What is Crowdfunding and How Does it Work?

Crowdfunding and peer-to-peer lending platforms can help your business get financing. It’s typically more flexible than traditional options, but it can require a lot of effort.

Jeff Salway Published on 01 October 2021.
What is Crowdfunding and How Does it Work?

When businesses look for funding they can sometimes find that the traditional routes are closed to them.

Whether it’s lenders tightening their criteria, offering too little flexibility or charging too much, there are various reasons why businesses sometimes need to consider alternative funding routes, especially in the early stages.

Recent years have seen one of those alternatives become increasingly popular, with more businesses bypassing traditional lenders and turning instead to crowdfunding.

What is crowdfunding?

As the name suggests, crowdfunding involves sourcing finance from a ‘crowd’ of different individuals or organisations. It’s a way for businesses and individuals to fund projects or ventures through donations from a large number of individuals.

It has become increasingly popular over the past 10 to 15 years, with social media and online services bringing together people or businesses that need funding with people looking to make money by helping fund ideas, projects and enterprises.

This is usually done through crowdfunding websites or platforms, where businesses can ‘pitch’ their project, business or idea and offer returns or rewards for those that pledge to lend or invest money.

The funding received by a business is sourced from multiple different lenders or investors, rather than a single entity such as a bank.

How does crowdfunding work?

There are several different types of crowdfunding.

Debt-based crowdfunding

In debt-based crowdfunding - also known as peer-to-peer (P2P) business lending - businesses set the amount they want to borrow and their case for securing a loan.

The crowdfunding or P2P platform sets the interest rate and risk level, while each investor or lender using the service sets the amount they want to invest and the return they want from it. Lenders and businesses are then matched, with the business repaying lenders through monthly interest payments.

» MORE: Peer-to-peer lending

Equity-based crowdfunding

Equity-based or investment-based crowdfunding works on the same principle. The difference is that investors receive a stake in the business in return for their investment and so can share in the proceeds should the company be sold or floated on the stock market.

Rewards-based crowdfunding

Another option is rewards-based crowdfunding. This is where investors or lenders receive a product or service related to the project in return for the funding they have helped to provide.

Debt-based and equity-based crowdfunding are regulated by the Financial Conduct Authority, but rewards-based crowdfunding is not, only the payment services used for this.

How to set up a crowdfunding page

To get started in crowdfunding you’ll need to set up a page on a crowdfunding platform.

Your page will tell investors and lenders how much finance you want, what you intend to use it for and it should also include a marketing presentation that sells the case for your project or idea. This could include a short, accessible and compelling video presentation.

Each platform has its own guidelines, charges and criteria, while some will also specialise in certain markets. So it’s important to compare different sites and identify those most suitable for your needs.

What are the pros and cons of crowdfunding?

The broad benefit of crowdfunding is that it allows businesses and individuals to cut out the middlemen (i.e. banks and building societies) and go directly to those looking for returns or interest in exchange for giving money to projects and/or companies.

Crowdfunding is typically more flexible and sometimes cheaper than traditional options and it can often be quicker to secure funding. It also doubles up as a form of marketing and promotion for your business.

However, it’s not necessarily easy to secure funding and it can require a lot of effort to put forward a persuasive business case, while you may need to be able to field questions from potential investors.

Different platforms also have different requirements and restrictions, such as minimum years of trading and credit rating criteria, which can limit the options available.

Each type of crowdfunding also comes with its own advantages and disadvantages too.

For example, in equity-based crowdfunding you are giving investors a stake in the business and by extension a degree of control over the future of the business.

In debt-based or P2P crowdfunding, you’re not ceding any ownership of the business to lenders, but there is a risk of damage to your credit record if you aren’t able to repay the loan.

» MORE: What are business credit scores?

What other business funding options could be available to me?

The funding options for businesses range from traditional bank and building society loans through to government grants, rolling credit facilities, asset financing and angel investors.

Each has different criteria and its own advantages and disadvantages and it will depend on your individual circumstances as to which option may be the best for you.

» MORE: Funding options for expanding your business

How can I compare business loans?

Comparison sites can be a good place to start when you’re looking at the traditional options such as bank loans and alternative lenders.

Most comparison services offer business loan tables that tell you the amount each provider can lend, the terms available and the interest rate. The interest rate gives you an idea of how different providers compare, but it is important to remember that the exact rate you’ll be offered will depend on factors such as the length of your loan, how much you’re borrowing and your credit record.

» COMPARE: Business loan rates and deals

Image Source: Getty Images

About the author:

Jeff is a freelance journalist who writes across finance & business. He was the personal finance editor at The Scotsman & Scotland on Sunday & a member of the Financial Services Consumer Panel. Read more

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