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Alternative Financing for Small Businesses – Crowdfunding

• Business Law

• December 1, 2022

Crowdfunding is the practice of asking a large number of people to make relatively small donations in order to finance a cause or business venture. A crowdfunding campaign is conducted on an online platform, such as Kickstarter or GoFundMe. The platform charges the user a processing or hosting fee in exchange for offering a central location to promote the crowdfunding project and accept contributions.

The most common type of crowdfunding is donation-based crowdfunding, where the fundraiser runs a campaign to raise funds in support of a certain cause without any obligation to repay the donors. Examples of donation-based crowdfunding include raising money for a family who has lost a loved one and raising money to support a youth sports league. The options are nearly limitless for donation-based crowdfunding – a fundraiser just needs an idea and the courage to solicit donations to fund it!

Although donation-based crowdfunding is the most prevalent type of crowdfunding, there are three other types of crowdfunding available to business owners that serve as useful tools for generating capital from third parties. These other types of crowdfunding are rewards-based crowdfunding, equity-based crowdfunding, and debt-based crowdfunding.

• Rewards-Based Crowdfunding – This type of crowdfunding involves a business – often a small business, startup, or even a nonprofit – soliciting cash contributions in exchange for providing rewards to contributors. Businesses often use this type of crowdfunding to raise capital for a new product or service. Examples include a clothing designer rewarding everyone who contributes at least $200 with a branded t-shirt, or an inventor of a new video game giving everyone who contributes $500 early access to the game before public release. Because this type of crowdfunding involves a bargained-for exchange, the fundraising entity is not required to pay back the contributors for any of their contributions, so long as the promised rewards are actually delivered to the contributors.
• Debt-Based Crowdfunding – This type of crowdfunding involves the fundraiser (the borrower) accepting cash from contributors (the lenders) with an obligation to repay the contribution. As part of the campaign, the fundraiser will specifically describe how the borrowed amounts will be used and provide a form loan agreement setting forth the applicable repayment terms. Businesses commonly used debt-based crowdfunding to access liquid working capital to pay off higher interest liabilities, to finance growth, or to serve as an alternative to a traditional line of credit. Common forms of debt-based crowdfunding are referred to as peer-to-peer lending, mini-bonds, and invoice financing.
• Equity-Based Crowdfunding – This type of crowdfunding involves a company asking individuals to invest cash in exchange for a small amount of equity (ownership) in the company. Equity-based crowdfunding is an attractive way for start-ups and small businesses to raise capital without giving up control or trying to secure venture capital funding; however, it is important to note that this type of crowdfunding (also referred to as “regulation crowdfunding”) is regulated by the Securities Exchange Commission (SEC). A company can only launch equity-based crowdfunding campaigns on registered platforms and is subject to regulations impacting the amount certain investors can contribute and the total amount the company is allowed to raise in a calendar year.

To start a crowdfunding campaign, the fundraiser generally needs to follow these steps: (1) select the crowdfunding platform; (2) set a fundraising goal; (3) set the length of the campaign; (4) create the campaign pitch; (5) define the incentives (i.e., rewards, interest rate, ownership); and (6) promote!

The emergence of crowdfunding has been one of the most dramatic changes to the business finance landscape in the last 10-15 years. Although crowdfunding is an exciting way to generate capital with low financial risk, a business should ensure its intellectual property is protected, it has appropriate form agreements in place (especially with respect to debt-based campaigns), and any equity-based campaigns are in compliance with applicable SEC regulations. Additionally, any nonprofit utilizing crowdfunding should be careful to not put its tax-exempt status at risk.

Before utilizing crowdfunding, a business should obtain advice from an experienced corporate attorney to help identify and minimize any risk associated with the anticipated fundraising and to facilitate a successful fundraising campaign.

The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information, content, and materials are for general informational purposes only.