Crowdfunding vs Self-Funding: Pros and Cons

Crowdfunding Platforms vs Investing on Your Own

Crowdfunding has emerged as an innovative new way for entrepreneurs and startups to raise money. But is it better to invest through a crowdfunding platform or independently?

In this blog post, we will examine the pros and cons of both approaches. First, we will look at what crowdfunding is and the different types of crowdfunding models. Then, we will compare the advantages and disadvantages of investing via crowdfunding versus on your own.

What is crowdfunding?

Crowdfunding refers to raising money from a large number of people via the internet. Entrepreneurs create campaigns on crowdfunding platforms detailing their ideas or businesses and set fundraising goals.

Backers then pledge money, typically from $10 to $1000 each, to support the campaign. If the goal amount is reached, the money is collected and the business gets funded. If the goal is not met, backers are not charged.

Types of crowdfunding

There are four main types of crowdfunding:

1. Donation-based crowdfunding

This is the most basic model, popularized by platforms like GoFundMe and Kickstarter. Donors provide money to causes or projects out of goodwill without receiving anything in return, besides the satisfaction of supporting something they believe in.

Common examples are individuals raising money for medical expenses, charities funding raisers, or artists and creators receiving small donations from fans. There is zero financial return expected – donations are treated as gifts rather than investments.

2. Rewards-based crowdfunding

This is also referred to as the pre-purchase model. Backers of a project receive a small token of appreciation in return for their funding, such as first access to the product being developed, limited edition merchandise, or just recognition on the website.

Kickstarter is the most prominent example of rewards-based crowdfunding. For instance, backing a new tech gadget on Kickstarter might get you the very first edition of that gadget when it is produced. The rewards have only nominal value compared to the amount donated.

3. Debt-based crowdfunding

With debt-based crowdfunding, backers are effectively acting as lenders, providing capital in exchange for eventual repayment with interest. The entrepreneurs take on debt obligations to the crowd investors. Sites like LendingClub and Prosper specialize in facilitating loans funded by everyday investors.

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This model allows backers to earn fixed returns of around 5-10%, while the entrepreneurs leverage the capital without giving up ownership equity.

4. Equity-based crowdfunding

Also known as crowd-investing, equity models allow backers to become actual part-owners of the business or startup they support. In exchange for investment capital, backers receive equity shares or revenue-sharing rights. Equity-based crowdfunding usually takes place through regulated online platforms like SeedInvest and Crowdfunder.

This structure carries the most potential upside for investors but also the most risk, since startup failures are common. For the entrepreneur, it means giving up more control and ownership than other models.

Advantages of Crowdfunding Platforms

Advantages of Crowdfunding Platforms

Crowdfunding platforms offer several benefits compared to investing independently:

1. Low Investment Minimums

One of the biggest benefits of crowdfunding is the low barrier to entry. Most campaigns have minimum pledge amounts between $10 to $100. This allows ordinary middle-class investors to participate in opportunities that previously would have required high net worth individuals or venture capitalists.

Someone can diversify across multiple crowdfunding investments for the same cost as a single traditional angel investment. This democratization of investing opens up access for those new to the world of private capital.

2. Access to New Opportunities

Crowdfunding exposes investors to innovative or creative projects they likely would not encounter through their own networks. Platforms like Kickstarter and Indiegogo feature thousands of campaigns in diverse fields – tech, consumer products, entertainment, design, restaurants, and more.

The wisdom of the crowds identifies and elevates entrepreneurial ideas that most individual investors would never source independently.

3. Diversification Potential

The ability to invest small amounts into many different campaigns creates diversification. This helps mitigate the risks inherent with investing in startups and early-stage ventures where failure rates are high.

While some crowdfunding bets will inevitably fail, diversification allows investors to also gain exposure to breakout successes. $100 invested across 10 random startups is less risky than $1,000 into a single startup.

4. Built-In Community

A crowdfunding campaign builds an engaged community invested in its success. Investors act as brand ambassadors and an instant focus group for the product.

They provide feedback, ideas, and early word-of-mouth marketing, creating useful momentum for the business. The aspects of crowdsourcing, transparency, and accountability help drive participation and support.

Disadvantages of Crowdfunding Platforms

However, there are also some downsides to keep in mind:

1. High Failure Rate

While crowdfunding opens up investing to more people, the downside is limited due diligence. Investors have to rely largely on the information provided by the entrepreneurs themselves to evaluate the viability and risk of the venture. There is very little expert review or detailed analysis of the business plans and financial models.

