What Is Crowdfunding and How Do Crowdfunded Investments Work

Getting the right kind of funding for any project is a crucial step in ensuring the success of that project or venture. While the most common practice under regular circumstances is approaching a few prospective investors to convince them into pouring in funds into the venture, there is a new method that is getting more and more attention, especially when it comes to startups and small businesses. This method is called crowdfunding.

 

The name may sound self-explanatory but there are a lot of details that go into explaining this concept. Let’s start with the basics as you try to understand what exactly is crowdfunding and how crowdfunded investments work in reality.

What Is Crowdfunding?

The basic premise of crowdfunding is accumulating small bits and pieces of capital from a larger group of people. This capital is then used to fund a business venture. This method of gathering financial resources is relatively new and attempts to put together the combined resources of a vast base by using powers of the internet. These resources help new entrepreneurs (or veterans in the business) fund their projects through specialized crowdfunding websites by harnessing the power of social media.

 

These bring the entrepreneur and the investor on one platform so that they can benefit from each other’s capabilities. While the market isn’t exactly at the peak of its popularity at the moment, crowdfunding is gathering momentum in a way that it is changing the way in which investment is being viewed in many spheres. The graph is expected to move up consistently over time as these platforms give small investors a chance to put even their smaller resources to use.

 

Types of Crowdfunding

Crowdfunding isn’t just limited to one sphere. There are a bunch of situations in which this concept is becoming more and more popular. Some of these are discussed below.

 

Peer-to-Peer Lending: There are a bunch of crowdfunding platforms like Prosper and Lending Club that use the very basic concept of one person lending money to another person to build a full system that allows you to access funds that other people are willing to put up. It is now bringing in a lot more money into circulation.

 

Reward-Based Crowdfunding: The second type of crowdfunding that is extremely popular at the moment is reward based. Some specialized websites like Kickstarter allow regular people like you and me to put in money into a specific cause or project. This can be an artist looking to produce a particular type of work, a new technological advancement, or just something that you believe in.

 

Donation-Based Crowdfunding: This form of crowdfunding brings your personal beliefs and values to the forefront. Using websites like GoFundMe and Kiva.org, you can pledge money to a cause that is close to your heart, or something that resonates with you. It can be related to education, microfinance, the legal system, or helping someone in need.

 

Human Capital Crowdfunding: This may sound odd but there are people out there who have been crowdfunding their education. They open accounts on platforms like Upstart in order to do so. You can invest in other people as well. For example, there may be an extremely popular athlete that you wish to invest in. There are platforms like Fantex that allow you to assess the cash flows that are linked with specific professional athletes.

 

Real Estate Crowdfunding: The next type of crowdfunding is related to the real estate market. There are a bunch of approaches that are linked to this. You can either crowdfund someone’s mortgage or loans so that they can buy a particular property, or you can crowdfund specific projects like those related to solar energy or wind energy.

 

Equity Crowdfunding: The last type of crowdfunding is not the most popular one at the moment but has great scope for growth over the coming years. This is equity crowdfunding where investments into business ventures by private companies are funding by crowdfunding platforms like AngelList, CircleUp, FundersClub and OurCrowd. This method has incredible potential of harnessing funds from smaller and unconventional investors.

What Are the Benefits of Crowdfunding?

There are a large number of benefits that are associated with crowdfunding that can give the regular methods of raising funds good competition. Some of these are discussed below.

 

Wider Reach: Most crowdfunding platforms use the power of the internet to give an entrepreneur access to a much larger base of investors than any traditional method of raising funds. You can put your proposal in front of these prospective investors and even discuss it with them.

 

Comprehensive Presentation: The process involved in putting together the campaign that is aimed at getting you your funds is extremely thorough and helps you get a better understanding of the idea yourself. When you go through the rigorous step-by-step exercise of taking all the information you have and reducing it to the essential points, you are able to give the other person a better insight into your project.

 

Handle Marketing Aspects: The entire public relations and marketing process of the crowdfunding campaign can be handled using these platforms. They help in creating a buzz around your project that will help you attract more traffic to your project.

 

Get a Better Understanding of Your Own Work: When your project or venture is out in the open with hundreds or thousands of people looking into it, you will be able to streamline the idea in a better way. When prospective investors approach you, they may want to get some clarifications or suggest some issues. Access to this kind of insight is helpful in making your campaign more streamlined.

What Is Investment Crowdfunding?

Now that you have an understanding about the general idea of crowdfunding, it is time to delve deeper into equity crowdfunding, or investment crowdfunding. This is a relatively new form of funding where companies can access a larger pool of potential investors to pool in smaller amounts of money to raise enough funds for a project. Under regular circumstances, these investors get equity shares of that particular company in return.

