How should you crowdfund your startup?
Crowdfunding is rapidly gaining popularity as a way for startups to fund their businesses. It doesn’t require winning over investors, it gains attention for your startup before its launched, and it helps you evaluate what kind of demand there is for your product. Whether you fund your startup entirely through crowdfunding, or use it as a stepping stone to winning investment from venture capitalists or the bank, here is a guide to the different kinds of crowdfunding – and which ones are best for you.
Equity-based
Equity-based crowdfunding involves multiple people investing in the business, receiving equity in the business in return. For example, you might put up 10% of the business in return for raising £90,000, with individual investors taking very small percentages – a 1% stake in the business would set an investor back £9,000, a 0.1% stake would be £900, and a 0.01% stake £90. You get the general picture. Popular platforms include Crowdcube and Angels Den.
The FCA has recently started taking steps to oversee the sector – new rules stipulate that only experienced investors are allowed to invest significant sums. New investors, often attracted to equity-based crowdfunding because of the ease and relatively small commitment, are limited to 10% of net ‘investibles ‘ (which basically means spare cash, excluding pensions and property.) This is due to the risk of startups. However, this only applies to equity-based crowdfunding and peer-to-peer lending (more on that below) – reward-based crowdfunding remains unregulated.
The benefits of equity-based crowdfunding include no pressure to manufacture ‘rewards’ – it’s all about the future of the business – and the potential to gain larger sums of money then with reward-based crowdfunding, if you find investors who believe in your product. However as with anything that gives away equity, you’re relinquishing some stake in the business (however minor). You should also ensure that you’ve considered all the implications for multiple people holding equity in the business and draw up a contract that states what rights everyone has, to prevent problems down the line.
Who it’s good for: Businesses that are already established and looking to expand, or businesses whose product would be difficult to leverage as a reward.
Example: Say you’ve been running your hat business for a year, but you want to expand to a new location and diversify your range of hats. First off you have your business valued, giving you a figure of £150,000. You decide you’re happy to give away 10% of your equity to investors in return for £15,000. You raise the money from 7 different investors, the largest share going to someone who invested £5,000, and the rest split in varying amounts amongst the others. You now own 90% of your business, but you’ve got a sweet £15,000 to cover your expansion costs and help manufacture your new line.
Reward-based
Reward-based crowdfunding is the crowdfunding you’re probably most familiar. This is crowdfunding where people pledge money in return for rewards – anything from a grateful shout out on social media, to early-bird access to your product or service, to VIP tickets to your lavish celebrity-strewn launch party. You don’t give away equity in the business – your responsibility is simply to raise the cash, and then make sure you can honour all of the pledges.
You set several tiers of rewards, increasing in value – so where a £5 pledge might get a thank you, for £100 or so people will expect a significant return, just as you would when buying a product. Where equity-based crowdfunding and debt-based crowdfunding often attracts people who are more investors than supporters, the people who will be backing your reward-based crowdfunder are your future customer. A good rule of thumb within the crowdfunding community is to think of these backers as ‘friends of friends’ - people who’ve seen your campaign as it was shared by your immediate friends and family, then shared it to their friends, etc. Knowing your audience appropriately can help you set the correct reward tiers.
As mentioned above, reward-based crowdfunding is currently unregulated, as projects funded in this way are deemed to be less of a financial risk than the FCA. Websites such as Kickstarter and Crowdfunder don’t just fund businesses – they fund individual projects, artistic endeavours, and projects within the community. And if your goal isn’t met, the project won’t be funded and pledgers won’t lose out. But if the project does meet the goal, it’s an excellent way to show future investors that there is a significant demand for your product, this validating your business idea.
As with all crowdfunding, if you don’t raise enough money then you can be left with long-term negative repercussions for your business – investors might be wary of backing a project that has publicly failed, especially if it’s bombed particularly hard. On the other hand, if your project does particularly well and you overfund, you might have difficulty fulfilling all the orders, which can result in the anger of those who have pledged or, if you’ve miscalculated costs, leave you out of pocket.
Who’s it good for: Crowdfunding is ideal for new projects that are yet to get off the ground, as it doesn’t depend on convincing investors – it just depends on having a great idea that a lot of people can get behind, and on marketing this idea. If you don’t have a track record, it’s an ideal way to go about getting one, proving demand for your product.
Example: Mous are a Virgin StartUp-funded business who needed an extra cash injection in order to finish manufacturing their innovative phone case that keep your headphones safe and tangle-free. Taking to Kickstarter, they raised enough money to start manufacturing the cases for other models of the iPhone. Rewards such as limited-edition colours and press attention saw them smash their goal. To avoid the problems of over-funding the Kickstarter, they built in a contingency plan for what would happen if they raised over their goal amount – these are called ‘stretch goals’ (extra goals that only happen if the project raises over the target.)
Debt-based (peer-to-peer lending)
Debt-based crowdfunding, or peer-to-peer lending, is a different sort of crowdfunding to what we’ve spoken about so far. It’s similar to a bank loan, except you’re lending from a syndicate of different people, often backed up by various corporations and government schemes. You are charged interest on this loan, just like any other loan. Funding Circle is one of the most popular peer-to-peer lending services for businesses in the UK.
On these sorts of platforms, businesses will be assessed for credit-worthiness before being approved. Investors can then choose who they want to invest in and agree an appropriate interest rate. If the business ends up defaulting on the loan, the lender will lose out on the money, but as the loan is repaid the lender will make a profit thanks to the interest. Peer-to-peer lending is also an area increasingly overseen by the FCA.
Who it’s good for: As with winning investment from the bank, this is a form of crowdfunding more suited to more established businesses with business plans and a healthy financial track record. However it is less restrictive than a bank loan, and terms can be negotiable.
Example: You are a consultancy that needs to invest in some high-tech equipment to take you to the next level, but you don’t want to lose equity in the business for this. Rather than go for a bank loan you decide to lend from your peers, as you know there are some investors who would be interested in contributing, and you feel peer-to-peer investors will be easier to win round than the bank. As it’s for a fixed short-term cost, you feel confident that you’ll be able to repay it with interest to the lenders – keeping equity in your business, but benefitting from the new equipment.
Donation-based
While not relevant to most businesses, there’s one other form of crowdfunding that it’s worth mentioning - donation crowdfunding. This is most similar to reward-based crowdfunding – except there are no rewards in return. This type of crowdfunding is usually used to fund not-for-profit projects, help out individuals, or by charities and social enterprises.
Who it’s good for: Donation-based crowdfunding will only work for businesses that have a really strong social cause, or for individual projects within social enterprises.
Example: You’re a social enterprise based in the UK that wants to find extra money to fund the building of a well abroad. You start a campaign to raise money for this project, pledging to match the amount raised with the business’s own funds, and all money raised goes to this cause (except for the fee taken by the platform).
