One of ways of raising capitals for starting and expanding businesses is through crowdfunding. This is a fund sourcing approach, whereby a large number of investors contribute money to sponsor a business in return for something or nothing. Crowdfunding has its perks and drawbacks as mentioned here. However, it is a project that is worth giving a try.
But for crowdfunding to be most successful, the entrepreneur needs to consider some things. One of them is the model to opt for. Some types of crowdfunding require returns on investment (ROI) while others don’t. Further, each type has advantages and disadvantages. Hence, considering the one you can opt for will be necessary as you make your plans towards the project.
Types of Crowdfunding
There are several types of crowdfunding but they all follow one or two basic formats. The basic types of crowdfunding, therefore, are peer-to-peer lending, equity crowdfunding, reward-based crowdfunding, donation-based crowdfunding, profit-sharing, and hybrid models.
- Peer-to-Peer Lending
This is in the form of a loan. It is borrowing from the crowd with the intention of paying back with interests. Put differently, peer-to-peer lending, also known as debt crowdfunding, is borrowing money from many investors, whose money will be repaid with interests. This is more like borrowing from the traditional banks except that a large number of investors are involved here, and the capital sourcing is usually done online.
The benefit of this type of crowdfunding is that SMEs and start-ups have access to loans without providing collaterals. This is also beneficial to entrepreneurs that could not meet requirements requested by traditional banks for accessing loans. Hence, entrepreneurs could set-up their businesses through loans even when they don’t have the wherewithal to obtain loans. However, it is possible the investors may demand for higher interest than what the bank would have asked for. Another disadvantage here is, like other crowding funding types, investors may demand to know everything about the intended business. This could cause the entrepreneur to divulge all secrets regarding his business and, thereby, risking having his ideas stolen by competitors and idea thieves.
- Equity Crowdfunding
This type of crowdfunding is similar to selling and buying stocks of companies. Here, investors raise money for the entrepreneur in return for shares. In this case, the ROI is shares or stakes in the company even though the business is not registered with the stock exchange. So, after contributing for the business, the investors become part owners of the company.
The benefit of this type is that shareholders act as the promoters of the business. Just imagine if you have two hundred investors in your business and the two hundred own shares in it; this means you have two hundred advertising outlets. This is because the investors will want the business to grow because they are, partially, its owners too. Further, the entrepreneur has control over how much the investors contribute since he decides how many shares to sell and how much each will cost. However, the entrepreneur will encounter challenges with finding investors in this case because it’s a long term investment, which ROI might not come immediately.
- Reward-Based Crowdfunding
This is also referred to as seed crowdfunding. This involves borrowing from the public with the intention of paying back in kind. Here, investors are paid for their investment in the business with nonfinancial rewards. The reward could be provision of services at a reduced rate, being the first to access products after they are finished, free services, donating to the community, acknowledging investors, sending appreciation letters, and so on.
Entrepreneurs that opt for this type have a lot to benefit from it. First of all, the no-interest feature makes it cheaper for entrepreneurs to raise capital. Furthermore the business owner has total control over his business. However, because the ROI does not involve financial gain, investors may not be forthcoming. This means this approach might not work for entrepreneurs seeking a huge amount of money.
- Donation-Based Crowdfunding
This is usually done for charitable purposes. It is where the public contributes funds for a project without expecting any ROI, be it in cash or kind. In donation-based crowdfunding, there is no fixed amount of money each investor should contribute. Usually, they donate small amounts of money to raise the huge sum needed. Nevertheless, beneficiaries usually encourage large donations by providing rewards for them. However, the money invested is never returned.
This type is best for humanitarian purposes. It is best for NGOs and other charity organisations for funding their projects. However, because of lack of ROI, investors do not usually contribute large sums. This makes it unsuitable for capital-intensive projects.
- Profit-Sharing Crowdfunding
This is also known as revenue-sharing crowdfunding. As the name suggests, entrepreneurs that use this model pay back their investors by sharing profits made by the business. For this to happen, investors have to contribute a fixed amount of money. The benefit of this model is that the entrepreneur is only obligated to pay ROI from profits the business generated. This method might be most suitable for high risk businesses that may or may not generate profits. The returns are higher when profits are high and lower when profits are low. Hence, entrepreneurs are not pressured to pay back their investors: so long as profit is made, investors will be repaid. Hence, the financial performance of the company determines how investors are repaid. This is one model that favours both investors and investees immensely. However, it will be imperative to convince investors that the business will be profitable so they can part with their money.
- Hybrid Model
As the name suggests, this model combines two or more types of crowdfunding depending on the entrepreneur’s needs and choices.
Note that choosing the type of crowdfunding that is suitable for you requires you consider the purpose and the intended investors. By purpose, you have to consider the type of project you want sponsored and its purpose. By intended investors, you need to consider if you want business moguls in your team or just anyone that has interest in the purpose. This means you need to research further on the type of investors that each crowdfunding type attracts. That way, you won’t make avoidable mistakes.