One of the greatest trends over the latest years in entrepreneurship is related to Crowdfunding, and particularly how you can use Crowdfunding to fund your startup.
However, truth be told, this is a financing mechanism that is still unknown to the bulk of the entrepreneurs, as we aren’t used to understand specifically how we can benefit from it.
“Oh, that’s too complicated for me, I’ll just take a Bank Loan.”
That’s what so many of us typically think, right? Well, first of all, I hate bank loans and will always recommend against taking one, especially to starting a business. There’s nothing worst than starting a business with a rope around your neck.
So, Crowdfunding presents itself as a tremendous opportunity because it is absolutely risk free and you can not only validate your idea but actually fund the entire development of your business through some online platforms that we’re going to talk in a second.
Now, I’m not saying Crowdfunding is the only way to do fund your startup, but it’s definitely one of the best. If you’d like to read more on having your business funded without investors, feel free to read this article on having the customers funding your project.
In this article we’re going to talk about the two types of Crowdfunding: a first one that is simple to understand, and a second one that presents so many doubts to first time entrepreneurs, and we’ll invest some minutes in detailing exactly how it works.
So, let’s get started.
Essentially, there are two types of crowdfunding:
- Equity Crowdfunding
And first, a brief description:
- The Donations Crowdfunding is the classical crowdfunding as we’ve already mentioned. You decide to start a specific undertaking and you ask a lot of people to give you individual small portions of money, so you’re able to accomplish the development of your project.
- The Equity Crowdfunding presents a different perspective: instead of having people giving you donations because they believe the project you’re creating will impact positively their lives or someone else’s lives, in equity crowdfunding, we’re merely talking about an investment tool – a financial tool. This second one is also better suited for companies with some sort of traction. If you’re just starting out, perhaps it’s not for you YET.
Now, let us dive in how you can use these platforms for your business:
- First of all, you can obviously use it to validate your business idea.
- Secondly, you can use it to actually fund your business, even though that’s usually more demanding because while you won’t need a huge amount of money to validate an idea, to fund a business you might require a higher amount of cash.
Either way, I’d definitely recommend you start by the Donations, not only because it will be simpler, but also because the equity crowdfunding is more oriented toward companies that already have sales and traction; it works more like an investor, at the end of the day.
Let’s imagine that you want to validate your idea and fund your business, if possible.
So, how should you proceed?
Creating a campaign
Ok, so, the first thing you must do is choosing a platform. Being so, let me give you some lights when it comes to what types of platforms you can find:
- Kickstarter is considered by many the number one crowdfunding platform.
- It works through donations and it’s really quite simple to use.
- However, there’s one small constraint: if you’re not creating a project related to creativity, arts, music, video, or even some really innovative and disruptive technology, it might be trickier to raise money here.
- This is the perfect platform for who is trying to raise money for a personal project that’s related to arts.
- It’s the typical all or nothing platform, which means that if by the end of the campaign time you don’t have your objective achieve, all your money will be given back to the contributors and you’ll win nothing.
- GoFundMe is best known for its use in personal causes and life-events, such as education, medical treatment, sports teams, etc., basically, everything that’s related to social impact and humanity.
- It has 5 minutes support guaranteed which is awesome to help you getting started
- The user experience is optimized for sharing, which, as we’ll see, it’s quite important as crowdfunding usually depends on making the word spread
- And the only thing less positive is that it requires you to have a Facebook account, but I’d say that’s not a major bottleneck.
- Indiegogo is the one with the highest fees in transactions, having a 5% overall platform fee, a 3% plus 30 cents per credit card transaction and a 3 to 5% fee for PayPal transactions.
- But the good thing is that’s a platform open to all types of projects across all industries, typically with lower funding goals. There’s where the Indie name derives, by the way.
- One of the good aspects of IndieGoGo is that even if you do not meet your funding goal, you will still retain the capital that was given to you, even if that is 5% of your total goal, which can naturally come in hand.
