This post is part a series of articles that explain, in plain English, new technology tools and platforms that are changing the face of finance. Check out other articles in this series here.
What is crowdfunding?
Crowdfunding combines crowdsourcing and micro finance. It's literally what its name means: raising money from the crowd. People looking to raise money can post a project to a crowdfunding platform and backers can choose to financially back a crowdfunding project. Crowdfunding provides a way for people, businesses, and causes to raise money efficiently because of the social nature of crowdfunding -- people who choose to back a project tend to share it with their friends and families.
Interesting. Are there different flavors of crowdfunding?
Sure. Crowdfunding's roots are in charitable giving -- donors can donate a few dollars to people in need and these small donations, when aggregated together, provided necessary capital to families and small businesses around the world. Crowdfunding didn't stop with charity, though. The most popular crowdfunding platforms are essentially pre-buying platforms -- people like artists and technology developers raise money from fans to help fund the production of their ideas.
There's also for-profit lending, where individuals and businesses borrow money from the crowd -- that's called peer to peer or marketplace lending.
Lastly, investors are using crowdfunding to invest in small businesses around the world (equity crowdfunding). Instead of plopping down $25k to $100k to invest in an early stage company, some equity crowdfunding platforms take investments as small as $100.
Why would someone want to raise money by crowdfunding?
Crowdfunding doesn't only provide capital to the people who use it to raise funds -- it also works to build an audience of fans and supporters. A new handheld technology device can use crowdfunding to finance development of the hardware, but it also works to attract enthusiasts and supporters of the product before it ever hits the market. In fact, crowdfunding backers typically provide a lot of product feedback to the project owners.
Also, the money raised via crowdfunding typically isn't dilutive -- it's mostly categorized as a donation, loan, or pre-selling a product. So, unless a project owner conducts equity crowdfunding, with is the same as taking an investment, she retains full ownership over her company without selling off to external investors.
It sounds weird -- what motivates people to donate, lend, and invest via crowdfunding?
A big chunk of people who donate or back a crowdfunding project have some connection to the person or team running the campaign. But people crowdfund for a lot of reasons. Technology and artistic projects are some of the most popular crowdfunding categories as they attract fans and enthusiasts to back projects. On the investment side, people back equity crowdfunding campaigns because they expect to make a profit, joining others who are making the same bet. Donors who back charitable crowdfunding campaigns feel good that their small donation, when combined with donations from their peers, can amount to a significant gift to someone who can really use it.
Is crowdfunding legal?
Good question and the answer is somewhat complicated. Crowdfunding regulation is in flux. It's useful to make a distinction between not-for-profit crowdfunding and for-profit crowdfunding. Not-for-profit crowdfunding has been legalized in most places around the world, though regulation exists to help protect donors from fraud. Regarding for-profit crowdfunding (lending and investing), many geographies are currently working on, or have recently passed, legislation to legalize crowdfunding. For example, in the US, equity crowdfunding (the investing flavor) was legalized in 2012 by President Obama's JOBS Act, but wasn't fully implemented until 2016.
How is fraud not overwhelming crowdfunding platforms?
It's interesting how different platforms address fraud. At the minimum, most platforms monitor the projects on their sites in search of fraud. This could be a cursory sweep of submitted crowdfunding projects or could entail requiring lots of identifying documentation to ensure projects are legit. Interestingly, the crowd itself has proven to be pretty good at sniffing out scams and when they do, the platforms shut down shady projects.