Crowdfunding Growing Increasingly Popular – But Not Without Risk Potential

Steve O'ConnorFunding Options, Small Business FinancingLeave a Comment

Crowdfunding provides a way for small business owners to raise funds when traditional financing sources leave a shortfall…but now without its own risks.

In 2012, new U.S. legislation, called the Jumpstart Our Business Startups Act (or JOBS Act), paved the way for equity-based crowdfunding, which essentially allows businesses to raise funds and gain access to capital through social platforms. According to Forbes, “For the first time in our lifetime, every American will have access to investing in startups and small businesses.”

Likewise, small businesses that don’t have access to wealthy investors or venture capitalists can now tap into new networks to fund their need for cash. It’s an emerging business model that enables social entrepreneurs to consider traditional lenders and investors as well as alternative financial resources. That is, many small business owners find their ability to raise capital doesn’t fulfill their complete “go to market” capital needs; crowdfunding in one such way to help fill that gap.

Donation-Based Crowdfunding vs. Equity-Based Crowdfunding

Unlike equity-based crowdfunding, donation-based crowdfunding isn’t new. Donation-based crowdfunding allows the general public to donate to creative projects, such as art, design, or technology, and to philanthropic and civic projects, such as bringing clean water to third world countries or empowering at-risk youth. Since Kickstarter launched in 2009, 51,000 creative projects have received more than $857 million from 5.1 million people. And that’s just one crowdfunding platform.

Whereas donation-based crowdfunding collects donations, equity-based crowdfunding sells small amounts of a company to many investors. This type of investing was not legal until the JOBS Act, but is gaining popularity today. Forbes estimates that, thanks to the JOBS Act, equity-based crowdfunding may soon outpace donation-based crowdfunding. In fact, in 2013, an estimated $3.2 billion will be invested in small businesses through crowdfunding platforms. Small businesses that raise funds in this way can also avoid SEC filings.

Because equity-based crowdfunding limits the amount of capital businesses can raise through this strategy, it is ideal for startups — companies with new, small-budget/low-capital projects and innovations and companies that don’t need to raise more than $1 million in a 12-month period.

Equity-Based Crowdfunding Means Opening Up Your Business to Shareholders

As small business owners raise capital, however, they must give careful consideration to how much equity they’re willing to give up to investors in exchange for the funds. “Companies that issue shares through crowdsourcing ultimately are beholden to … investors who own tiny stakes in the business,” according to the Fox Small Business Center. As the value of the business goes up, so does the value of the investors’ equity; the reverse is also true.

But adding a group of investors to the mix may have a negative impact on the ability to raise funds through traditional lending channels. That is, lenders may be concerned about potentially unsophisticated investors having a say in business operations, a fact that may hamper the business’ ability to receive credit and small business loans. In those cases, small business owners will want to be well-educated on the risks crowdsourcing may bring to the overall business plan.

Crowdsourcing may be an ideal solution for your project or growth strategy, or it may not. Like any financial decision, small business owners are best served by thorough research and understanding of all potential outcomes.

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