 

The 2012 Jumpstart Our Business Startups Act (more popularly known as the JOBS Act) has allowed more investments through crowdfunding in such private companies where there is infrastructure to facilitate this.

 

Other than stakes in the form of equity, this type of crowdfunding can also include gaining access to debt. In such a case, a larger group of people can invest money that will be forming a small part of a bigger loan. They are informed about the terms and purpose of the loan in most cases, and can avail interest rates that are higher than regular debt instruments.

How Do I Invest Using Equity Crowdfunding Websites?

The JOBS Act discussed in the previous section was the turning point in crowdfunding structures in the country. A large number of crowdfunding sites have come up in the years that have followed. Some examples of these are WeFunder, SeedInvest and so on.

 

The process to register with these platforms is quite similar to the process that is linked to a regular investment website. They will ask you for some personal information, as well as information about your banking situation. After your account is set up, you are equipped to start making investments.

 

The minimum amount for investment varies across platforms. While there are some platforms that hold you to a minimum of $20 in a company – for example Kickfurther – there are others like Fundrise that may require large initial investments upwards of $5,000. This may sound like a large sum of money but when you compare it to older prerequisites that ran into millions, it is still smaller.

 

Considerations before Investment

The idea of crowdfunding your investment can seem quite exciting but if you are a new investor, there are many things that you will have to consider before you take this step. There is always a chance that you may not see a profit, or even a full repayment of the money you put it. There are cases where you may lose all of it.

 

Chances of Finding a Unicorn Are Slim

You will see a large number of companies using crowdfunding platforms to gain financial resources that will help the company in completing a pet project. Most of these companies do not have any funding from other resources like venture capitalists. The likelihood that you will strike gold by choosing one of these companies is quite low in reality.

 

Element of Illiquidity

This process doesn’t work in the same manner as regular brokers who buy and sell shares. There will be no option to get your money back as and when it suits your needs. The company that you have invested in will have to start turning profits for you to receive any money.

 

Legal Limitations on Investing

There are legal systems in place that keep you from investing all the money that you have. People who earn under $100,000 each year are only allowed to invest 5% of their income – or $2,000, whichever is more. If you earn between $100,000 and $200,000 annually, you are eligible for investing up to 10% of your income. These are limitations that you will have to consider.

 

What Are the Risks Involved?

On a similar note, there are a bunch of risks that are involved in the process of investment crowdfunding. While we have already discussed the problem related to illiquidity, some others are discussed in more detail below.

 

Loss of Capital

The important part when you are looking to make an investment through such crowdfunding platforms is that you only invest the amount of money that you can afford to lose. Startups are a fun place to work and put in some money, but it is important to realize that a majority of these companies fail in the initial stages itself. If you have poured too much money into a company, you will not be getting any of it back when it tanks.

 

Dividends

Even if the startup that you choose to invest in stands strong through the initial phase where most startups fail, more companies take time to turn a profit. Once they start making profits, these are re-invested into the business, without you seeing much money in terms of dividends till much later.

 

Dilution

When you invest in a company using a crowdfunding platform, the number of shares that you own will be diluted over time. As the company brings on more and more investors, the percentage of your shares will reduce consistently, thereby reducing the dividends that you receive.

 

Diversification

Do not try to make this your sole source of income. Investing in such platforms should be seen as a way to diversify your portfolio. Many users do not understand this aspect well and invest without much research. In reality, it is recommended that you invest small amounts into a larger number of businesses.

Is It Worth It?

After reading about all the risks that are associated with investment crowdfunding, you may be wondering whether it is even worth the hard work. There is only one way to answer that – yes, absolutely.

 

Any sort of business involves taking risks but you should be aware of this when you’re getting into it. This makes you better equipped to mitigate these risks and improves the quality of rewards that come your way. There is a report that shows angel investors receiving almost 2.2 times the money they invested for an average investment period of approximately 3.6 years. This 22% return rate is phenomenal when compared to the regular deposit account.

 

The key here is to remember that an angel investor’s success will be dependent on those startups that manage to succeed and not those who fail in the initial stages. However, other than the monetary factor, there are some benefits that come with investments made into newer companies. These include the creation of employment, interaction with a dynamic bunch of entrepreneurs and a front row seat to the actions that may change the world.

 

One the other hand, you must also take steps to mitigate the risks that are involved with this type of equity crowdfunding. This involves steps like being an active investor, taking tax reliefs into consideration, looking into any follow-on investments and so on.

 

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