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What is crowdfunding and how does it work?

Article

9 mins read

Updated on 27 November 2020

Crowdfunding offers entrepreneurs a way to raise finance without going to funders like banks, venture capitalists, private equity or angel investors and the like. It’s becoming more and more popular, especially when the economy is on a downward trend. In this piece, we explore how crowdfunding works, the upsides, and downsides, and what you need to know if you’re considering it as an option.

What is crowdfunding?

Crowdfunding is an internet-based way to raise money from the public. You can use crowdfunding if you want to fund a charity, put on a play, build a product or finance a project or business, for example. It’s changing the way that businesses, individuals, and charities look to fund themselves.

By using a web-based crowdfunding platform or social media to showcase their business or idea, an entrepreneur can pitch to virtually everyone on the planet.

Rather than relying on banks or investors to provide capital, businesses approach individuals directly for funding. While the amounts that each crowd funder provides may be small, your reach is greater, thus enabling you – in theory at least – to raise an equivalent amount of finance.

In the UK, there are a number of web-based platforms that are used by companies looking to crowd fund, for example Crowdcube, Seedrs and Funding Circle. Each platform will have different rules as to who can apply to pitch and how much they can raise. Generally, it’s less bureaucratic to build a campaign for crowdfunding than pitching to an investing or lending firm like a VC or bank. You will have to pay a fee to the platform.

What are the different types of crowdfunding?

There are three main types of crowdfunding used by businesses, rewards-based, equity-based and loan-based.

Rewards-based crowdfunding

Rewards-based crowdfunding is where you offer people the chance to be the first to buy a new product or to receive some kind of reward in return for funding. Effectively, this is pre-selling in advance of a product being created. The amounts advanced tend to be relatively small.

While there have been some notable successes, generally you need to have a fabulous prototype and good marketing ability to succeed in this arena.

Equity-based crowdfunding

Most private investors such as VCs, private equity and angel investors will want shares in return for finance. In the same way, equity-based crowd funders will expect equity in return for their money, and to receive dividends and a share in the proceeds if the company is sold or liquidated.

Usually, you’ll pre-approve investors before they can provide funding in return for equity. Crowd funders may include professional investors such as VCs, and individual amounts advanced tend to be larger than with reward-based crowdfunding with investors being more sophisticated and discerning.

Companies who look for equity-based crowdfunding tend to be start-ups or early-stage businesses looking for fast growth. It’s unlikely that a business at seed or pre-seed stage would have sufficient evidence to satisfy investors of its potential, so equity-based crowdfunding may not be suitable if you’re at this point, nor if your offering is B2B as your potential customer base is smaller and more specialised.

If you are considering equity-based crowdfunding, you’ll need to create a campaign designed to appeal to investors. UK investors are particularly interested in companies who are eligible under the SEIS/EIS schemes as these offer tax breaks to funders, so you’ll need to understand how they work and make sure your company qualifies in advance of your campaign being launched.

One of the advantages of equity-based crowdfunding is that you’ll be attracting potential customers as well as investors to your business.

Loan-based crowdfunding

In loan-based crowdfunding (also known as peer-to-peer lending), individuals provide finance to businesses just as banks do. Internet-based platforms put lenders in touch with borrowers, and amounts loaned can range from as little as £20 to £250,000 and beyond. Borrowers pay lenders interest agreed in advance who expect their capital to be returned.

How does crowdfunding work?

Crowdfunding usually takes place on a website platform such as Kickstarter, Crowdcube or Seedrs who administer and coordinate the fundraising. These platforms allow businesses or individuals to raise money, and investors to provide that money. The business or individual seeking finance will generally pitch their venture online, where the audience is potentially millions, to attract loans or investment from as many people as possible.

How is crowdfunding regulated?

Crowdfunding is regulated by the Financial Conduct Authority (FCA), and in addition most of the major crowdfunding platforms have signed up to the UK Crowdfunding Association (UKCFA) that has a voluntary code of conduct to which members agree to abide.

For loan-based crowdfunding, the following legal rules apply:

Information about the platform must be clear so that lenders know who they’re dealing with.
Marketing materials like adverts must be fair and not misleading.
Investors must have information about the rates of return and how easy it is to exit.
The investor’s money must be held in a separate account and with a third-party so it’s safe if the platform runs into financial difficulties.
If the platform fails, there must be guarantees in place so loan payments will continue to be made.
Lenders have 14 days to cancel.
The Financial Ombudsman will hear any complaints.
Platforms must have a percentage of the funds loaned available as a capital cushion.

For equity-based crowdfunding, the following rules apply:

Platforms are only allowed to work with investors who are eligible, such as high net-worth funders and VCs.
Client must take regulated advice or acknowledge that they know the risks of investing.
Clients must confirm they will not invest more than 10% of their net worth.

What are the benefits of crowdfunding?

