Crowdfunding For Startups Part I: Is It A Good Fit For You?
Welcome to my 2 part series where I dig deep into crowdfunding for startups. We will look at many reasons why it might be a good fit for your startup and some reasons why it might not be right for you.
In the end, you will have a good understanding of the ins and outs of crowdfunding enough to make a decision as to whether or not it might make sense for your funding round.
When it comes to raising capital, many startups look at all the options that they have. There’s the traditional way that has seed funding, VC funding, series A funding, and so on. The issue with this sequence is that it can sometimes be challenging to find investors who are willing to take a chance on startups – especially those who are in their very earliest stages of funding. However, there are other methods of raising capital. Entrepreneurs sometimes look at crowdfunding for startups as a way to raise money, instead of going the more “traditional” investor route.
Over the last few years, new laws were passed to allow “non-accredited” investors an opportunity to participate in the startup ecosystem through crowdfunding. So if you have a startup and want an alternative to pitching to angel investors or Venture capital firms then this might be the way for you to raise seed-stage funding for your company. We won’t go into the various reasons why pitching to Angel investors and VCs might be a challenge for you. Suffice it to say, if you have a product or service that you feel is worthy and that many people can get behind and support, then this might be a great opportunity for you.
Don’t forget that you’re still pitching to investors, but the methods and tactics are entirely different. However, If you’re looking to raise money and are interested in crowdfunding, here are a few Pros and Cons for you to decide if it might be the right fit for you!
Table of Contents:
Crowdfunding is “the use of small amounts of capital from a large number of individuals to finance a new business venture.” Essentially, the way crowdfunding works is that entrepreneurs seek to raise funds through multiple individual investments. Instead of asking for a $250,000 check from an investor, they ask for 10,000 people to kick in $25. If the product is fantastic, then out of eight billion people in the world, presumably 10,000 of them would be interested in seeing this product come to light and would “invest” that $25 to see that product come to fruition.
Traditional investors take a slice of the company in exchange for their capital contribution. For example, an angel investor might ask for 25% of your business in exchange for $100,000. Over the last few years, crowdfunding has split along the lines of an ownership stake. Some crowdfunding sites, like the original sites Kickstarter and Indiegogo simply take a piece of whatever you raise off their platform. Others are actually “crowdfunding equity” sites that pool investors for equity and then manage the group of micro-investors equity participation. Examples of are companies like Wefunder, SeedInvest, StartEngine, and NewChip.
The original crowdfunding platforms were very useful initially with consumer products and hardware. This is because a physical product could be offered or discounted to encourage people to buy into their idea and make a “ donation” (AKA an investment) in the product. There were the same challenges as detailed below but over time more and more of the consumer products offered never shipped which soured the process for potential “investors”. Some of this was due to the fact that product development is very difficult, as Marc Andreessen has said “ Hardware is hard! However, in many cases, the startup was little more than a scam offering an unrealistic product to defraud “investors”.
Basic crowdfunding platforms like Kickstarter and Indiegogo seem to attract mostly consumer product startups. Startups that join these platforms or platforms like them have no intention of giving up equity ownership. In other words, as an “investor” you do not expect to receive an equity position in the company. Investors in these crowdfunding sites effectively “donate” the money to the business in exchange for a reward, early access to the product, or a large discount on the final product …if it ships. For example, a video game startup might raise $100,000 to develop a game and then give everyone who donated $25 an advance copy of the new video game.
Crowdfunding equity is a hybrid solution where the Investors (usually micro-investors) want to participate in the huge potential upside of investing in startups. Imagine if you had invested early on in Facebook, Airbnb or Uber? The problem was the only people that could legally invest in these at the time were Accredited investors which in a nutshell meant that you had to have $1,000,000 in liquid assets before you were deemed “experienced“ enough to take the risks associated with investing in startups. The SEC successfully changed the crowdfunding law (Regulation Crowdfunding CF) in the last few years which makes crowdfunding equity a possibility.
These crowdfunding equity platforms have a different business model, but the basic concepts are the same. They host your startup on their platform and promote it to a large number of micro-investors and accredited investors, in the hopes that enough of them will commit funds to help the startup meet its funding round.
If the round is met, then they bundle all the micro-investors together and manage the bundle as a single entity so as to not muddy the Cap Table too much. A large and confusing Cap Table can have a negative impact on future investments.
These crowdfunding equity platforms might charge you to join their cohort, they might take a percentage of equity or money raised, they might do a combination of any of these. Remember that these crowdfunding platforms are there to make money. They are a business first and your startup is the product. If they cannot sell your startup to investors or get you to pay for additional services, then they will not be in business very long.
If you choose to use a crowdfunding equity platform, make sure you are well aware of all of the costs and their expectations from your startup before you sign a contract. In addition, there are SEC-mandated rules that you must follow and documents you will need to produce to legally participate in a crowdfunding equity raise. The hurdles are not insubstantial but for especially new startups with only a prototype the document production is not very challenging.
Crowdfunding is popular because it is a simple concept, and it is accessible. The logic behind it is sound. However, is it right for your startup?
