How Does Crowdfunding Work? Here’s Your Quick and Easy Primer

One of the toughest challenges an entrepreneur confronts when launching a business is raising money to get the venture off the ground. Which is why nurturing new ways to help those entrepreneurs to connect with sources of capital is essential.

According to a 2015 report, U.S. main street entrepreneurship is up, though remains below pre-recessionary levels. At the same time, crowdfunding has emerged as a promising and innovative way to steer capital funding to smaller businesses and start-ups.

Traditional routes for financing start-ups and small businesses include self-funding, loans and gifts from family and friends, credit card financing, bank loans, angel investors and venture capital (VC). In each of these arrangements, a business lacking access to the broader capital markets seeks funding from a single or relatively limited number of sources.

Crowdfunding is a form of peer-to-peer lending and investing that connects an entrepreneur to a large number of investors, often contributing relatively small amounts, to amass operating capital. Contributions are typically coordinated through web-based portals, rather than through traditional financial intermediary institutions.

One of crowdfunding’s advantages is that it collapses geographic barriers to funding by allowing entrepreneurs to “fish in a bigger pond,” so to speak, by tapping larger social networks. So while many technology start-ups are founded in places like Silicon Valley, New York, and Austin to gain proximity to leading VC firms, crowdfunding allows entrepreneurs in far-flung locations to connect with potential investors around the world.

‘A potential game-changer’

There are several types of crowdfunding, as Dr. Ethan Mollick, a management professor and crowdfunding expert at the University of Pennsylvania’s Wharton School of Business, explains in a 2013 study:

· In the patronage model, funders behave essentially as philanthropists, with no expectation of a direct return on their investment.

· In the lending model, funders loan money to the business and expect a return of their invested principal plus accumulated interest at a scheduled future date.

· Reward-based crowdfunding, currently the most popular form of crowdfunding thanks to web services like Kickstarter, Indiegogo, Kiva, and GoFundMe, offers funders a reward for donating toward a designated goal. They may receive benefits like early access to a new product, the opportunity to support a cause they believe in, and other privileges in exchange for their early contribution.

· Equity crowdfunding makes funders actual investors in the company, offering them an ownership stake in return for their investment, with the hope of future returns if the company grows and prospers.

The last of these, equity crowdfunding, has gotten a boost in recent years in the U.S., thanks to the bipartisan Jump Start Our Business Start-ups (JOBS) Act, which has provided a means, and regulatory structure, for the public to access equity crowdfunding. In signing that bill into law in April 2012, President Obama called it “a potential game changer” for small businesses and start-ups.

“Right now, you can only turn to a limited group of investors — including banks and wealthy individuals — to get funding. Laws that are nearly eight decades old make it impossible for others to invest,” Obama said. “But a lot has changed in 80 years, and it’s time our laws did as well. Because of this bill, start-ups and small business will now have access to a big, new pool of potential investors — namely, the American people. For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”

A key challenge to equity crowdfunding is regulation. The Securities and Exchange Commission (SEC) has issued regulatory guidance for equity crowdfunding, to ensure the proper level of oversight and reporting, and to protect investors from potential fraud. It will be a delicate balance to ensure the sector is properly regulated but still has the flexibility to experiment, grow and thrive. (A user-friendly summary of SEC guidelines for crowdfunding investors is here.)

Risks and interests in equity crowdfunding is appropriate for you?

Crowdfunding may have the potential to democratize venture capital investing, but there’s one aspect of investing that crowdfunding can’t eliminate: investor risk. The reality is that whether you’re investing through traditional markets or through a crowdfunding initiative, the possibility of losses exists.

Daniel Isenberg, writing for the Harvard Business Review, warns that equity crowdfunding can carry unforeseen risks for investors who may be unprepared to assess a business’s strengths and weaknesses. Isenberg argues that most investors “simply cannot know enough about the highly risky ventures or the highly complex venture investing process to make informed investment decisions.”

Still, interest in crowdfunding remains high as many investors and entrepreneurs are interested to see how this financing stream might serve to open up new avenues for capital investment. Wharton’s Mollick notes that crowdfunding investment totaled more than $2 billion in the United States last year. Of course, that’s a small sum compared to the vast amount of funding made available through traditional debt and equity capital markets — but it reflects a growing sector.

For all the enthusiasm, most retail investors probably aren’t ready to take part in equity crowdfunding projects at this point. The SEC’s regulations take this reality into account, placing strict limits on how much small investors can put into equity crowdfunding initiatives in a given year.

For the entrepreneur, it’s certainly worth exploring crowdfunding alternatives for financing.

As noted by entrepreneur and strategy consultant Sraman Mitra in the Harvard Business Review, “…working capital financing is one of the key requirements of all small start-ups. Today, banks take notoriously long to approve minimal amounts of credit. If that pain can be addressed via crowdfunding, that would massively lubricate small businesses, unleashing tremendous amounts of growth.”

In a time of steady, but slow economic growth, that would be an outcome we could all celebrate.