Types of Crowdfunding: Donation, Rewards, and Equity-Based
The three primary types of crowdfunding are donation-based, rewards-based, and equity crowdfunding. We discuss the nuances of each crowdfunding method so you can choose which one is best for your fundraise.
Just like there are many different kinds of capital round raises for businesses in all stages of growth, there are a variety of crowdfunding types. Which crowdfunding method an entrepreneur selects depends on the type of product or service they offer and their goals for growth.
The three primary types of crowdfunding are donation-based, rewards-based, and equity crowdfunding. This guide looks primarily at rewards-based and equity crowdfunding.
- Donation-Based Crowdfunding
Broadly speaking, it’s correct to think of any crowdfunding campaign in which there is no financial return to the investors or contributors as donation-based crowdfunding.
Common donation-based crowdfunding initiatives include fundraising for disaster relief, charities, nonprofits, and medical bills.
- Rewards-Based Crowdfunding
Rewards-based crowdfunding involves individuals contributing to a business in exchange for a “reward,” typically a form of the product or service the company offers.
Even though this method offers backers a reward, it’s still generally considered a subset of donation-based crowdfunding since there is no financial or equity return.
This approach is a popular option on Fundable, as well other popular crowdfunding platforms like Kickstarter and Indiegogo, because it lets business-owners incentivize their contributor without incurring much extra expense or selling ownership stake.
Rewards based crowdfunding is an attractive fundraising option for thousands of small businesses and creative projects. And it’s easy to see why — it’s more efficient to prepare, launch, and manage compared to traditional business finance; it can capture the hearts of customers and snowball in popularity with social sharing; and, best of all, just about anyone can pledge a little cash and back a business.
And though the centralization and sharability that come with a well-crafted crowdfunding campaign can make the job of managing the raise considerably easier and more efficient, it’s by no means a fundraising magic bullet or a hands-off “set and forget” approach. Those founders who successfully attract backers and raise crowdfunding capital do so because they do two things very well:
They have a market-validated product or service that fills an unmet need better than any competitors, and
They are able to share that product or service with enough people, anticipating their specific questions and making compelling asks.
Before launching a rewards campaign:
When raising crowdfunding capital, it’s the entrepreneur’s job to answer the audience’s questions and build their confidence, persuading them to support and share the campaign.
It’s up to the entrepreneur to identify some of the specific needs and questions that customers will have, but there are several universal components to any successful campaign.
a. Compelling pitch
The pitch should be a lean, well-rehearsed narrative about where the entrepreneur and company came from, what the company does, and what the company needs in order to change the world with the product or service.
While the goal is to tell a story that resonates with the specific audience, every successful pitch does three things:
State the problem: The first and most important part of a great pitch is to identify a painful problem. The more severe the problem or need that a company addresses is, the more valuable the business’ solution will be.
Introduce the solution: Once the audience understands the problem on an intellectual and emotional level, the entrepreneur can present the product or service as the best solution. It’s important to be clear and concise and to focus on the solution’s big picture, not every last feature.
Define the market size: Once the audience understands the problem and how this company is uniquely equipped to solve it, the entrepreneur needs to put the opportunity in perspective. The bigger the market, the greater the potential value of the company is, and the more enticing the opportunity becomes for backers and investors.
b. The elevator pitch
Adapt the pitch into a ready and rehearsed elevator pitch, a condensed version that can be delivered in the span of 30 seconds to a minute.
In the same way that an entrepreneur can never know who they will run into and have a chance to pitch to in the real world, they can’t predict how distracted a potential backer might be when they happen upon a crowdfunding page, and they definitely shouldn’t assume they have that backer’s full attention.
For these situations, it’s best to have a short, three to four sentence elevator pitch at the top of the page and keep it focused on the problem, solution, and market size.
Here’s the secret to crafting an irresistible elevator pitch.
c. The email pitch
Email marketing is just one of the approaches entrepreneurs should be thinking about for promoting their campaign. Similar to the elevator pitch, craft a brief version of the email pitch that the recipient can skim in under two minutes, being sure to use these best practices for writing compelling emails.
Here’s a quick guide to crafting the perfect investor email pitch.
d. The company video
Campaigns that include an overview video have been shown to perform better, and the reason why is understandable: The average user would rather watch a short, well produced video than take the time to read the same content.
Founders should invest the time (and production cost) to produce a professional video that features the company’s founder or core team, explains the unmet need that sparked the idea, details the product and how it’s different than anything else out there, shows where the business is at right now, and hints at its long-term potential.
This is the sort of content an entrepreneur can build into a campaign that’s not only more likely to get seen, but also get shared online.
Here’s how to create a crowdfunding video for your startup.
e. Product overview
Entrepreneurs should write a detailed description of the product or service, how it works, and why people would want to see it brought to market.
Since the company is likely to be offering a per-order of this product as a crowdfunding reward, they should be “selling” the product as much as explaining it.
