Which Type of Crowdfunding Is Best for You?

Originally published in the Entrepreneur


In her book, Cash From the Crowd, Sally Outlaw, founder and CEO of crowdfunding website Peerbackers, reveals the secrets of funding your business with help from colleagues, peers, family, friends and even perfect strangers through a crowdfunding campaign. In this edited excerpt, the author explains the five types of crowdfunding to help you decide which might be right for you.

Even though many people think the term crowdfunding is universal, there are actually multiple options available for those needing to raise funds. These models of crowdfunding basically break down into those that offer a financial return for backers and those that do not.

Choosing the best form of crowdfunding in which to engage is the first decision an entrepreneur must make before moving forward. Options include a donation model, a reward model, a debt model, one that offers royalties, and finally the newest approach, which allows equity (the purchase of company shares in exchange for the backing).

1. Donation. This is the most straightforward approach, in which a contribution is made to a project or cause, and the donor doesn’t receive anything in exchange other than a good feeling for supporting something in which they believe (and perhaps a tax write-off). This approach is more often used for social causes, charities and political campaigns, rather than for entrepreneurial endeavors.

2. Reward. This approach to crowdfunding–also called “perks based”–is one in which the campaign contributors get no financial return for their donations but are offered a thank-you reward or perk in exchange for their support. Most often the reward offered is the product that the project owner is trying to launch. This model functions as a sort of pre-sale. Many service companies use this approach and offer things such as a discount on their services. One of its biggest benefits is that you don’t have to repay the money, so you’re not starting your venture in debt, nor do you have to give away shares of your venture. You just deliver the perks you promised when your campaign is over.

3. Debt, aka peer-to-peer lending. This is where crowds lend their money in small increments to project owners via the platform and expect repayment over time with some fixed rate of interest. The advantage of this model is it may be easier to win support for a campaign since the backers are attracted to getting a return. In addition to the entrepreneur usually getting a lower cost of financing, the entrepreneurs can bypass the sometimes complex and costly application process for bank loans.

An important thing to know about debt crowdfunding is that it usually is targeting a very different user than is targeted by reward platforms. Candace Klein, the CEO of SoMoLend, a debt-based funding platform, points out: “We are usually targeting consumer-facing brick-and-mortar companies–restaurants, retailers, salons, gyms–that already have customers, already have cash flow, and can service debt. Typically we look for a business that is at least a year old and has at least a year’s worth of receipts.”

4. Royalty. This type of crowdfunding offers backers a percentage of revenue from the project or venture the backer supports, once it is generating capital. A good example of this approach is a mobile app website where backers can support an app before it’s fully developed or launched, and then share in the revenue once the app starts selling to the public.

Quirky offers a different twist on this model: It invites community participation into the product inventing process, offering anyone who adds value to the final product a small royalty percentage from sales. While the entrepreneurs/inventors who originally submitted the idea do not retain the rights to the product, they do receive a larger share of the royalties.

5. Equity investment. This is the newest form of crowdfunding, where the crowd is tapped for micro-investments. Until recently, due to long-standing SEC regulations, backers couldn’t receive an ownership interest, a portion of profits or anything else that could be perceived as a financial return on money provided to projects via crowdfunding. Equity crowdfunding allows businesses seeking capital to sell ownership stakes via crowdfunding platforms, thereby creating the opportunity for individuals to become shareholders and have a potential for financial return. This new development comes as a result of the April 2012 Jumpstart Our Business (JOBS) Act but is in a holding pattern while we wait for the SEC to create the rules and framework.

As we wait for the JOBS Act to clear the way for anyone to invest in businesses via SEC-approved crowdfunding platforms, entrepreneurs can post on some websites that are open only to accredited investors, which under SEC rules includes individuals earning at least $200,000 a year or those with a net worth of $1 million or more. They are considered sophisticated enough to buy unregistered securities.

In addition to the different models of crowdfunding, there are varying fee structures. Most reward-based platforms charge the same success fee (5 percent) on funds raised, although some charge a higher rate (usually 8 or 9 percent) if you don’t reach your goal, so be sure to check the fine print! All platforms clearly state their fees in their FAQs, so review this as part of your decision-making process. The costs for using a debt, equity or royalty platform are not as straightforward. They can involve variables like the campaign owner’s creditworthiness or fees based on the amount the entrepreneur is trying to raise, so research this when looking to post your campaign.

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