Crowdfunding is an increasingly common means of raising working capital for businesses. So how does crowdfunding work? And what are the advantages and disadvantages for SMEs and start-ups?
What is crowdfunding?
The Australian Centre for Financial Studies, in its submission to the Financial System Inquiry, noted that while credit growth in housing has steadily increased since the GFC hit in 2008, credit growth for business is yet to return to positive territory. So it makes sense that SMEs and start-ups are increasingly looking for alternatives to funding from banks.
As the name suggests, crowdfunding is the process of raising capital from members of the public. Unlike seeking investors or venture capital, crowdfunding is based on donations, and is most commonly used by start-ups seeking seed capital.
According to MoneySmart, people are often inspired to support a fledgling business not by financial rewards but gifts, discounts on the product, service once it’s released to the market or simply just acknowledgement on the company’s website.
- The most obvious benefit of crowdfunding is the ability to sidestep restrictive bank lending practices.
- It is a simple process for a business to elaborate on its concept and what funds will be used for.
- Money raised does not need to be repaid, making it a cost-effective option for struggling start-ups.
- It acts as a test of the product or service on the open market. If people are fast and generous with their contributions, they clearly believe in that business. Conversely, a lack of donations suggests a fundamental flaw with either the product or its marketing.
- Crowdfunding enables business owners to retain full ownership of their company and concept.
- Achieving the desired level of funds is highly uncertain. The volume of contributors, and the amount they pledge, can and does vary drastically.
- Crowdfunding is also still a relatively new phenomenon, meaning there is still a somewhat limited pool of potential backers.
- It can be time-consuming to manage the process and reach the financial target.
- Difficulties can arise in finding sufficient encouragement for backers to pledge funds.
- It’s a two-way street. While there can be lots of potential backers in the marketplace, so too are there are lots of other businesses competing for funds from those backers.
Ramifications to consider
There are a number of both financial and legal ramifications to consider before a business ventures into a crowdfunding initiative.
For instance, tax implications can be complex to determine, such as calculating GST on capital raised from crowdfunding.
There are also legal issues when dealing with contributors. Would-be backers cannot be given false or misleading information, either about the product or service, or in relation to any incentives for pledging.
And if the business cannot be brought to fruition, backers need to be refunded or provided with a detailed explanation of what their funds were put towards.
Run these pros and cons past your start-up or SME clients to see whether crowdfunding could provide an out-of-the-box financial alternative for them.