Crowdfunding is a form of fundraising where a business asks the public for a contribution, usually in exchange for equity in the company.
Crowdfunding usually entails a private company asking large numbers of people for small contributions. This differs from the more conventional practice of raising money through angel investors or venture capitalists, where a handful of actors inject larger sums into your business.
In return for investing in your business, supporters will receive equity, albeit with less liquidity than what they would get with public stocks. There are also more relaxed rules governing crowdfunding than IPOs.
“Sometimes, companies don’t know where to look for suitable investors and decide to raise capital through a crowdfunding campaign” says Nicolas Castonguay, Senior Account Manager, Technology Industry at BDC. He adds that crowdfunding can work in tandem with other forms of financing.
“It does not typically pose a problem for later rounds of financing, assuming the founders limited their equity dilution and haven’t allowed the crowdfunding round to become oversubscribed,” he says. A stock is oversubscribed when more investors than planned want to buy the stock. Oversubscription can cause equity dilution for founders, depending on how it's managed. (See: Managing equity dilution: 5 mistakes to avoid)
In exchange for their money, investors receive shares in a company or the right to a portion of revenues or profits from a specific product. This model is usually best for early-stage companies that want to grow.
In this model, investors lend their money to a company at relatively high interest rates. Because each individual amount they lend is small, they mitigate their overall lending risk by spreading a large amount of money in small increments across a large number of loans.
A company sets a fundraising target and asks for donations—in exchange for some kind of token or receipt of the eventual product or service to be developed. If the target is not met, the funds are returned to the investors.
Who can invest in crowdfunding?
As opposed to private equity markets, there are no restrictions on who can invest in crowdfunding. In Canada, only accredited investors and individuals listed under the private issuer exemption can purchase securities in a private company. To obtain that accreditation, individuals must have:
- net assets valued at $5 million or more
- an annual income of $200,000 or more, or a combined household income of at least $300,000
- financial assets—cash, stocks or other securities—of at least $1 million
With these kinds of restrictions, it is little wonder that many see crowdfunding as a way to democratize private investing.
Forms of financing similar to crowdfunding
Crowdfunding attracts multiple shareholders, all with a very small stake in your business. Angels have a larger stake and may be inclined to monitor their investment more closely.
Angel investors and crowdfunding contributors usually enter at the same early stage of funding. Angel investors, however, will typically be tougher on company valuation and may request more involvement in the running of the company.
A SAFE note (simple agreement for future equity) is another method employed for early-stage investment. These instruments offer an investor the chance to acquire equity in your company, specifying that certain milestones need to be reached. That might mean a round of funding, sale or merger of the business, or other transactions.
SAFE notes are often used by start-ups to raise seed capital. They have no fixed duration and remain in effect until conversion. Most importantly, there is no interest to pay. They are essentially a promise to give the investor equity, later, in exchange for money, today. These instruments are “founder friendly” because they offer flexibility to the entrepreneur, and do not require extensive legal work to complete.
Selling equity to angels or via a SAFE note brings with it more reporting obligations than crowdfunding. Not having that reporting makes crowdfunding riskier for the investor.
Pitfalls to avoid for start-ups
One challenge with crowdfunding is finding investor members for your board of directors.
In some cases a board will have investors with a significant portion of ownership in the company. But crowdfunding investors typically have a low level of ownership relative to traditional investors. Not having any external advisors on the board could become an issue in subsequent rounds of financing. Many believe there’s an echo chamber effect when the board is entirely made up of internal stakeholders.
“This would be a minor, but entirely fixable issue, one that founders can easily avoid,” says Castonguay.
He recommends that your company add new external board members or replace existing board members with external people.
2 examples of crowdfunding
A crowdfunding investor contributes $4,000 and receives four shares in the company, valued at $1,000 each.
In this example, the total company valuation is $1,000,000, with 1,000 shares outstanding.
A crowdfunding investor contributes $4,000 and receives a discount coupon to purchase equity at a 10% discount in the next round of funding.
In this example, the total company valuation is $1 million with 1,000 shares outstanding. This investor can purchase shares at $900 (10% less than the going rate) but would not be able to purchase more than 50 shares at the price.
This provides a return of $5,000 if the investor sells the shares immediately, netting a profit of $1,000.
How to create a crowdfunding project
1. Set a valuation
The first step in creating a crowdfunding project is to set a valuation for the company.
This should be fair enough that it does not underestimate any potential gains but low enough to generate interest from potential investors.
2. Outline what investors will receive
A clear outline of the structure of the deal will also be required. That means founders will need to clearly spell out what investors will get in exchange for their money, such as equity in the company now or discounted equity in a future round of financing.
3. Take note of maximum amounts
Some jurisdictions put a cap on the amount a start-up can raise through crowdfunding, though in most cases there is no cap.
Some individual investors may have a cap on the amount they can invest in a single company through crowdfunding.
Accredited investors, or friends and family of the founders, typically have no cap on the amount they can invest in a single start-up through crowdfunding.
For more information, see the Canadian Securities Administrators’ FAQ page on the subject.
4. Share your crowdfunding campaign
A robust communications and marketing plan must be developed and executed to let potential investors know of the opportunity to purchase a small stake in the start-up.
However, companies raising money through crowdfunding are not typically cash-rich and need to get creative to get the word out. Often, this means telling their network of the crowdfunding.
“Because companies partaking in crowdfunding generally don’t have an extensive marketing budget, these campaigns are most often promoted in an ad hoc manner. Entrepreneurs put the word out through their network, on LinkedIn and social channels,” says Castonguay.
It’s a good idea at this stage to reactivate any contacts with a strong network and ask them to help spread the word.
5. Meet your target
Most companies put minimum target amounts on crowdfunding raises, as well as maximum thresholds. If a campaign does not meet its minimum target, it can be cancelled. If that happens, all funds are paid back to investors.
Risks of investing in crowdfunding companies
If you are an investor, crowdfunding does provide investment opportunities, but it comes with significant risk. For one, shares obtained via crowdfunding investing may be difficult to sell because they are not traded publicly on a stock exchange, and so buyers can be difficult to identify. Also, unlike traditional stocks, these assets are not protected by the Canadian Investor Protection Fund.
Many start-ups don’t make it in the long-term, and given that laws around disclosure and regulatory review are far less stringent for crowdfunded companies than for publicly traded companies, an investment in a crowdfunded start-up can bring with it the risk of losing your investment.
Which crowdfunding platform is best?
There are several crowdfunding platforms specifically geared to business rather than personal fundraising campaigns. There are several sites with best-of lists.
How do business and personal crowdfunding differ?
There is a major difference between business and personal forms of crowdfunding such as GoFundMe. A personal page might have a dog owner asking for help to get surgery for their pet, with those financing the initiative not receiving anything in return for their contribution. Crowdfunding, on the other hand, helps your business raise capital while also providing some equity to the contributors.
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