What Is Crowdfunding?

by youngro lee

sunrise field

What is crowdfunding?

The simple answer:  crowdfunding is where people pool their money online to fund a project or cause.

But crowdfunding often means different things to different people. Perhaps you’ve heard of a local artist crowdfunding to put up an interesting mural… or a crowdfunding campaign to help a family recovering from a tragedy… or a product company that crowdfunded millions by pre-selling the coolest cooler ever made. Considering all these incarnations, it’s only natural to wonder, “What is crowdfunding, really?”

Let’s set the simple answer aside and dig a little deeper. It’s helpful to start by categorizing.

What are the different types of crowdfunding?

  1. Rewards & donation-based crowdfunding

If you heard about crowdfunding 3+ years ago, the conversation was probably about rewards-based crowdfunding or donation-based crowdfunding. Led by platforms such as Kickstarter, Indiegogo, and GoFundMe, these crowdfunding platforms allow individuals, non-profits and for-profit companies to raise funds online from the public. Supporters of the campaigns receive non-cash rewards in exchange for up-front cash contributions, or they simply make donations without any direct benefit at all. In both cases, supporters do not expect a financial return on the funds they contribute. In fact, financial returns are strictly prohibited by law in this type of crowdfunding because a contribution would then be considered a sale of a “security,” which would be subject to government regulation.

As an aside, the IRS will often categorize funds raised through rewards-based crowdfunding as revenue, which means you’d have to pay taxes on it. If you’re thinking about launching this type of crowdfunding campaign, you should consult a tax specialist to understand the tax implications.

  1. Investment crowdfunding

Rewards-based crowdfunding has picked up steam and become recognized as a legitimate and powerful way to raise money. We have seen the rise of crowdfunding (all across the world, but particularly in the UK and Asia) where you can receive financial returns on your contributed funds. Commonly referred to as investment crowdfunding or securities crowdfunding, this type of crowdfunding has recently gained traction in the U.S. as the federal and state governments began passing laws to allow and regulate it. Within the investment crowdfunding category, there are two main sub-categories – equity crowdfunding and debt crowdfunding.

a. Equity crowdfunding

Equity crowdfunding is where companies sell a portion of their equity interests to investors online. Investors purchase a company’s shares and become actual shareholders with proportionate economic and voting rights. In equity crowdfunding, there will typically be a term sheet that describes the legal rights of future shareholders as well as the total valuation of the company. The company valuation will determine the price of the shares being offered. Typically, equity owners in tech companies will not realize profits or receive cash returns until there is a liquidity event – i.e., when the company is sold or grows to a point where it conducts an IPO (initial public offering). Because of this, equity crowdfunding is the epitome of “swinging for the fences” – high risk, high reward.

b. Debt crowdfunding

Debt crowdfunding is where companies borrow money from investors online and are obligated to pay their investors back by a certain date, with interest (or its equivalent). These companies are not selling equity. In debt crowdfunding, the key terms include when and how investors will be paid. For example, investors could be paid monthly or quarterly, and receive fixed payments or variable payments. Investors look to debt crowdfunding for consistent cash payments, typically at a lower risk level than equity crowdfunding. NextSeed is an example of a debt crowdfunding platform.

As you can see, crowdfunding offers something for everyone, whether you’re looking to raise money or if you want to play a part in someone else’s project. Welcome to the world of crowdfunding – we are in the early days of what we believe will be a sea change in how people and businesses access capital all around the world.