The term “crowdfunding” has become the latest craze for those seeking financing in various sectors. Crowdfunding is an emerging alternative financing option that involves the collection of finances from backers—the crowd—to fund a company, product or project. One of the most talked about was the recent funding of the Veronica Mars film.
There are five main models of crowdfunding, which are important to understand when grasping this idea:
- Donation-based. This is the most widely known approach, and also the most straightforward. Someone asks for funding for his or her project or cause as a donation. It’s important to think of the donation-based model as its name suggests—a donation. Those who give money to the project or cause will not receive anything in return, other than the good feeling that they supported a cause in which they believe. Donators may also get a tax write-off. You’ll often see this in political campaigns, charities and social causes.
- Reward-based. Similar to the donation-based model, those who give money to the campaign (be it a project or product) will not receive financial return. However, since it is also known as “perks-based crowdfunding,” contributors will receive a reward for helping to fund the campaign. This may be the product that is being launched or perhaps a T-shirt, depending on the project and how much that person has contributed. The reward-based model is a very attractive approach for entrepreneurs because you don’t have to reimburse investors, with the exception of sending off a thank you reward.
- Debt-based. Also called peer-to-peer lending, the debt-based model refers to crowds lending funds in small increments to project owners and expect repayment over time. There’s also a fixed rate of interest involved in that repayment. This is attractive to investors because they can expect financial return. It also is appealing to entrepreneurs because they can usually bypass the painstaking bank loan process. It should be noted that the entrepreneurs may be turning to debt-based crowdfunding after unsuccessfully applying for a bank loan—investors, be mindful of this—though the entrepreneurs must still show “creditworthiness.”
- Royalty-based. This approach deals with revenue share. Backers are offered a percentage of revenue from the project or venture the investor supports, as soon as it is generating capital. It’s simple, which is one of the upsides of this type of crowdfunding. The pros of royalty-based crowdfunding is that there’s a higher ROI (or return on investment) and could be much more lucrative than simply loaning your money. Many mobile app companies use royalty-based crowdfunding. Once the app starts selling, the backers receive a percentage of the revenue.
- Equity-based.It’s the newest model of crowdfunding, and probably the one that’s exploding the most right now. Since President Obama signed the JOBS Act in April 2012, equity-based crowdfunding has taken off. The Jumpstart Our Business Startups Act of 2012 eased restrictions on fundraising by small companies, making it legal for entrepreneurs to publicly advertise their efforts to raise money. In other words, businesses are now freer to promote investments on the Internet to individuals known as accredited investors. An accredited investor is one who has a net worth of at least $1 million (excluding a primary residence) and who has earned at least $200,000 ($300,000 with spouse) each year for the past two years.This model works for anyone who has a company or product worth investing in, though the project owner has to be willing to give up a piece of equity in return for a crowdfunded investment. One of the sectors where it is really taking off is real estate. Now, accredited investors are able to invest in real estate in their own backyard and actually have it be a tangible investment (as opposed to a REIT, in which you don’t know what your portfolio includes). This is also a great way to diversify one’s portfolio.