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This results in high failure rates for crowdfunded projects, estimated to be around 75% for tech products and 90% for restaurants. Without adequate vetting, investors underestimate risks.

2. Illiquidity

Crowdfunding investments cannot be easily resold or exited for cash, at least until the project is commercially successful. Unlike stocks or bonds, there is no secondary market for crowdfunded stakes.

You are locked into the investment until the entrepreneur achieves milestones that trigger payouts to investors, which may take years or never occur at all. Lack of liquidity is a major risk.

3. Possibility of Fraud

While reputable crowdfunding platforms implement some level of fraud detection, there is still risk of scams or misrepresentation from fundraisers. Unlike regulated securities, the crowdfunding arena has limited oversight and accountability measures.

Entrepreneurs may exaggerate claims, misuse funds, or simply fail to deliver on promises made to investors. Recourse options are limited if campaign owners engage in overt fraud or mismanagement of capital raised.

4. Lack of Oversight

Beyond fraud, creators may simply be overly optimistic or inexperienced, resulting in crowdfunding project failure. Investors count on entrepreneurs to use funds appropriately and make sound business decisions after fundraising.

But novice founders often encounter unforeseen challenges. Without active investor oversight privileges, the crowd has minimal say in steering the ship if things go off course.

Advantages of Investing on Your Own

Advantages of Investing on Your Own

Investing independently outside of crowdfunding platforms has some advantages:

1. More Control Over Due Diligence

When investing on your own, you can conduct extensive due diligence before committing capital. This includes reviewing financial statements, analyzing competitors, assessing management teams, validating market size, etc. You gain a comprehensive view of the risks and opportunities.

Crowdfunding investments must be made based only on limited information provided by the entrepreneur. Do-it-yourself diligence enables deeper evaluation.

2. Access to More Asset Classes

Crowdfunding focuses almost exclusively on early-stage companies, limited by what campaigns happen to be hosted on platforms. But investing independently allows you to deploy capital across the full range of traditional and alternative assets – stocks, bonds, real estate, commodities, fine art, etc.

You can build a highly customized portfolio rather than crowdfunding’s narrow opportunity set.

3. Flexibility in Structuring Terms

Direct investors have more leverage to structure investment conditions favorable to their interests. This includes negotiating aspects like equity stakes, profit-sharing, board seats, voting rights, liquidation preferences, and other governance terms.

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Crowdfunding standardized structures leave little room for customization. The ability to craft bespoke investment agreements provides downside protection and higher upside.

4. Oversight Capabilities

Unlike passive crowdfunding backers, direct investors often gain oversight capabilities like board representation, advisory roles, and shareholder rights. This allows for protecting your interests through ongoing monitoring and strategic guidance.

If the venture underperforms or pivots, you have the influence to help correct course. Crowdfunding investors cede control once their campaign contribution is made.

Disadvantages of Investing On Your Own

However, investing on your own also has some challenges:

1. High Costs of Diligence and Deal Sourcing

While performing your own diligence is advantageous, it comes at a significant cost. Proper due diligence requires hiring legal counsel to review documents, auditors to analyze financials, industry experts for technical assessment, etc. These professional services quickly become expensive.

There are also search costs associated with identifying quality investment prospects in the first place. This can involve extensive networking, research, informational interviews, and attending industry events to source deals.

2. Substantial Time Commitment

Beyond initial due diligence, actively monitoring and managing investments once made requires a deep ongoing time commitment. This includes things like reviewing quarterly financials, providing strategic and operational guidance to management teams, assessing new investment rounds, negotiating exits, and otherwise steering the investment.

Most crowdfunding investors take a fully passive role after making their initial contribution. Hands-on investing demands considerable attention.

3. Lack of Diversification

When investing your own capital independently, it is challenging to achieve sufficient diversification. Unlike crowdfunding’s micro-investments, direct capital deployment requires writing larger checks, often $50,000 to $500,000 minimum.

Building a portfolio across enough private companies requires having both substantial investable capital and deal flow access. Concentration in just a few investments amplifies downside risk if they underperform.

Conclusion

In summary, both crowdfunding platforms and independent investing have pros and cons. For investors who want to take an active role and have the capability to assess opportunities, independent investing may be preferable. But for those with limited capital and experience, the accessibility and community of crowdfunding make it an intriguing option.

Combining the two approaches can also help expand prospects while managing risk. As with any financial strategy, one’s own resources and risk tolerance should dictate the ideal balance between crowdfunding and direct investment. Learn here more about investing and passive income tips.