- It’s also a great platform when it comes to insights and analytics
- And one not-so-good aspect is that it has less traffic and a lower quality reputation.
Now, there are many other platforms that we could mention, such as RocketHub, Razoo, and Fundify. All of these work on a donations-based model. For example, this last one Fundify is great to help you connecting with potential investors for your business, so if you have the time, don’t forget to sign up in their portal; you’ve nothing to lose.
Ok, the first thing to get started is definitely picking the right platform.
What’s your goal?
Then, the second thing you want to consider is: how much will you be asking for – what’s your goal?
And this one is critical, for a set of reasons:
- If you pick a too high amount of money, chances are people won’t see your project as credible and might even think that you’re trying to make a buck out of crowdfunding. It must be as pragmatic and serious as possible.
- If you’re in an all or nothing platform and you pick a high amount of money and you don’t reach 100% of your objective, you’ll get nothing at the end of the day.
- If you pick a too low amount of money, you’ll also face some constraints: you want to be sure that you ask enough money to actually be able to accomplish what you’re setting yourself up to.
So, as always, the key lies in the balance, and here I cannot help you much more because it will depend uniquely on your specific business idea.
A third point that is crucial in crowdfunding is, naturally, our old friend promotion.
Here’s the thing: even though all these platforms have more than 25M visitors per month, there are far too many campaigns being created per day.
So, you’ll need to spread the word about the crowdfunding campaign that you’re doing, whether you’re looking to fund your business or simply to validate your idea.
Being so, there are 3 main actions that you can take to promote the campaign:
- Social Media: obviously, we had to mention social media as it is probably the one that mostly impacts the success of your fundraising with each share amounting to an average of 30$.
- Media coverage: a great way to bring a lot of attention to your campaign is coordinating its launch with some news on media. This is not as hard is it seems, there are thousands of journalists eager to find interesting news to add to their online magazines or newspapers. All you’ll need is something out of ordinary that is worth mentioning and you should be able to see your campaign covered in 2 or 3 online publishers.
- Guest posts: Now, assuming that you have a website and, once again, that you’re creating something different, new, remarkable, impactful for the society, etc., you can also reach out to well-known bloggers or website owners to promote your work through guest posts that truly add value to their audiences. Remember it’s not advertising, you’re writing an article that they can present on their website about the cause you’re standing for and, by the way, if the reader wants to support it even further, he can donate to your crowdfunding campaign.
Which startups benefit the most out of Crowdfunding?
So, who do you think will benefit the most of this channel to raise money?
Well, here are some of the crucial traits that your business idea should have:
- It should be new, important, different, innovative, etc. If you’re creating something that everyone already knows and doesn’t have an impact on the society it won’t generate enough enthusiasm around it. So, this is the perfect channel to startups that want to have an impact and stand for a major cause.
- It’s also a great platform to who doesn’t have much time, as the promotion shouldn’t take you too much time and you don’t need to work on the campaign every single day, so you can continue focusing on your day job while the donations occur.
- From an equity standpoint, this is a good vehicle of capital for those who don’t know how to reach out to investors, don’t want to invest a lot of effort in it or don’t feel the need for smart money.
Let us detail a little bit the Equity Crowdfunding.
So, I believe the three biggest and most relevant equity crowdfunding platforms are:
To guarantee that we understand how these platforms work, we’ll look at them from an investor standpoint, instead of the startup standpoint.
This is not a finance course, but the first thing you should understand is that investors look for equity crowdfunding platforms mainly to diversify their portfolio. This means that instead of investing only in security, bonds, stocks, etc., they’re also adding a new channel that is Companies or Risk Capital. Typically they don’t allocate a big proportion of their whole assets to it, but it’s fine to invest some money there.
So, if I have some dozens or hundreds of thousands of dollars to investing and I’m looking to diversify my portfolio, I can go, for example, to Seedrs via equity crowdfunding and I’ll have a look at the startups raising money there.
