Pros & Cons of Crowdfunding for Start-ups and when does it make sense for your business?
In 2017 alone, a staggering USD 35B has been invested through crowdfunding platforms (Fundly.com, 2018), although it is still being dwarfed by VC investment reaching an alltime high during the same period of USD 81.9B in the US alone (Pitchbook.com, 2018), Crowdfunding has converted itself into one of the major sources of financing for start-ups worldwide, with platforms such as Indigogo and Kickstarter processing on average 20,000 successfully funded projects each year (Icopartners, 2018). In Latin America, platforms such as Broota in Chile have favorably launched the crowdfunding model in the region.
This article intends to evaluate the drivers of crowdfunding, its potential benefits and downsides to traditional financing rounds using venture capital.
First of all let’s have a look at the particularities of crowdfunding rounds, as they behave fairly differently to VC deals.
Whereas VC deals are usually being negotiated behind closed doors with a certain degree of secrecy between competing VCs and startups, crowdfunding projects are out in the open, aiming for maximum public exposure during the fundraising process to gain public attention and stick out of the thousands of projects on the platform. Self-promotion is key here, with a professional intro-video and media attention to generate a buzz. Whilst VCs dive into excel sheets of the nitty-gritty details of each possible deal, evaluating unit economics back-and-forth, successful crowdfunding projects seem to look at standard rules of marketing communications selling their product, focusing on emotions and establishing a connection with the backer, as in most cases he or she is not a professional investor, but a private individual looking to back a cause he considers best.
Successful crowdfunding campaigns, such as Danish stylish e-bike brand, Mate, raised more than 4,230% above target on Indigogo and accumulated a total of 6.8M USD capital raised in October 2016. These specific campaigns are rather looking at commercialization of the product and financing production with the actual campaign than raising capital through equity.
The backer does not take equity in the company itself, but rather pre-finances operations for the start-up willing to wait several months, before receiving the product. In this case, crowdfunding is an extremely efficient way to finance your product, basically receiving interest free credit from your future customers.
Thus, crowdfunding behaves fundamentally different from VC rounds, offering the entrepreneur to finance its business in many cases without significant previous traction or proof of concept. So, one could say that crowdfunding is a more democratic way of financing and offers an interesting alternative to angel or early stage VC investment.
Looking in more detail at the benefits of crowdfunding with equity, it can be a more attainable source of capital in the early days of your business rather than finding professional investors. However, there are also several downsides to the crowdfunding model. Crowdfunding investors, as they are non-professional by definition, do not bring smart-money to the table, adding hardly anything, but the capital they put in.
Also, if not done smartly through a syndicate model, crowdfunding will fill up your cap-table with dozens of small stake investors that may scare away VCs in future financing rounds. Additionally, crowdfunding rounds involving equity usually tend to raise money below target at a lower price point, consequently not confirming an attractive post-money valuation for the startup, on the contrary in many cases a lower one.
These three factors make crowdfunding rather a suboptimal solutions in comparison to professional investors. But as previously elaborated, there are cases when crowdfunding can be very attractive, particularly to pre-sell a strong marketable product and not to forget new more sophisticated crowdfunding models such as Angellist in the US, the Israeli platform OurCrowd or Founderlist in Latin America, that follow a mixed approach, using lead investors with experience to back deals and syndicates to better structure the deals afterwards and with a professional set-up of operations.
Still, Venture Capital remains the main source of start-up financing today providing a potent network for future financing rounds to thousands of entrepreneurs globally. Although sometimes criticized for its dubious aura, low ethnic and / or gender diversity and the ubiquitous smart money that one can hardly put their finger on, looking at how the currently most valuable companies in the world today where initially financed by VC money, prove the validity of the model and the tendency that it will stay the main source of capital for high impact entrepreneurs in the coming decades.
However, in all cases, we encourage the diversity of different financing options that are present in the market today, giving the entrepreneur multiple options to choose from and see what fits best for their individual start-up and stage. Crowdfunding adds the necessary mix of start-up financing, we were looking for and might be as elaborated in some cases be a more suitable options to the business rather than raising VC money early-on.
Key takeaways to raise a successful crowdfunding round
- Focus on a strong presentation of your business that appeals to the emotions and interest of the potential investors
- If looking to raise equity always choose a platform that allows you to syndicate the round
- Prepare simple and understandable financial documents to present on the crowdfunding platform
- Plan and execute a a buzz strategy through the media to promote your round. Use this actions to promote your product/service as well.
- Make sure to have a few early backers lined up to fill the first bits of the round. At least 30% of the round should be fulfilled by the moment it gets published.
Article written by Patrick Alex — Investment Analyst at Mountain Nazca’s Chile fund