One solution to the limitations posed by traditional means of financing has been to rely directly on the public to search for potential funders. Crowdfunding is the process of raising short-term funds in the form of small contributions to help businesses (or individuals) turn an idea or a project into a reality through the direct connection between investees and a large number of potential investors. Although especially useful for newly established businesses, crowdfunding has also been utilised by larger, more established companies. For example, Lego used crowdfunding to engage consumers in testing some newly developed products before launching them on to the market.
The crowdfunding process is mediated by dedicated online platforms, which have specialised in different business areas (for example see Fundable [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] or AngelList). There are two types of crowdfunding:
- Reward-based crowdfunding is perhaps the most common type. Individuals contribute small amounts of money to projects in return for a reward that reflects their contributions. This reward can take many forms, such as vouchers, tickets for a showcase event, or even a prototype of the new product once available. In this case, crowdfunding falls under the category of debt finance, since no ownership control is shared with funders.
- With equity crowdfunding, the ‘crowd’ invests in a business in exchange for a portion of its capital, namely a share. If the business does well and is profitable then the funders will receive a share of the profits. If, on the contrary, the business fails then investors can lose part, or all, of their investment. Equity crowdfunding can be seen as a system aimed at expanding the number of people that can fund the early stages of business goals – a system once dependent on wealthy individuals.
Crowdfunding has expanded worldwide. However, it comes with risks from both the investor’s and investee’s perspectives. Although crowdfunding provides an easy way to raise finance for a niche opportunity, the system provides little or no protection for the investor, which, in the extreme, means it could be a victim of fraud. Moreover, even though this can be a way to test the potential of a project, the idea could be stolen by other businesses.