At the heart of any rewards-based raise are, of course, the rewards. Although a small number of backers will support a business solely out of personal affinity or the desire to see a founder succeed, the vast majority will decide to pledge based on what they get out it.
What an entrepreneur offers backers is entirely up to the company, so it’s worth thinking long and hard about what would incentivize potential customers. Rewards generally fall into three main categories:
Pre-orders: By far the most popular type of reward, this approach simply involves selling pre-orders of the product the company is raising money to produce. This is a great mid-level reward and is a exciting way for backers to experience the impact of their contribution.
Services: If pre-orders aren’t available or don’t fit the business model, entrepreneurs can offer special services in exchange for support. Some examples include everything from Founders preparing a home-cooked meal for backers, to developers offering to write code for fans and supporters.
Recognition/swag: A perfect entry-level reward for donations under $20, this category offers backers some sort of personal recognition for their support. This can include a company t-shirt commemorating the campaign or the backer’s name on the company website.
Whatever rewards an entrepreneur chooses, it’s best to have at least seven rewards tiers — a small price point that offers some sort of simple recognition, a mid-sized price point that offers a pre-order, and a large price point that offers special recognition for generous backers.
g. The Ask
The point of crowdfunding is to raise money, so it all comes down to the ask. It’s important to be crystal-clear about exactly how much money a company is raising, and know exactly how the company plans to spend it.
Detail is the key here — the more information a company can provide, the better. In as much detail as possible, be able to explain how the company plans on spending the crowdfunding capital raised and explain specifically what milestones it will help the company reach.
This is a great chance to build backer confidence by showing that the company has spent the time to chart the business’ course forward.
Some common categories in rewards campaigns are product development, sales and marketing, recruitment of key personnel, legal and accounting, and operating expenses. These broad categories are a good starting point, but be sure to expand upon them when possible.
For example, entrepreneurs can explain which product features this funding will help develop, or which key team members they’ll be able to hire, and what those hires will do for the business.
- Equity-Based Crowdfunding
Unlike the donation-based and rewards-based methods, equity-based crowdfunding allows contributors to become part-owners of a company by trading capital for equity shares. As equity owners, contributors receive a financial return on their investment and ultimately receive a share of the profits in the form of a dividend or distribution.
Equity crowdfunding is perfect for companies that are looking to raise more capital than those that choose a rewards-based approach. These companies are typically seeking sums higher than $50k and have achieved social proof and gained enough traction to incentive their backers with the chance to own a small piece of their company as it grows.
The very nature of equity crowdfunding makes it a considerably more involved fundraising approach than rewards crowdfunding. Add to that the fact that it’s still a fairly new funding method and that the rules and regulations are still evolving with new federal legislation, and it can be a little tricky to navigate.
Here’s a walk through of setting fundraising terms, preparing a campaign, new legislation, and how to drive investors to a business.
a. Setting Terms
Here are the basic terms for any equity round and how to think about them with particular fundraising goals:
Raise Amount: The natural starting point for any round raise is deciding exactly how much capital a company wants to raise, which will stem directly from predetermined business goals. Whether a company is looking to raise capital for equipment purchase, a facility build-out, or the next year’s operating expenses, they’ll need to decide on a figure that’s high enough to finance stated goals, but also that’s low enough that they can meet or surpass it by the end of a 60-day crowdfunding campaign.
Duration: How quickly a company closes a campaign will depend on a number of factors, like the amount they’re raising, the completeness of the business plan and supporting documentation, the ability to pre-empt potential investors’ questions with these materials, and due diligence. A typical equity campaign on Fundable lasts 60 days, and though the entrepreneur decides how long theirs runs, committed investors will have to renew or withdraw their commitment every 90 days. This ensures that both parties — startup and investor — retain some flexibility and control and aren’t locked into an arrangement that doesn’t fit their fundraising and investment goals.
b. Equity or Convertible Debt?
Most startups will be raising their first equity round using straight equity, which means that investors get an ownership stake in the business at a set valuation when they invest. Another option, convertible debt, is a slightly different instrument that implies that a valuation is not set right now, but will be set at a later date.
Convertible debt is an attractive option for some startups, as it allows them to defer setting a valuation until a later equity round, and it also keeps the founders’ ownership stake intact as they aren’t exchanging investment for shares.
The primary appeal of convertible debt for an investor is the opportunity to invest their money as a convertible note, wherein their initial investment is automatically converted to equity at a discounted rate during a later funding round. By receiving more shares at a later date in exchange for their initial investment. For more about the differences between equity and convertible debt, and which approach may be right for your business, check out our complete guide to convertible debt.
The valuation is the proposed value of a company at the time of the investment. Entrepreneurs need to be sure to include the amount that they are proposing to raise in the total valuation (also known as a “Post-Money Valuation”). For example, if an entrepreneur is valuing the company at $750,000 and raising $250,000, the valuation is $1 million, and investors in this round are getting 25 percent of the total value, including their investment.
