Crowdfunding seems like a promising way for entrepreneurs to raise money, but there are many risk factors you must be aware of before signing on. Crowdfunding is not the be-all and end-all of alternative funding options, and it can actually hurt a small business. Weigh the pros and cons of crowdfunding before jumping in over your head.
What Is Crowdfunding?
Crowdfunding is a relatively new concept where individuals and groups who support your idea contribute monetary donations to fund your business. Crowdfunding sites such as Kickstarter and GoFundMe have gained notoriety with a few smashing successes, leading many to believe this could be the apex of alternative funding. You don’t have to pay investors back, you gain brand recognition, and you can get your idea up and running. It’s a win-win-win, right?
Limitations of Crowdfunding
In 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act. Under this act, new companies can raise capital and go public through alternative sources such as crowdfunding. As of May 2016, the Securities and Exchange Commission (SEC) finally issued proposed crowdfunding rules more than three years in the making. These rules significantly restrict crowdfunding with limitations such as:
• Funding caps
• Restriction periods on shares
• Restriction of non-U.S. companies and investment companies from crowdfunding
• Investment caps
• Broker-dealer involvement
• No advertising except to lead investors to your broker
On any crowdfunding site, registered broker-dealers manage investments and handle the paperwork side of things. They charge commissions on successful investment rounds and limit most investments to five percent of annual income. The problem with using broker-dealers and funding portals for crowdfunding is that once you select one, you must exclusively conduct crowdfunding through the one you’ve chosen. They may also avoid smaller deals.
Startups don’t have to repay the money they receive via crowdfunding, but that doesn’t mean it’s free. Crowdfunding comes at a different price—the price of an ownership stake. An investor can demand a say in how you run your business in exchange for his or her contribution. Each investor through crowdfunding is a partial owner. If hundreds of people, including inexperienced shareholders, own a piece of your company, it could spell big trouble for you in the future.
Turning Away Larger Investors
Crowdfunding as a source of startup money looks unattractive to large and experienced investors. As a newer concept still in its fledgling stage, crowdfunding isn’t a prestigious asset to your business’ resume. Your investors are typically unsophisticated, each owning a tiny stake in your company. This unstable structure deters venture capitalists who don’t want to invest in a firm owned by thousands of shareholders who don’t know what they’re doing.
False Sense of Success
Successful crowdfunding gives entrepreneurs the false belief that their products or services have already made it to the masses. Crowdfunding encourages vanity metrics—how many people are interested in your brand. It doesn’t, however, focus on the metrics that keep your business running: marketing strategy, scalability, and growth plans. No loan guarantees success, but traditional investors (such as banks) support your enterprise because they have deep industry knowledge and truly believe you’ll succeed. The masses don’t always know everything; a fantastic idea doesn’t automatically translate into a successful business.
Slow Funding Process
If you have all the time in the world to generate funds for your small business, by all means try crowdfunding. However, if you have a pressing timeframe, this is most likely not a viable option. As a small-business owner, you may need funds quickly to take advantage of a limited-time deal, develop a new product, or fix an emergency. Crowdfunding isn’t a fast or reliable source of financing in these situations, unlike an alternative method like factoring, which immediately gives small businesses money for accounts receivable.
Crowdfunding may look like the ideal solution for startups that need “free” funding, but in reality, it comes with a host of threats. Instead of getting caught up in the hype, take a sensible approach to funding and carefully weigh all your options.