Making the decision to create a crowdfunding campaign has different legal requirements depending on if you are using a straight crowdfunding platform like Kickstarter than if you are going to create a campaign on a crowdfunding equity platform.
Failure to follow the requirements when setting up your crowdfunding equity campaign can cause big headaches down the road. Please be aware that there are requirements for any startup to meet in order to take advantage of REG CF in particular. You will want to work with your Crowdfunding platform to make sure that you meet all the legal requirements as outlined by the Security Exchange Commission (SEC).
These requirements may have an impact on your decision to start a crowdfunding campaign. Sometimes these are more rigorous requirements than what you would encounter with a pre-seed angel investor that only wants a pitch, a few meetings, and some basic due diligence.
Regardless of your decision to engage a crowdfunding campaign make sure you meet all the requirements and you take a look at the 5 conditions that most startups will need before finding success with a crowdfunding equity campaign.
Crowdfund is not right for every startup. There are certain distinct conditions or attributes that make crowdfunding right for a startup. If you meet one or more of these conditions, then you might consider creating a crowdfunding campaign for your startup.
Getting 1,000 people online to give you even $25 if they have never heard of you before is challenging. Even if you succeed, you’d only raise $25,000, which may or may not be enough for your particular business. If you are trying to educate a new audience on the benefits of your platform, service, or product you can count on spending a lot of money on advertising. People, in general, need to be exposed to a product or concept 7 or more times before engaging. Depending on the investment you are looking for from every investor this can have an impact on the number of people that commit.
However, If you have a strong fanbase already with lots of customers or social media followers that have previously known, seen, or heard about the product, service, or platform you are promoting, then convincing those individuals to contribute to your next project is easier. If you’re a game developer, for example, with 100,000 fans that love your previous games or are following your current game, it would be easier to convince 10% or more of those to chip in $25 for you to continue developing. They already know they’re going to like what you make, so convincing them to invest in $25 is not as much of an uphill battle as starting fresh. A conversion like that would net $250,000 which is well within the range a pre-seed or seed-stage investment from an angel investor.
If you have a strong fanbase or social media following, it makes it much easier to hit your targets without spending as much on advertising your project. Of course, many startups have not been around long enough to build a following like that. In this circumstance, it’s usually one of the founders or initial backers that has a strong personal brand with sufficient following that they can leverage that to the benefit of their new startup.
Similar to the fanbase condition, if you have celebrity endorsement for your particular endeavor, then you will find it much easier to convince people to back its development. That this doesn’t mean you need to have Michael Jordan back your innovative new shoes, for example (although it wouldn’t hurt!). The term “celebrity” in this context is more flexible.
These days any individual with a strong personal brand and many followers on YouTube, Instagram, Twitter, etc. could be considered celebrities. If one of these people has endorsed your product or service either from a paid endorsement or because you’ve offered them an equity position or board seat (remember William Shatner and Priceline). As long as you have someone with a significant outreach backing your project, then it is significantly more likely to receive substantial crowdfunding backing.
Companies can raise money from multiple sources! One strategy can be to obtain funds from an angel investor, for example, and then use crowdfunding to “top off” your funding round if you do not meet your goals. This is a key point, the initial angel investor funding acts as a kind of endorsement for the micro-investors. So, if you raised a partial round and cannot find additional funding from other angel investors for whatever reason, then leveraging your partial angel funding to convince the crowdfunding investor to fill out your round is a good alternative.
In essence, these companies know that they are already going to be developing a product with the guidance of other investors, but they can use crowdfunding for startups to boost their capital a little bit more. Even if they only raise $100k to $200k from the site, it’s still a boost that can help an early-stage startup meet or exceed their funding round.
As we have seen, there are many pros and cons to crowdfunding for startups. On the one hand, it’s accessible, convenient, and downright “easy” to put a listing on a popular crowdfunding site and market it. You might not reach your goal, but you won’t necessarily be penalized (except in wasted marketing dollars) for at least attempting it. On the other hand, it also doesn’t seem like a significant ROI. When you think of all the time, effort, and money to do the campaign right, the fact that 70% of these campaigns raise less than $10,000 is discouraging.
Typically, crowdfunding works in limited scenarios, where companies have a strong following already, or they are merely using crowdfunding to top off a funding round that has fallen short from more traditional methods. Your startup may wish to consider the pros and cons carefully before engaging in a crowdfunding campaign.
About the Author:
Jonathan Hung is One of the most active angel investors in Southern California, his mission is to drive value creation within each portfolio company. In support of this mission, he serves as Co-Managing Partner at – Unicorn Venture Partners.
Jonathan and his team target investments in US companies that have global market potential with a focus on long-term growth expansion to East Asian markets.
Jonathan developed his investing prowess as a Managing Member for his family office fund, J Heart Ventures, which made investments in start-up companies such as Gyft, ChowNow, Miso Robotics, Clover Health, Bitmain, to name a few startups he funded.
Jonathan has various degrees from the University of Southern California, London School of Economics, Massachusetts Institute of Technology, and The Wharton School at the University of Pennsylvania.