What Every Startup Should Know About Crowdfunding

VC Spotlight
By: Joseph R. Martinez
February 1, 2013

From financing Oscar-winning movies to video game companies raising tens of millions of dollars to fund new video games, crowdfunding has become a major source of capital for businesses. It has been reported that well over $2 billion have been raised worldwide using crowdfunding.

With the amount of money being raised, crowdfunding cannot be ignored and should be considered part of a capital raising or marketing strategy for certain startup companies. Despite the increase in popularity of crowdfunding, startup companies should nonetheless be aware of the various legal pitfalls that come with this approach to raising capital. This article will explain the types of crowdfunding and help entrepreneurs understand the legal minefields that currently exist.

Crowdfunding Defined
Crowdfunding allows individuals to pool small amounts of money together from diverse sources to raise funds for a particular purpose. Crowdfunding is an outgrowth of social media and collective cooperation, as the internet has made it much easier to raise awareness through online campaigns. In many ways, crowdfunding has been a response to a general lack of access to capital due to the economic downturn over the last several years and as a result of angel and other early stage investors adopting a more conservative investment approach.

Generally, four types are recognized, which include equity, lending, rewards and donation-based crowdfunding.

  • Equity-Based - In equity-based crowdfunding, a company seeks to raise money by issuing equity (typically stock or convertible promissory notes) in exchange for a donation. Funders become owners of the business and have all rights pertaining thereto. As discussed below, there are significant restrictions related to equity-based crowdfunding in the United States, but new legislation purports to make equity-based crowdfunding a reality.
  • Lending-Based - With lending-based crowdfunding, contributions are exchanged for the right to receive a fixed payment of the original contribution plus interest at some future date. Think: crowdfunding meets banking. Lending-based crowdfunding is also known as peer-to-peer funding (or P2P).
  • Rewards-Based - In rewards-based crowdfunding, a funder receives a non-financial reward in exchange for making a contribution. Think “PBS fundraising campaign” meets social networking. Depending on the business seeking donations, typical rewards may include music CDs, t-shirts and video games.
  • Donation-Based - In donation-based crowdfunding, a funder donates to a cause that he or she wants to support with no expected benefit or compensation. The donation is purely philanthropic, and the ‘reward’ is seeing a successful campaign. Donation-based crowdfunding is used for “social good” campaigns, such as campaigns geared around certain environmental, community or religious causes.

For further information on this topic, please contact Joseph R. Martinez.