Because early-stage valuation is based mainly on where the founder projects the business will go in the future, it can be tricky to figure out.
Here are some major factors that will influence a startup’s valuation:
Traction: This is perhaps the most valuable asset that a startup can show a potential investor, and plays a key role in determining its valuation. Has the company achieved social proof? How many users has it acquired? How quickly did it acquire them? Were there pre-orders? Has the company gained exposure or endorsement through favorable media coverage? Does the company have any committed advertising partners? Read more on different types of traction.
Reputation: Investors will always be more interested in an opportunity if the company has a seasoned team behind it. Entrepreneurs with prior successful exits or a Board of Directors comprised of industry veterans are sure to catch the eye of investors and merit a higher valuation.
Revenue: If a company already has paying customers and is generating revenue, it becomes easier to value because the financial projections are based less on estimate. Early-stage revenue, however, can be a double-edged sword when it comes to valuation — it can both raise and lower it. That’s because if a company is already charging users for a product, they may gain new customers more slowly, resulting in slower overall growth. When it comes to valuation, this becomes a balancing act — investors want to see that the company is making money, but they also want to see that they’re positioned for rapid growth.
Timeliness: An up-and-coming startup in a “hot” industry will often be more appealing to investors, contributing to a higher valuation for your company.
Here are 10 real-world methods for valuation of your startup.
The concept of dilution is fairly simple – as a founder takes in equity investment from investors, the investors become part-owners in the company, which means that the founder’s ownership percentage decreases. The more people sharing the pie, the smaller the pieces.
It’s important for founders to carefully consider the total dilution they’re comfortable with as they plan their equity round, and that decision will be closely tied to the company valuation.
The idea of coming out ahead as ownership stake is diluted may seem counterintuitive at first. After all, how does a founder win by giving up ownership of their company?
It all comes back to valuation. The goal in closing any equity round is to own a smaller percentage of a much larger, more valuable company.
Here are some numbers for a quick example:
If a founder owns 10% of a $1M company, their ownership stake is worth $100k.
If the founder kicks off a new funding round with a funding goal of $2.5M and a $7.5M valuation going into the round, the post-money valuation is $10M.
After raising that $2.5M, the founder’s ownership percentage gets diluted by 25% (2.5M capital raised / 10M post-money valuation), and drops from 10% to 7.5%.
After the funding round closes, the value of the founder’s ownership stake increases from $100k to $750k.
e. Preparing To Launch
Preparing to actually launch an equity campaign looks a little different than setting up a rewards campaign. Making sure all the pieces are in place well in advance of a fundraising round, or at least having a plan for getting them created, will help founders avoid any delays or surprises as launch day approaches.
Here’s a list of everything founders need to put together a successful equity campaign:
Executive Summary: This is the high-level overview of what a business does, how a product works, and the strategic plan to develop the business. This is often the first part of an offering a potential investor will read, so it needs to be enough to engage them, but isn’t meant to be comprehensive. Read our article on private investors in which we dive further into what they’re looking for including the Executive Summary.
Terms: Founders need to decide upon and clearly state the terms of a fundraise, including the amount that they’re looking to raise, the total percentage of equity they’re offering potential investors, and any other relevant deal terms. They’ll also have to set a campaign duration so investors know when the deal is expected to close.
Business Plan: This is the comprehensive summary of a business and a detailed plan for growth and profitability. A business plan should include a detailed analysis of the company’s market segment, sales and marketing strategy, strategic growth plan, and corresponding financial plan. Many sites don’t require founders to present a full business plan, however it’s an extremely helpful tool in convincing prospective investors that founders have thoroughly planned and charted a business’ course forward. Here’s how to write a business plan that investors will love.
Pitch Deck: The pitch deck is a simpler, more visual adaptation of the executive summary, and is most widely used for in-person presentations. More and more, the pitch deck is replacing the executive summary as the first document requested by investors, as it forces entrepreneurs to be brief and to-the-point. Potential investors are often short on time, patience, and attention, so it’s important that founders do everything they can to present their materials in an easily digestible format. Here’s a cheat-sheet for your startup investor pitch deck.
Financials: At the very least, investors will want to see use of funds and multi-year financial projections before considering investment. We recommend providing this information as a downloadable file on a crowdfunding profile.
Closing Documents: When a founder closes a fundraising round, they’ll need to have some specific documents ready for committed investors. For example, they’ll need to complete a subscription agreement which provides detailed terms of the investment. At the very least, it’s a good idea for founders to have a working draft of a subscription agreement and other closing documents prepared before the round closes.
Remember, crowdfunding campaigns aren’t (just) a fast track to capital or product validation. A successful crowdfunding campaign is a marketing project, just like any other marketing project your company might undertake. It takes strategy, planning, and, above all, effort to make it a success.
The original content can be found here: https://www.startups.com/library/expert-advice/types-of-crowdfunding