Starting off in America with sites like Kickstarter.com, this funding option is quickly finding its feet in the UK. However, the Financial Services Authority (FSA) has not been quite so quick to give crowdfunding its backing.
Here we look at the pros and cons of this new way to access finance.
How does crowdfunding work?
Businesses can get funding by attracting a 'crowd' of people through a crowdfunding website that want to invest in a project or business idea.
Funders can be individuals who simply support the project, another business or a professional investor. Unlike traditional or 'angel' investment, where one person typically takes a large stake in a business, each funder contributes by making a small contribution to a funding target.
The other major difference with traditional investment is that crowdfunding does not always offer participating funders a stake in the company.
Instead, entrepreneurs are coming up with new ways to entice people to part with their money, for example free samples for small individual donations or sponsorship deals for companies.
To attract funding, you first have to write a 'pitch', which is usually checked by the site's owner for suitability and chance of success before being published.
Once it is, it's up to you to raise awareness of your pitch – many businesses use email and social media to do this – and try to find investors to support you.
If you do not meet your funding target, your pitch is deemed unsuccessful and the money donated will be refunded to the funders.
If your pitch is successful, there is a short 'cooling-off' period where investors are given the opportunity to confirm or withdraw their investment.
Once all the funding is confirmed, the case is referred to a legal department who formalise the deal and the money is then transferred to your bank account.
Unless they've chosen to be anonymous, you are given your investors details so you can deliver their rewards and keep them up to date with how their money is being spent.
How much does crowdfunding cost
It's usually free to publish a pitch, but the website will usually take around 5% commission from your target if you reach it.
It is worth factoring this amount in to the target total when you write your pitch. You will also need to consider the cost of your 'rewards' to funders.
These are incentives to encourage funding and are usually staggered in value to reflect the amount given. These can include samples, discounts, exclusive first access to the product you're developing and sponsorship – or anything you can think of that might make your pitch appealing.
Some funding websites do allow you to offer a small proportion of equity in your business, to attract larger investments. The business benefits of crowdfunding
Quick and simple – It's relatively quick when you compare it to other types of funding. Pitches generally only run for a few weeks, and some people reach their target in a matter of days. Legal admin is usually handled by the site as well, so you don't have to worry about that.
Create fans – By investing in your business or idea, funders are going to be instantly more engaged with your company and interested in seeing it become a success.
Less risk averse – Crowdfunders may be more likely to take a chance on an unproven business idea, simply because they believe in it.
A vote of confidence – Getting public backing from individual customers and other companies is a great way of showing that your idea has support.
It's newsworthy – With crowdfunding being a relatively new concept in the UK, your local press might be interested in running a positive story on your business's success.
Tax breaks for investors – If you decide to invest via a website, the Government's Enterprise Investment Scheme means anyone investing between £500 and £1m in a qualifying business will be eligible for income tax relief worth 30% of the amount invested.
What's the downside of crowdfunding?
Copycats – If you've got a particularly unique idea, you may not want to share it on the internet. Make sure your work is protected by intellectual property laws including trademarks and patents first, if necessary.
Promotion – Although your pitch will get some exposure just by being on a website, it will take a lot of your time and energy to create a buzz around it and let people know about it.
Little or no regulation – Only one UK crowdfunding website (Seedrs) is authorised and regulated by the FSA, meaning that no other site is currently covered by the Financial Services Compensation Scheme or by the Financial Ombudsman Service.
Is crowdfunding right for my business?
Currently, Crowdfunding seems to be attracting mainly start-ups who are trying to get their business idea off the ground, but this doesn't mean other businesses can't participate; all you need to create a pitch is a strong idea and an interesting story that will compel people to back you.
Pitches that are uninspiring or struggle to explain a complex business idea are more likely to struggle to attract funding. Badly thought out pitches are also destined to fail. Do your research beforehand to find out if your business idea really has legs and discover what kind of rewards potential investors will respond to.
There's a new way of financing business ideas and projects called crowdfunding. In this article we explain how it works and explore whether it might be the right option for your business.