It’s now an established and efficient way to get funded. Because as an entrepreneur, you’ll be focussed on running your business, crowdfunding is now seen as a (relatively) easy way to seek funding, at least compared to applying for a loan or looking for investors yourself and pitching to them. If you pick the right platform, you can set up your campaign quickly and easily and be seen by millions of potential funders at once, rather than have to pitch to each investor individually. Businesses can also use crowdfunding to get access to finance that before was simply not available and get their hands on it more quickly.

Visibility and social proof. Crowds tend to flock to businesses that are popular with others. Once you have successfully attracted a few investors, then others are likely to follow, and you’ll achieve more traction for your campaign. This is known as ‘social proof’. Early-adopters and fans of your business are likely to use social media to promote your business too.

You’ll get feedback about your business. Because you’ll be attracting potential customers as well as investors to your business, you’ll likely be receiving a lot of feedback about your offering. This will enable you to fine-tune your product or service so that it’s as attractive as possible.

Reach. Established crowdfunding platforms, especially those who offer equity-based investing, already have many accredited investors who are looking to place more funds.

PR and marketing. Because you’ll need to stand out from the crowd, you’ll have the chance to perfect your pitch and so that potential investors can get under the bonnet of your business. This will be beneficial for you, and you can refine your offering according to any feedback you receive. Plus, you can use the platform for PR and marketing, directing traffic to your own website.

What are the disadvantages of crowdfunding?

We’ve looked at the benefits but what are the disadvantages of crowdfunding?

It’s all or nothing. On most crowdfunding platforms, you have to achieve your funding target before you receive any money. If you don’t reach it in time, you get nothing, and this can also affect your business’s reputation.

Stealing your ideas. Because you pitch online and need to be clear about your offering, there’s always a risk that someone will poach your idea. Make sure you’ve registered any trademarks or domain names you need before going live. Our intellectual property lawyers can help with this.

Bandwidth. You’ll need the time and attention to focus on your fundraising efforts. This can take you away from running your business for a period.

Costs. You’ll need to spend time and money preparing your pitch, and in addition, you’ll pay a fee to your chosen platform.

Which type of crowdfunding platform should I use?

Here are our suggestions for picking the right platform for you:

If you’re a seed or pre-seed business, have an eye-catching idea, are a B2C (business to consumer) company and can ace your marketing pitch, a rewards-based platform may be right for you.
If you’re already successful in your chosen market, have a target customer base that would enable you to expand and scale, you may be attractive to equity-based crowd funders.
If you’ve a good cash flow and steady revenues, a loan-based platform may be a better alternative than a bank.

How to successfully crowdfund a project

Once you’ve decided that crowdfunding is right for your business, how can you ensure a successful pitch? Here are our tips:

Tell a powerful story. For a pitch to be successful, you need a strong call to action – a reason to invest. Paint a picture of how the idea came to you, the personalities of your team, and why your product is so important. Don’t hard sell, let your product do the talking.

Practice your pitch and make it interesting. Attention spans are limited these days. Cover all the main points but don’t provide too much detail. Include lots of different types of content – photos, interviews, videos, infographics so that your offer stands out and is memorable.

Be active on social media and mine your network. Reach out to potential investors on as many social sites like Facebook and Twitter as possible. If your offering is photogenic, Instagram is a must. Tap into your existing network and let them know what you’re doing and ask them to share it with their friends and colleagues. Create a contact list and do regular email campaigns. If you’re good at it, blog.

Offer juicy rewards. The usual offer is a discount on an early order, or first-run of your product. Encourage higher levels of funding by offering tiered rewards.

Do your homework and be prepared for extensive questions. Make sure you’ve researched the right platform and created the perfect pitch. Work hard before launch to secure some early investors, as people tend to want to go where others are. Now is not the time to cut corners. And once you’re live, be prepared to answer questions about your business. Lots of them.

Keep going. Once you’ve launched your campaign, don’t kick back and relax. Interact with your followers, keep sending emails, keep updating your content, give them your news and your thanks if you’ve reached a milestone in your campaign. Most successful campaigns have only around 1,000 participants, so keep going.

Cover off the legals. Getting a law firm on board if you’re considering crowdfunding is a great investment. Solicitors that are experienced in legal support for start-ups can take care of some of the detail needed if you’re preparing a pitch, from drafting your terms and conditions of sale and negotiating the platform’s terms, through to helping you protect your intellectual property and making sure that you have the right to use any IPR that’s critical to your business.

As we’ve seen, you’ll be most attractive to experienced investors if you’ve pre-qualified under the Enterprise Investment Scheme or Seed Enterprise Investment scheme. Our experienced lawyers can help prepare your company to be eligible under the scheme.

As an alternative to crowdfunding or angel investors, find out about our venture capital legal services, including how we can help you with the documents and advice you’ll need during the venture capital process.

Knowledge Hub for Growth