Creating Alternative Financing – Part III: Advantages and Disadvantages of Crowdfunding

Creating Alternative Financing – Part III: Advantages and Disadvantages of Crowdfunding

Crowdfunding is just one of many ways of financing a business venture or a project. Like all other methods, crowdfunding has its advantages and disadvantages. Below I discuss some pros and cons of raising money through a donation-based crowdfunding platform.

Pros

In my opinion, the main and unique advantage of crowdfunding is that people who are raising capital through crowdfunding (I will refer to them as entrepreneurs) can also use it as a marketing tool. Publishing information about a product or a project with a goal of raising capital on a well-read crowdfunding platform also raises product or brand awareness. Crowdfunding is not just limited to one single website. Supporters of the project disseminate the information using their social networks and encourage people in their networks to do the same.

Also, in addition to the money, entrepreneurs often get feedback. What can be better than "beta testing" your product and simultaneously raising capital for it? If the project does not reach the funding goal, this may be a signal to the entrepreneur that the market is not responding favorably to the offering and perhaps a change is in order. Of course, it is possible that the crowdfunding crowd is not the intended market for the product, hence the limited response. So, entrepreneurs should listen carefully to the market signals they receive through crowdfunding feedback and respond appropriately.

Another advantage of crowdfunding is that entrepreneurs can raise capital without giving away any equity. It is just like receiving a gift or a donation that you get to spend on your favorite project.

Finally, raising money through a donation-based crowdfunding platform is relatively inexpensive (especially given the fact that entrepreneurs do not need to give up equity). There is usually no need to engage lawyers or other advisors to assist in the process. Most sites charge a fee equal to about 5% fee of the money raised and another 3-5% in processing fees. Entrepreneurs also need to pay taxes on the raised capital (that would be income to the entrepreneur) and send out gifts or rewards that entrepreneurs are expected to give to their donors.

Cons

The main disadvantage of raising capital through crowdfunding is that entrepreneurs may be limited in the amount of money they can raise. An average raise amount is between $2,000 to $10,000. This may be enough money for a small project but not for a sizable venture. The reason is simple: people are reluctant to give money if they do not get any return on their investment. This is reasonable, and should be factored into the initial calculation.

Another disadvantage of using crowdfunding as a means of raising capital is the fact that your business idea would be exposed to the whole wide social network and there is no guarantee that someone will not decide to implement it. You cannot sign a confidentiality agreement with the internet.

There are risks for the donors as well. The crowdfunding sites may conduct a preliminary check to ensure the business is legitimate, but it is unlikely that they will be held responsible if it turns out otherwise. Also, the sites usually do not enforce allocation of the funds or that supporters receive their promised gifts. What happens to the project that is only partially funded? Some crowdfunding platforms would still release the money to the entrepreneurs. However, there may not be enough funds to launch the project originally contemplated, which begs a question of how and for what purpose this money would be used then. In my opinion, lack of accountability may present a serious problem as the number of participants on crowdfunding sites increases proportionately to the likelihood of occurrence of fraud. This may serve as a potential deterrent for donors as well as expose the crowdfunding platforms to liability.

In the next post, I will talk about the ideal candidates for using crowdfunding to finance their businesses or ideas.

Read more commentary from Arina Shulga on the legal aspects of operating new and growing businesses at Business Law Post.

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Comments

Anonymous
Anonymous
  • 05-22-2011

This article is an informative overview of crowdfunding. The article states that donations are taxable income. I beg to differ. Income is taxable only when the donor receives value for the donation. If there is no reciprocal transfer of value then the donation is not taxable (unless, of course, the recipient is a registered NPO). At least, this is the case in the U.S.