United States: Crowdfunding 101: The Four Types You Need To Know

Last Updated: September 3 2015
Article by Foley & Lardner

This post was originally written by Dylan Rochon, 2015 Foley & Lardner LLP Startup Connector.

The term "crowdfunding" is closely associated with websites such as Kickstarter.com and GoFundMe.com. These sites provide a platform for startup companies to attract attention and funding. They provide an avenue for a wider group of investors to help fund or completely fund entrepreneurial startup projects. They have become popular among entrepreneurs, allowing them to "test the waters" and launch ideas that may otherwise not have been launched. In 2013, the crowdfunding economy reached $5.1B, more than three times larger than it was in 2011. Crowdfunding is said to be in startup mode itself and is expected to continue rapid expansion.

There are essentially four types of crowdfunding, and each one has its own pros and cons.

Donation Funding. The first and oldest type of crowdfunding is donation funding. This category is mostly made up of social impact organizations with goals such as creating ecofriendly products or bringing clean water to impoverished countries. Funding to these projects takes the form of simple donations, with the reward to the funder being the satisfaction of "doing good." Gofundme is an example of a donation funding site.

Rewards-Based Funding. The second form of crowdfunding is rewards-based. By far the most popular form of crowdfunding, rewards-based funding allows individuals to pledge however much they want to a project in exchange for gifts or rewards. These gifts range from a t-shirt to (literally) a role in a movie, depending on the funding amount. Rewards-based funding is most popular with tech products. Kickstarter is a prime example of this type of funding.

Debt-Based Funding. The third type is debt-based crowdfunding, also known as "crowd lending," and is similar to a loan from a bank. However, this "loan" can come from multiple funders, may be more accessible, and often has lower interest rates than banks. Individual lenders are investing in potential company growth in hopes of interest-based returns. This form of funding follows many of the same rules and regulations as equity funding described below and the two are often confused. There are also ways in which these investors can turn their "loan" into common shares. Just like equity funding, a lender is betting on the success of the startup, and there is no guarantee that the lender will see a return. Lending Club is an example of debt-based crowdfunding.

Equity-Based Funding. The final type of crowdfunding and possibly the most interesting form is equity-based. Just as it sounds, equity-based crowdfunding is when individuals invest in equity of a company. This form of funding has been around since the Jumpstart Our Business Startups (JOBS) Act was passed in 2012. The initial set of rules and regulations that allowed "non-accredited" investors to fund companies in exchange for equity were quite strict and many incubators and companies raised concerns about their difficulty. In response, the SEC recently passed Regulation A+ (Reg A+), a ruling that lessens certain compliance burdens on companies and raises permitted funding limits. This new regulation took effect June 19, 2015. While it should make crowdfunding easier, some experienced investors remain skeptical and believe that the regulations remain expensive and troublesome. Check out Angel List for an example of this type of funding.

Time will tell whether and what types of crowdfunding will become successful and established alternatives to traditional forms of early stage financing. One thing is clear: the demand for startup funding remains high, and many investors have shown a willingness to participate in crowdfunding as a new and innovative way to provide their financial support.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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