Crowdfunding has emerged as an exciting alternative to traditional business financing. In essence, a crowdfunding model solicits a large number of smaller investments from an extremely broad base of investors, allowing entrepreneurs to raise the capital they need to get a project off the ground without exposing any single investor to a deterring level of risk.
While crowdfunding has shown some promise, there is still risk involved and investors need to have realistic expectations. Also, entrepreneurs should be aware that many crowdfunding ventures fail before they reach an operational stage, and understand strategies they can use to increase their chances of success.
Because of its collective nature, crowdfunding shields investors from significant losses and because individual contributors don't generally contribute large amounts of money. However, there are risks involved, which both entrepreneurs and investors need to be mindful of.
First, Internet-based crowdfunding platforms require fundraising campaign goals to be met within a specified time period. If those goals is not met, contributors may not be able to recover their initial investment, which can be detrimental to an entrepreneur's reputation and make it difficult for them to attract interest for future projects.
Another risk is that many developers are reluctant to disclose full project details through a crowdfunding platform, fearing that their ideas will be stolen or otherwise misappropriated. This can limit investor interest in a project. Also, so-called "donor exhaustion" can occur if a developer continually taps into the same base of potential investors. Finally, transparency limitations can create concerns among investors that their funds may be misappropriated or used in undisclosed ways, which may also make them reluctant to contribute.
When crowdfunding first emerged, investors could not be given equity in the business they were helping to finance, which limited the potential for a worthwhile return. Thus, investors would contribute because they wanted to see a particular project succeed, not because they wanted to make a profit.
The 2012 JOBS Act changed the crowdfunding landscape, creating the possibility for individual investors to receive equity in a venture in exchange for their financial contribution. However, the JOBS Act did place limitations on the amount of equity an investor could receive. Individuals with annual incomes of less than $100,000 are limited to 5 percent equity, while individuals with annual incomes in excess of $100,000 are limited to 10 percent equity.
Despite the passage of the 2012 JOBS Act, many Internet-based crowdfunding platforms are still not offering equity to investors because equity crowdfunding models require the use of a self-regulating organization (SRO) to ensure that all equity is properly distributed. Thus, developers and entrepreneurs need to do their due diligence when selecting a crowdfunding platform to ensure the proper protections and regulatory mechanisms are in place which will allow them to provide the commensurate amount of equity to contributors.