Now, I have three ways to invest money in Equity Crowdfunding:
- Pure Equity
The first one seems quite straightforward, right? I’ll contribute to your business with 10k$ and, in exchange, I’ll get access to, for instance, 1% of your company. Sounds fair?
Now, I’d like to give you a brief introduction on Equity because that’s one of those very simple concepts that can still generate some doubts, especially if you mix it up with what you learn in finance classes (trust me, you don’t want know for now).
From a business standpoint – and especially from what we call “an early-stage” startup standpoint – when someone mentions Equity, we’re talking about how the company’s shares are divided. Yes, even though when you’re just starting out you don’t have shares in the stock market, the fact is that your “project” already has a distribution of equity.
We could, for example, look at your company like it would have only 100 shares. Initially, the founders have all the 100 shares, but as the time goes by and other investors invest in your startup, they will require some of those shares for themselves, reducing the owners’ stake gradually.
And here, some of the most common doubts typically are:
- What means having an Equity stake?: You see, 1% of equity means this investor owns 1% of your company.
- And what can we do with Equity?: Typically, nothing unless you sell your shares to someone else. That’s called selling your participation.
- Can the investors withdraw money from the company through Equity?: No, that won’t happen unless in the governance terms that you sign with your partners or that you agree upon with the investor it is written that whoever owns equity has the right to withdraw his correspondent proportion out of the free cash flow (the profits) at the end of the year. But, in the vast majority of cases, this clause will never be written by the owners, namely because it makes no sense at all, you want to guarantee the future of the company, and there would be no interest for investors to withdraw money if that would mean harming the health of their investment.
Alright, this one tends to be trickier. First things first: do you know what’s a Convertible Note?
A Convertible Note represents a method that some entities or investors use to invest in your business before you have a specific market valuation.
For example, let’s look at an incubator. An incubator might give you office space, their advice, and their mentoring without demanding any payment. And this means that you won’t have to cash-out when you don’t yet have revenues which is great for someone who’s just starting out.
However, their services have a theoretical and implied price that can be, say, 20k$ in office space and hourly rates of their managers for a 6-month program. Makes sense so far? They won’t charge you, but they value their total services in 20k$.
So, instead, they agree with you on the following: if you manage to get to further funding round – let’s imagine you raise some money (300k$) and your company valuation is set to 1M$ – then, the 20k$ the incubator initially offered you will convert to a specific % of this new valuation, and that % will become the incubators’ equity stake in your company.
So, in this really simple example, if the incubator offers you 20k$ in services and, then you raise capital with a 1M$ valuation, they would get 2% of your company.
The same also happens with any investor, but instead of receiving services, you’ll actually receive cash. A Business Angel might agree with you that he’ll invest 80k$ in your business as a Convertible Note. What does that mean?
Well, that means that he’ll give you the 80k$ and won’t negotiate a specific Equity % in return, he will let that be decided by the market price of your company – also known as Valuation. So, if you, then, raise money with a 1M$ valuation, he’ll get 8% of your company. If your valuation is, instead, 800k$, he’ll get 10%, and so on.
I’d like to make a small break to explain you how to calculate a company valuation because this is the type of verbiage that is very common and accessible for people within the Risk Capital industry but for someone just starting out it might present some questions. If you already know this, feel free to jump ahead.
So, have this in mind: the market price of your company is the maximum price that someone is willing to pay for it – this is merely an economics definition. And when an investor offers you 200k$ for 20% of your company, as an example, he’s literally stating publicly that he is willing to buy 20% of a company worth 1M$.
This is how you know your company valuation.
The formula is quite simple:
Amount of money offered * 100% / Equity % asked in exchange
So, if an investor offers you 500k$ for 25% of equity, that means your company valuation is 2M$ (4 times more). If the investor offers you 150k$ for 20% of your company, it means your valuation is 750k$, you see?
This is how you calculate your company’s valuation; the offer you receive is always a proportion of the total 100% value.
