtually anything.
As far as individuals go, the advantages are extremely loaded towards the side of crowdfunding.
If you need to raise money to fund your education, you need to approach a bank and apply for a student loan. If you're lucky, you receive enough of a salary upon graduation to be able to pay these loans back over the course of a few years.
Unfortunately, many people in America aren't so lucky. Student loan debt is a bigger part of debt that ever.
Donation based crowdfunding allows people to graduate without debt and actually build a stable financial future for themselves. The number of causes that you can raise money for are literally unlimited!
Looking to raise money for an emergency operation? For a surprise birthday party? To raise funds for a local animal shelter? The list goes on and on.
None of these causes would ever be funded by a bank in the form of a loan. You'll need to expend a lot of energy to raise awareness of these causes via traditional charitable fundraising.
It isn't just donation based crowdfunding that helps with these causes. You can raise money to clear debt as well!
What really matters the most is that you tailor your campaign pitch accordingly and hit the right notes with your campaign video and other media.
If you're looking to borrow money from a traditional lender and apply for a loan, you're going to have to wait for a while.
Despite the length of the wait, there's no guarantee you'll be approved. As I mentioned earlier, the ones who need money the most tend to be rejected by traditional lenders.
With P2P lending platforms, you'll receive a decision within a few days. What's more, your chances of getting funded are higher than usual because there are more people willing o back you.
In the case of traditional lending, there's one loan officer you need to convince and their view tends to be the final decision.
When you borrow from the crowd, no single person bears all the risk of the loan and as a result, your chances of getting approved are higher. There are simply more opinions in play and this boosts your chances automatically.
What's more, you're also likely to receive better terms in most instances than compared to what you would receive with traditional lenders.
As you can see there are a ton of differences between the way crowdfunding works and the way traditional funding sources work.
In some cases, the traditional methods offer better results but when it comes to individual lending, it's a no contest.
This doesn't mean to say that crowdfunding is always better. A lot depends on your individual situation.
However, it's a great option for you to consider should you ever find yourself in a situation where you need to raise funds.