Crowdfunding Explained

Crowdfunding Explained

Crowdfunding is a way of raising financing for almost any purpose – from funding a product launch to startup capital for a business venture or raising money for a charity.

Online platforms allow users to create an account, post shareable links to their fund, and collate responses from supporters.

A typical application is in early-stage businesses that are often ineligible for conventional investment or bank loans, where organisations publicise their idea or offer or supply discounted products or equity shares in return for contributions.

Crowdfunding Basics

Most crowdfunding fundraisers are managed through a platform where the account holder can interact, respond to questions and keep a total of pledges.

The platform charges a fee, although sometimes waives this for charitable causes, which can be a fixed rate or a percentage of the target or the funds raised.

If a campaign succeeds, pledges are passed onto the fundraiser, and the campaign is closed – although some long-running fundraisers can be renewed almost indefinitely.

The standard is based on all or nothing; if the fundraiser hits its goal, the fund closes, and no one can make any further pledges or contributions. Deposits are returned to each investor or contributor if the fundraiser ends without reaching the target.

Crowdfunding can work in several different ways, depending on the nature of the fund and how the organisation attracts investment and incentivises its audience to contribute.

Peer-to-peer crowdfunding

This type of crowdfunding can act as a loan rather than an investment. The company asks investors to contribute upward from a threshold value. The business promises to repay the funds plus interest at a specific date or when an event occurs – such as reaching a revenue target.

The benefit for entrepreneurs or startups is that they can raise financing through peers, friends and family and don’t need to meet eligibility criteria applied by a bank.

Equity crowdfunding

Another solution is to offer equity shares in a company, distributed based on the amount invested. Similar to traditional venture capital investment, contributors pick fundraisers that they believe will lead to success, making their equity more valuable in the future.

Businesses can also model their crowdfunding based on profit sharing, whereby the company offers to distribute future profits in return for immediate financing, although it does not issue equity shares.

For retail investors, the attraction is that they can invest in an idea, business or opportunity with minimum contributions of as little as £10, offsetting the inherent risk in investing without an in-depth understanding of the businesses.

Crowdfunding based on rewards

Brands can fundraise for a business concept or a project with something non-financial offered in return. That might be a free service, an exclusive offer only for investors, or an item.

Charitable crowdfunding

Charitable causes use crowdfunding to maximise exposure of their fundraising events and do not need to offer contributors anything in return. There are advantages for non-profit causes or community organisations that are not registered with the Charity Commission but need to raise funds.

Examples include individual fundraisers, such as requesting contributions to purchase adaptive equipment or paying for private medical care.

Restrictions On Crowdfunding

Certain regulations and limitations apply to some crowdfunding exercises, depending on the return offered and the purpose of the fundraising initiative.

The Financial Conduct Authority (FCA) regulates crowdfunding in the UK, with rules as follows:

  • Platforms offering peer-to-peer fundraising tools are subject to limits on how and to whom they can advertise or promote a fundraising campaign.
  • Investors must have clear, accurate information about what they are investing in and what their funds will be used for.
  • The returns offered on loan-based crowdfunding need to be adequate to offset the level of calculated risk investors are taking.

Charitable crowdfunding and campaigns that raise donations or offer compensatory rewards are not included within the restrictions, provided they do not offer returns on contributions or equity stakes within a business.

Crowdfunding Fees

There are several crowdfunding platforms based within the UK. Others are located overseas but accept crowdfunding campaigns organised by UK businesses or organisations.

  • Crowdcube focused on high-growth, privately owned companies as an equity-based crowdfunding platform mainly used by new or early-stage businesses.
  • Crowdfunder UK supports a range of crowdfunding campaigns, including charitable, community, business and sports projects.
  • Seedrs is aimed at business crowdfunding, and equity raises, hosting campaigns for businesses and startups in the UK and Europe looking to raise seed capital.
  • Companisto is a German crowdfunding site backed by a team of venture capitalist investors and business analysts hosting startup equity crowdfunding campaigns.
  • Eureeca is based in Dubai, supporting crowdfunding campaigns in the Middle East, South East Asia, Europe, and the UK.

Platforms make money by charging a commission on the funds raised if the campaign is booming, and fees depend on the campaign size.

Seedrs also charges additional costs such as a retainer fee and a post-campaign cost if the campaign is successful, but the company decides to abandon the project.

Compared to traditional financing, crowdfunding is low-cost, and most platforms only levy a charge if the campaign achieves the target, with costs ranging from four to eight per cent of the total value raised.

However, some platforms have upfront costs, roughly £5,000 on average, to create a brand video explaining what the campaign is about and a pitch deck that makes the business case for the project and tries to demonstrate the potential value for investors.

Some businesses hire a crowdfunding consultant to manage their campaign, which is an additional cost, but this isn’t always necessary.

Many of the Crowdfunding platforms help startups seeking SEIS benefits. Visit this site to find out more about the Seed Enterprise Investment Scheme.

Advantages Of Crowdfunding

The obvious benefit for startups is that crowdfunding platforms provide access to a large group of potential investors, including seasoned investment professionals and venture capitalists who search for exciting ideas or business concepts that they think have a good chance of success.

Companies create crowdfunding campaigns and use the publicity to circulate press releases, digital marketing materials and social media campaigns to grow their audience as they attract investment.

Most crowdfunding projects are based on a reward, whether that is participating in a new product launch, owning an equity share in a new venture, or receiving an exclusive gift or membership benefit.

Video games and crypto projects are some of the most popular crowdfunding campaigns, with investors receiving a small amount of digital currency, early access to a new game, or in-game features to recognise their contribution.

Drawbacks Of Crowdfunding

Some businesses perceive that crowdfunding can damage their reputation, perhaps illustrating that the company or concept isn’t solid enough to attract conventional financial support.

Crowdfunding also means paying a proportion of the fund to the host platform and possibly having contributions and pledges returned to investors if the target isn’t reached, with the business receiving nothing – even if they have invested in an expensive pitch deck.

The rules and regulations that apply differ between crowdfunding sites and jurisdictions, but campaigns must comply with certain restrictions to avoid attracting investigation.

Crowdfunding FAQ

How does crowdfunding normally work?

Crowdfunding allows a company, organisation or individual to launch a campaign inviting investors or donors to contribute cash to a larger cause with low thresholds. The idea is that achieving several small investments is easier than a single, large lump sum. Investors can either make donations or earn a reward such as equity shares or a non-financial benefit.

What happens if a crowdfunding target isn’t met?

Successful crowdfunding raises mean that pledged investments are passed to the organiser less a fee taken by the platform. If the target is not met, the investments are usually returned, and the campaign closes.

Do companies repay finances achieved through crowdfunding?

Crowdfunding donations are not repayable. Investment-based or peer-to-peer lending is repayable at the terms offered in the original crowdfunding campaign. In other cases, the company provides exclusive rewards or benefits such as a limited edition product release, early access to a new service or a token reward such as a sample product.

Is crowdfunding a legitimate way to raise business capital?

Yes, provided the crowdfunding platform is registered and authorised by the FCA, it is legal – but legality does not impact the risk assumed. UK crowdfunding sites that offer investments in exchange for equity shares or as a loan with interest are subject to financial regulation. They must comply with rules such as providing accurate information about anticipated returns or limiting the maximum amount one investor can contribute.

Why is crowdfunding considered a high-risk investment?

Crowdfunding is open to early-stage or startup businesses with little or no trading history or performance records to help investors make informed decisions about their prospects. Because crowdfunding is an alternative financing method for businesses that cannot secure mainstream financing, most projects are at higher risk than a traditional investment through a stock exchange.

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