Now, let’s move on to Convertible Debt
And Convertible Debt as a lot of similarities with Convertible Notes, but some nuances are different.
For example, an investor in Seedrs can buy DEBT from your company that will convert to a % in equity when you fundraise in a future round.
Wow, what the hell did I just say?
Whenever you buy debt from a company, what that really means is that you’re lending this company money, ok? So, pretty much like a bank loan. But instead of having the company asking you for the loan, you’ll voluntarily invest in that company; you’ll lend them the money and you’ll win an INTEREST RATE through that investment.
So, the Convertible Debt starts by having an investor, for example, lending you money and you’ll have to return the entire amount of cash plus an interest rate, which, in my humble opinion, is a terrible position for any entrepreneur to be in.
And here, the word convertible means that in a financing event occurring in the future – when this entrepreneur or startup raises capital and there’s a market valuation being set – the entity that invested in the convertible debt will see the remaining debt being converted to an Equity percentage of the new market price of the company.
Now, I hope I’m not making it too overwhelming to you – this subject is never simple to explain – but in the vast majority of the cases, there might even exist what we call “a discount” in the convertible debt.
What does that mean? And if you weren’t lost before, here’s when he really gets tricky:
It means the investor lending you the cash will be assuming a “pre-money” market valuation of, for example, 1M$, and per year, your market valuation is supposed to increase by, again, for example, 24% (a good rule of thumb, it is the common practice). So, if you take 6 months to raise capital, your startup’s market price will be 1.12M$ by then, or if you take 12 months, your market valuation will be 1.24M$, which naturally favors the initial investor / lender.
So, you might wonder why would any entrepreneur choose Convertible Debt over other types of financing such as straight Equity or simply Debt – for example, asking for a direct bank loan.
Entrepreneurs use this method when they’re certain that they’re going to raise venture capital in 6 to 12 months and they really need some cash right now to create an operation. That’s why they’re open to secure the interest of the investor by agreeing on an interest rate, but if everything goes well, the remaining debt will convert to Equity and they won’t have to pay anything else.
I’d like to recommend these outstanding articles by Asheesh Advani for the ones who want to deep dive into Convertible Debt:
Now, funds are quite simple to explain. Once again, from an investor standpoint, instead of investing in one single startup or company, I’ll be investing in the managerial capabilities of the team running the platform – or, in some cases, it’s even a Venture Capital firm chosen.
When you invest in a fund on Seedrs, you will become a shareholder in each of the underlying businesses that the fund organiser or manager chooses.
They’re the ones who will select which companies to invest in, with the end goal of generating an above average return to me, as an investor.
That way, I don’t need to spend a huge effort trying to understand which are the best companies to invest at, the platform will do that for me and will use my money to invest in a set of companies.
And this is it, guys, we’ve now talked about everything you need to know to raise money through crowdfunding.
Remember that if you’re just starting out with your business, perhaps you might prefer going with the Donations and more traditional crowdfunding because it doesn’t require you to have traction and it’s way easier to understand for someone who isn’t comfortable with finance.
We’ve also covered the Equity Crowdfunding, an industry that is growing exponentially over the latest years but that is many times hard to understand for startups without management or finance know-how, or at least that don’t have some sort of mentor to guide them.
I’d always advise you to pay attention to the details and, if possible, consult a lawyer or someone who is more experienced in Equity Crowdfunding, who has a background in finance or has been working as an investment analyst, just to make sure you’re understanding what you’re getting into.
It’s definitely not a big deal, we just have to be careful to make sure we are aware of the whole contours of the operation.
Hope it was insightful!
P.S. If you haven’t downloaded yet my 10-Step Quick Guide to Raising Money for the First Time, I’m sure it will help you a lot structuring your ideas and action steps to building a remarkable business and, who knows, the next tech giant.
Click on the image below, sign up, and I’ll send you the Quick-Guide immediately.