The Four Types of Crowdfunding

Imagine you’ve come up with a brilliant idea for a new widget.

It’s a pretty good idea. You’ve talked about it with your friends and they agreed your widget would make their lives better. Understandably, you’re suspicious that they’re just being polite, so you go out and do some market research. Instead of dissuading you, your research actually makes you more convinced that your idea will be a hit.

There’s only one problem: you don’t have the disposable income to spend money on a product that might flop. Your widget isn’t technically complicated, but you’d need to invest a bit more than you have in your savings account. If only you could drum up the cash to build a prototype and prove that your widget works.

Enter crowdfunding.

Crowdfunding is the process of raising money from a group of non-professional investors. Unlike traditional investing, crowdfunding is primarily coordinated between strangers over the internet. For example, websites like Kickstarter, GoFundMe, and WeFunder let people invest in creative projects, philanthropic causes, and startups.

Depending on the project this can be a major improvement for entrepreneurs. Instead of raising a lot of money from a few professional investors, crowdfunding lets entrepreneurs raise a little bit of money from a lot of regular people.

Crowdfunding can be broken into four categories depending on the type of project:

1. Product based

   The investors in product crowdfunding are also the customers of the product. It reverses the typical order of operations: customers pay for the product before it’s been created. This allows the creator to use the revenue to pay for the time and materials that bring the product to life.

   This type of crowdfunding works best when the creator is offering something unique. Customers are more willing to support projects that wouldn’t exist without their financial support.

   Kickstarter and Indiegogo are two of the most popular product crowdfunding websites. The Pebble smartwatch raised $20 million through Kickstarter. The Fidget Cube team raised over $6 million for their ingenious gadget.

   Product based crowdfunding is inherently risky. Investors receive nothing more than a tentative ship date and a promise of progress updates. Often, products never ship or don’t live up to the campaign expectations. However, when done right, crowdfunding can help create products with a cult following from day one.

2. Donation based

   Donation based crowdfunding has become extremely common with the rise of the newsfeed. Instead of offering a product, donation based crowdfunding is used to raise money for a nonprofit or charity. It’s popular to help pay for medical bills and funeral expenses in the event of an untimely death.

3. Equity based

   Equity based crowdfunding is a way for entrepreneurs to exchange equity for capital. This type of crowdfunding is similar to traditional startup investing, although it has historically been limited to accredited investors. Due to a recent change in the law, non-accredited investors can now invest in startups through a process called Regulation Crowdfunding.

   Equity based crowdfunding is typically riskier than later stage investments available through the stock market. Companies are not required to go through a lengthy inspection before selling their stock through Regulation Crowdfunding. This means that the valuations and information available to the investor are typically of lower quality than in other markets.

   However, equity crowdfunding provides a way to own a piece of a company before it’s obviously a success. If you have conviction in the technology or business model of a relatively unknown company, participating in a crowdfunding campaign is an opportunity to benefit financially from your belief.

4. Token based

   The last type of crowdfunding is also the newest: cryptocurrencies.

   Cryptocurrencies raise money from investors through an initial coin offering, or ICO. In most cases, if someone offers the chance you participate in their ICO, you should run away. However, there are some situations where ICOs offer a legitimate opportunity to invest in a real project.

   The Ethereum blockchain conducted an initial coin offering in 2014 for less than $1 per Ether (ETH). Today, the value of Ether is ~$2k per coin. The creators of Ethereum followed through on their promise to create a global decentralized computer capable of programming the flow of money.

   Token based crowdfunding is still relatively new and the space is largely filled with unproven projects. Unlike equity based crowdfunding, tokens do not represent ownership in a legal entity. Instead, you’re purchasing a form of currency or credit that becomes valuable if the blockchain network it is based on gains adoption.

   In a startup, the value of the equity is based on the present value of future cash flows. Since there is a high chance of failure early on in a startup, the cost to purchase equity is often heavily discounted to account for the risk. In a token based system, early users are incentivized to buy tokens that will allow them to perform certain actions when the blockchain network has reached critical mass. These tokens are valued based on the expected value of the network and the types of applications it will be used for.

   In the case of Ethereum, the associated token allows users to compute smart contracts which are used to support financial applications like loans and interest rates. For other blockchains, the applications are often less clear and the underlying tokens have historically been highly volatile.

   Token based crowdfunding is interesting because it allows decentralized communities to fund projects that would otherwise lack sufficient attention. Gitcoin, an initiative supported by the Ethereum foundation, is a form of donation based crowdfunding that is coordinated via a cryptocurrency. What’s unique about it is that it uses quadratic voting, a new type of coordination mechanism that is uniquely suited to blockchain based payment systems.

   All of this is a long way of saying that token based crowdfunding has potential, although the current space is risky for investors without the technical sophistication to judge projects based on their merit instead of marketing.

The internet is still reshaping the way that we interact with each other. As companies continue to geographically distribute I expect crowdfunding to increase in popularity. Just like you don’t need to be in Silicon Valley to make software, you don’t need to raise money from Wall Street to be a real company. Companies with exceptional capital needs can still tap into the public markets, but crowdfunding gives smaller and more niche projects a chance.

This is a good thing. Diversifying the number of people who can say “yes” to an idea means we’ll see an increase in the number of projects that would otherwise never have been funded.

I can’t wait to see what we build.