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Crowdfunding as a Source of Financing for Small Businesses

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Image of crowdfunding small business finance
@s john79

It was not very long ago that crowdfunding was a concept not really relevant to small business owners. The only type of crowdfunding that was relevant to small business before 2012 was actually a form of peer-to-peer lending. This type of crowdfunding is a simple concept. A lot of people become interested in your business and contribute small amounts of money to your company in hopes of its success.

What is Crowdfunding and how did it get Started?

Crowdfunding started, believe it or not, as a an offshoot of outsourcing. Outsourcing, when used as a verb, means obtaining goods and services from a group outside your small business in place of an internal source. Crowdsourcing, is basically a "parent term" of crowdfunding. Crowdsourcing is the process of outsourcing tasks to a distributed group of people. Where outsourcing delegates tasks to a specific group, crowdsourcing involves delegating tasks to an undefined (and unpaid) public.

If you are like me, those definitions are as clear as mud and we will try to clear that up. However, they do describe what crowdsourcing actually is. As an extension of crowdsourcing, in business, crowdfunding is the process of a start-up or existing business asking for money, usually on a crowdfunding site on the Internet. The business seeks pledges of varying amounts of financial support from members of the crowdfunding community.

Crowdfunding is one way that businesses can seek money to startup their businesses, finance a new product, or expand their operations. The individuals that make pledges to help the company financially are generally not professional investors. It is quite a new idea in the business world, though it has been used in philanthropy and charity for a long time.

How do Start-ups and Businesses Raise Money Through Crowdfunding?

Crowdfunding for business is carried out largely on the Internet through various crowdfunding websites. Kickstarter is the largest crowdfunding site on the Internet. You can "start" a project on Kickstarter.

In other words, you share your dream for a business with the "crowd" who use the website. You share, with the crowd, how much money you think you will need for to start your business, buy a new product, or whatever else your dream is. Then, you sit back and see if the crowd is interested in your project and if they think you are passionate enough about it to make it work. If they do, you will see them start to contribute small amounts of money. The average contribution to a Kickstarter project is $25. If your project gets fully funded, great! The investors in your project make good on their pledges. If it does not, then no one has to make good on their pledge.

Another crowdfunding website that has been around since the earliest days of crowdfunding is Indie Go Go. They have raised millions of dollars for projects in 194 countries and over 30,000 campaigns have been funded using their website. Their model is a bit different from that of Kickstarter. If you start a campaign for a project you are interested in, you can keep the money you are pledged even if the project is not fully funded, but you will have to pay a fee to do that.

There are a number of other reputable crowdfunding sites operating with a variety of business models. Crowdfunding for business is obviously in its infancy in the U.S.

Two Types of Crowdfunding

In the U.S., there are two types of crowdfunding - reward-based and equity-based crowdfunding. Reward-based crowdfunding is just what it says. You receive a reward of some value for making a donation to a crowd-funded project. Kickstarter, the largest crowdfunding site on the Internet mentioned above, is a reward-based crowdfunding operation. In 2011, rewards-based crowdfunding operations reached $102 million. That was a 266% increase over rewards-based crowdfunding in 2010.

Equity-based crowdfunding was only evaluated outside the U.S. This is because, in 2010 and 2011, equity-based crowdfunding was not legal in the U.S. Equity-based crowdfunding allows people to invest, even small amounts of money, in projects and, in return, receive a small piece of ownership of the project. That is somewhat like buying stock in a company without a broker, but in a crowdfunding context, all the U.S. rules and regulations are not in place. It's still rather like the Wild, Wild West in the crowdfunding marketplace.

It looks like the new Jobs Act, passed in April, 2012 is going to allow equity-based crowdfunding. All the details are not yet in place. If this works out, it could be a boon for U.S. small businesses, the primary job creator for the U.S. economy, who are seeking capital, during the economic recovery.

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