What works well: Equity based crowdfunding or debt-based crowdfunding?

Crowdfunding is definitely one of the trendiest terms in the startup world now. Although it is highly picking up amongst entrepreneurs, more and more people seem to misunderstand it. TechCrunch went on a big ranting post to declare ‘Crowdfunding is dead, what we are dealing with is marketplace investing’; but you can be rest assured, no matter what form it takes or what it is called ultimately, crowdfunding will exist.

Now the question comes – what is good for you?

You decided to raise funds via a crowdfunding round after reading Oculus’ $2 billion success story? Great, that was the easier part. The real struggle starts now. You will have a number of decisions to be made, followed by a number of plans to be made and ultimately a number of plans to be executed! Scared? Don’t worry; we’re here to cover you.

First and foremost, the very basic – what is crowdfunding?

As simple as it sounds, its very definition is the root cause of confusion for many. Crowdfunding is a way of raising funds directly from a mass; unlike a traditional private equity investment where you only have a few participants as investors, a crowdfunding round can have hundreds if not thousands of investors; each one donating in his/her personal capacity.

The most popular platforms for crowdfunding are Kickstarter and Indiegogo. This is where the confusion resides. Both Kickstarter and Indiegogo have a slightly different business model. They do not have equity or debt based model; what they are running is a donation-based model. Each investor gets rewarded with a gift against his/her investment. This way, the entrepreneur is able to raise money without any financial burden or without letting go of his/her equity; Kickstarter is able to charge commission on the amount raised by the entrepreneur and the investors are happy with their gift.

On the other hand, you have platforms like Lending Club and CircleUp, where a bunch of investors have their own ways of participating in crowdfunding rounds. Here are the two basic models used by them:

1. Debt Based Crowdfunding (also called Peer-to-Peer lending):

This works in a largely simple way. The entrepreneurs register their target amount with the platform. The platform then approaches hundreds or thousands of potential investors with a proposal, asking for their participation in the scheme, the amount they would like to invest and the interest they would prefer charging.

Once the investors agree to participate in the round, they invest in their individual capacities and are promised a date of receiving the returns.

2. Equity Based Crowdfunding:

Here, when entrepreneurs post the amount they are willing to raise, they also indicate the equity they are ready to part with. The equity works as an additional motivator for people to invest. Then, once an investor invests in the crowdfunding round, he/she gets the proportionate equity in the startup. They can stay invested or choose to sell their stake.

If you are startup, this can be very confusing for you. Understanding the pros and cons of each of these options can be rather complicated for a few. So, let’s discuss implications of both the types of crowdfunding, for your startup.

Here is what happens when you choose to raise funds via a debt based crowdfunding round:

a. There are higher chances of securing the funds. Because the investors are promised a date and return on investment, which motivates them to invest as this is a very secure deal.

b. The fund raising can be faster. Since people know that a date of returning is almost fixed, they know it works as a loan. This will make more and more people pay attention to the startup.

c. It lingers a financial burden on your startup. Until and unless, the debt is paid, your startup will not be completely yours. Plus, since you are supposed to pay interest (to the investor) and commission (to the platform), the cost of borrowing increases more.

d. Till the time you do not clear the debts, your startup’s cash-flow is uncertain. You will not be able to raise fresh funds easily, since no investor would want to invest in a startup which is already in financial obligations.

e. Your timelines will become stringent. The people who have invested in your startup are lenders and want their returns on the promised date.

Now that you know the nuances of debt based crowdfunding, this is what equity based crowdfunding can do for you:

a. You might find strategic partners. Because people would want equity in a business, only when they know that its valuation will jump; and the only way they can know this is, if they have any expertise in knowing that business.

b. Your fundraising round may take some time. Here, only the people, who believe in your growth and the power of your business, will invest. Others, who are simply looking for a low risk investment, might refrain from considering your business.

c. An advantage with equity based crowdfunding platforms can be, that many financial players like JP Morgan are fostering partnerships with platforms like Lending Club. This way, the crowdfunding platform actually becomes a marketplace where you can choose form a bunch of experienced investors.

A highly unique way of raising funds can be – have your own crowdfunding platform. This way, you can do away with any middlemen fees and straightaway approach the investors. After all, it is not that difficult to build a crowdfunding platform now. You can take the help of any UI design expert and use crowdfunding software like the Kickstarter clone to build a custom platform for yourself.

The simplest way to approach this decision is – look at the urgency of funds and understand whether you are willing to part with any equity or not. Think, do you just need funds or you need a strategic investor who can guide you on board. Once you know the answer to these questions, you will know where to go!

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