What it means
A business that needs $100,000 has traditionally asked a bank, an investor or its owners. Crowdfunding asks a thousand people for $100 each.
The internet made the asking cheap and the platforms made it organised, and the model has funded consumer products, films, games, restaurants, property, start-ups and charitable causes on a scale that has become part of the financing landscape. Reward crowdfunding is the form most relevant to product businesses.
The company presents a product it has designed but not yet manufactured, sets a funding target and a deadline, and offers backers the product at a pre-order price (and often other rewards at other price points). If the target is reached, the platform releases the money less its fee, and the company manufactures and delivers; if not, under the all-or-nothing model most platforms use, backers are refunded and the company receives nothing.
The company gains capital without giving up equity or taking debt, proof that customers will buy at the price, a first batch of customers who become advocates, and press coverage; it takes on the obligation to deliver, the risk that manufacturing costs more or takes longer than planned (the commonest failure, with a significant proportion of campaigns delivering late and some never), and the exposure of a public campaign that misses its target. Equity crowdfunding sells shares to the crowd.
It is a regulated securities offering, subject to limits on how much a company may raise, how much each investor may contribute, and what must be disclosed; platforms are licensed, and the company must prepare an offering document. The company gains capital and a base of small shareholders who are often customers and advocates; it takes on the administration of hundreds or thousands of shareholders (usually managed through a nominee structure that holds the shares on their behalf), the obligation to report to them, and, if the business fails, the reputational cost of having lost the crowd's money.
Valuations in equity crowdfunding are set by the company and are frequently higher than professional investors would pay, which suits the company at the time and complicates later rounds. Debt crowdfunding (peer-to-peer lending) matches borrowers with many small lenders through a platform that assesses credit, sets the rate and administers repayment.
For the borrower it is a loan, often faster and more accessible than a bank's and sometimes cheaper for good credits, with the platform's fee added; for lenders it is an unsecured (or sometimes secured) loan with the borrower's credit risk, diversified across many borrowers. Property crowdfunding applies the debt or equity model to specific developments.
Donation crowdfunding funds causes, community projects and personal needs; it is not business finance, though businesses use it for social ventures. The financial evaluation for a business is straightforward.
Reward crowdfunding: the campaign's net proceeds against the cost of delivering the rewards (product cost, fulfilment, the platform fee, the campaign's own cost), the value of the validation and the customers, and the risk of delivery failure. Equity: the cost of capital implied by the valuation and the shares sold, against alternatives, plus the administrative burden.
Debt: the all-in rate against bank alternatives. In each, the campaign's public nature is both the appeal and the risk.
In practice
Real-world examples.
Example
A board game designer raises $400,000 from 6,000 backers for a print run, delivering eight months later and using the community for the next launch.
Example
A restaurant raises $250,000 in equity from 300 local investors, who become its most loyal customers and its marketing.
Example
A small manufacturer borrows $150,000 over three years through a peer-to-peer platform at 9%, having been declined by its bank.
Think of it
“Crowdfunding is raising money from the crowd-many small contributions adding up to significant capital.
Formula
Calculation
Net proceeds (reward or equity) = Gross amount raised x (1 minus Platform fee minus Payment processing fee) minus Campaign costs
Reward campaign margin = Net proceeds minus Cost of rewards (production + fulfilment + support) minus Contingency
Effective cost of equity crowdfunding = Shares sold as % of company, at the implied valuation, plus ongoing administration
Effective rate of debt crowdfunding = Interest rate + Platform fees annualised over the loan term
Worked example, reward campaign. A start-up has designed a portable coffee grinder. It plans a campaign: target $120,000; product offered at $95 (retail price to be $140); stretch rewards at $170 (two grinders) and $250 (grinder plus accessories). Platform fee 5%; payment processing 3%. Campaign costs (video, photography, advertising to drive traffic): $18,000.
Result: 1,650 backers; 1,200 at $95, 300 at $170, 150 at $250: gross $114,000 + $51,000 + $37,500 = $202,500. Target exceeded.
