The Business Landscape Around Crowdfunding

The focus here is on equity crowdfunding, and not the other models of crowdfunding (e.g., donation, reward, pre-purchase, or lending). In assessing the pros and cons of crowdfunding, it’s helpful to understand the landscape around crowdfunding, and by “landscape” I mean the different solutions you have on the table other than crowdfunding and why crowdfunding is different than these other solutions to financing your business needs. More specifically, as entrepreneurs, I’m going to assume that the other solutions you have in mind are (1) bank loans, (2) venture capital (VC), and (3) angel investors.

It’s important to understand that each of these solutions exist for small businesses. As you know, Canada is comprised of mostly small to medium sized businesses, so the availability of finance for small businesses is closely tied to the economic health of this nation. But small businesses still have trouble raising money. Often small businesses turn to personal savings, or friends or family.

After this, going to the bank and getting a small business loan might be the natural next step. But most small businesses don’t have a lot of collateral, cash flow, or financial history to qualify for substantial bank loans. Banks are relatively risk-adverse and less flexible when it comes to credit risks and give little weight to the potential growth of your small business. As we all know, most small business fail within the first few years and small businesses are an inherently risky enterprise.

Venture capital funds can be the natural next step. VC firms are fine with the risk of small businesses because they hedge their bets by investing in multiple small businesses, and they only need one of them to be really successful. I’ll return to the side-by-side comparison between VC and crowdfunding, but, for now, what’s important to highlight is that VC funds are pretty selective. They’re partial towards tech companies, and they tend to look for companies that have passed the initial phases and have a potential for large growth; as such, venture capitalists end up rejecting almost all of the business plans submitted to them, and invest in only a tiny sliver of small businesses in Canada.

Next stop, angel investors. Angel investors are typically really rich individuals or a small group of rich individuals, and, like VC firms, angel investors also look for high growth opportunities. Angel investors can be a little more relaxed than VC firms in assessing a business. Unlike VC firms, angel investors might not be so concerned with the numbers, and instead place more emphasis on things like your team or your idea or your plan. Still, they’re not a charity and they’re also fairly selective when it comes to investing in a small business.

This leaves us with a huge number of businesses that fall through the cracks and can’t access financing from banks, VCs, or angel investors. Crowdfunding can help here. Crowdfunding can support businesses that can’t access these traditional sources of small business financing and present this business as an attractive investment opportunity to a wider range of people. A useful analogy that academics use is that crowding funding is a combination of crowdsource (i.e., combining contributions from many people to achieve a goal, like Wikipedia) and microfinancing (i.e., lending small amounts of money to poor borrowers who do not have access to traditional funds, like purchasing new nets for fishers).

Is Equity Crowdfunding Right for Your Business?

Now I want to layout the pros and cons of equity crowdfunding, especially in relation to VCs and angel investors. I’ll then switch to some of the considerations for moving forward with crowdfunding and give a picture of what it looks like from the investors’ side.

First pro: time. Crowdfunding doesn’t require networking, pitching, or going back and forth with VCs or angel investors. That’s a very taxing process and often requires jumping through a lot of hoops, like creating a detailed business plan, disclosing your financials, and having regular check-ins. Crowdfunding can be as fast as filling out some forms, signing up to a platform, and creating a video with some marketing.

Second: control. Often in VCs or angel investors, they not only want equity in your business, they want managerial control over your business. This can vary from a board seat to having every business decision being approved by them first. This is understandable insofar as they want to keep an eye on their investment, and it could be beneficial in some aspects because they often come with a lot of business expertise. But entrepreneurs often don’t like people breathing down their necks and being micromanaged, and crowdfunding offers investors who are completely hands-off. VCs and angel investors are also often very sophisticated in negotiating their control rights and using their bargaining power, so businesses need to take added caution against predatory deals.

Third: flexibility. One element of flexibility is related to control: often, in VCs and angel investors, there is very little flexibility to change the business. But another element of flexibility is the flexibility in the kind of the business. Recall that VCs and angel investors primarily focus on high growth industries like tech. With crowdfunding, businesses have the added flexibility to choose virtually any kind of business; businesses don’t have to be concerned with high growth, rather they can choose something like person passion or social impact and still attract investors.

Fourth: cost. While there are fees associated with crowdfunding platforms and getting started with crowdfunding, they are likely considerably lower than, say, the cost of giving up control or the interest on a bank loan (or, compared to an IPO, no banks or underwriters). Moreover, businesses have the power to set the prices for shares, and you can set them for a higher price than any VC or angel investor would pay for them. The result is that you get more money per share, which means you have less dilution of the shares and more control.

Before we move onto cons, I want to highlight some double-edged swords that can either be a pro or a con depending on your business. For one, the visibility of crowdfunding can cut both ways. It may be a good thing to drum up attention to your business, which could lead to more investors or customers. On the other hand, crowdfunding can carry reputational risks and some might view this as a lack of ability to attract traditional investors. Next, the lack of interference from a VC or angel investor can look attractive at first, but businesses need to seriously consider the importance of managerial experience and the benefits of working with experienced professionals. Now, moving onto cons.

First: liability. Businesses ought to consider the legal risks involved in crowdfunding. Businesses are liable for misrepresentations and should consider the terms they agree to, such as setting milestones or promises to investors.

Second: precariousness. There is no guarantee that crowdfunding will be successful or attractive to investors. Additionally, there are regulatory limitations on funding and businesses need to consider how they want to use their limited funding.

To overcome these cons, business should be familiar with the crowdfunding regulations, but businesses need to also consider things from an investor’s point of view. The biggest concern for the investor is the risk that their investment becomes worthless. This can occur due to fraud or, more commonly, the inherent risk of failure for small businesses. These risks make crowdfunding a lower-quality investment, but it gives investors (including non-accredited investors) and potential avenue for massive returns. Of course, another worry is that such an investment would take a long time to materialize, but the regulatory limits on investing assume that the investment has relatively little impact on the total wealth of the investor.

To attract investors, it’s important to alleviate their concerns. Businesses interested in crowdfunding ought to consider the importance of marketing. On this front, we can learn from non-equity crowdfunding that use viral marketing and simple value propositions. It’s important to tell a compelling story rather than spelling out the details and complexities of the business. A useful example of crowdfunding in our daily lives is a political campaign: look at how politicians collect small campaign donations from the public. To conclude, equity crowdfunding is an alternative to small business who do not have access to loans, VCs, or angel investors. However, this isn’t just a Hail Mary for small businesses left without any financing options. It’s a way for businesses to take risks and start innovative projects.