- Fees: 8% = $16,200; net from the platform $186,300; after campaign costs $168,300
- Rewards to deliver: 1,200 + 600 + 150 = 1,950 grinders plus 150 accessory sets
- Production cost per grinder at the 2,000-unit batch: $38 (tooling $30,000 amortised over the batch at $15, plus $23 unit cost); accessory sets $12; fulfilment and shipping $9 per parcel (1,650 parcels); customer support and replacements estimated at 3% ($6,000)
- Cost of rewards: 1,950 x $38 = $74,100; accessories $1,800; fulfilment $14,850; support $6,000; total $96,750
- Contingency for cost overrun and delay (the founders' base rate from comparable campaigns: 20%): $19,350
- Margin after delivering rewards: $168,300 minus $96,750 minus $19,350 = $52,200
The campaign funds the tooling, proves demand at a price above the planned wholesale price, delivers a first batch at a positive margin, and leaves 50 grinders and the tooling for retail launch. Had the campaign raised only $60,000 (below target), backers would have been refunded and the company would have spent $18,000 learning that the product did not sell at $95, which the founders regard as cheap information.
Accounting: on receipt of the net proceeds, the company records cash $186,300 and a customer deposit liability (contract liability) of $202,500 less the fees treated as a cost of obtaining the contracts (which may be capitalised and amortised on delivery under the revenue standard, or expensed if the policy so provides). Revenue of $202,500 is recognised when the grinders are delivered, with cost of sales of $96,750. Until delivery, the company's balance sheet shows a liability, not revenue, and the tooling in construction in progress.
Worked example, equity campaign. A craft brewery raises $600,000 by selling 12% of its shares through an equity platform at a pre-money valuation of $4,400,000 (post-money $5,000,000). Platform fee 7% ($42,000); legal and offering document costs $25,000; net $533,000. 1,400 investors hold their shares through a nominee. Annual costs of investor communication and the nominee: about $8,000. The brewery's alternative was an angel investor offering $600,000 for 20% (a $2,400,000 pre-money valuation): the crowd valued the company at nearly twice the professional's figure, and the founders kept 8 more percentage points. The cost is that the next professional round will be negotiated against a crowd valuation the professionals regard as inflated, which the founders accept.Case study
Seen in the real world.
A consumer electronics start-up ran a reward campaign for a smart home device with a target of $250,000 and raised $2,100,000 from 14,000 backers, an outcome the founders celebrated as proof of a business. The device had been designed but not engineered for manufacture. Manufacturing quotes came in at $110 per unit against the $85 assumed; certification in three markets cost $180,000 and took seven months; a component was discontinued and the redesign took four more; and customer support for 14,000 impatient backers required three staff for a year.
Delivery began 20 months after the campaign, 14 months late. Costs of delivering the rewards reached $2,400,000 against net proceeds of $1,930,000, and the company raised a bridge loan to complete. When the devices shipped, 9% were returned as faulty, and the backers' public reviews of the delay damaged the retail launch.
The company survived, barely, and its founders' account of the episode identified the error: they had treated the campaign as a fundraise when it was a pre-sale, and had priced the pre-sale before they knew what the product would cost to make. Their second campaign, for a simpler product, was priced after manufacturing quotes, capped at 3,000 units, and delivered on time.
Watch out
Common mistakes.
- Pricing a reward campaign before the product is engineered for manufacture and costed, which turns a successful campaign into an obligation the company cannot afford to meet.
- Treating reward proceeds as revenue or profit. They are customer deposits, recognised as revenue only on delivery, and the cost of delivery must be provided for.
- An equity campaign at a valuation the company cannot justify to the next professional investor, which makes the next round harder than the crowd round was easy.
Questions
People also ask.
Which type of crowdfunding suits a business?
Reward campaigns suit consumer products that can be pre-sold and delivered within a year; equity suits businesses with a community of potential shareholder-customers and a story; debt suits established businesses with cash flow that banks under-serve.
What does crowdfunding cost?
Platform fees of 5% to 8% plus payment processing of about 3%, campaign preparation and promotion, reward fulfilment, and, for equity, offering document and legal costs plus ongoing shareholder administration.
What happens if a reward campaign fails to deliver?
The company owes the product to its backers; platforms do not guarantee delivery, and backers have limited recourse beyond the reputational pressure they exert. Delivery failure is common enough that backers treat campaigns as risky pre-orders, and companies that deliver reliably build a following.
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