What is Crowdfunding and How Does It Work: A Complete Guide

If you’ve ever wanted to start your own business or raise funding for a special project, then you’ve probably heard of crowdfunding. With over $1.41 billion raised globally just in 2023, it’s definitely worth knowing about. But what is crowdfunding and how does it work?

Whether you’ve heard about it before or not, this comprehensive crowdfunding guide will teach you everything from A-Z about crowdfunding. You will learn what crowdfunding is exactly, what benefits and risks it comes with, and what types of crowdfunding there are. Plus, we’ll mention some crowdfunding platforms so that you can get started on your own project.

What is Crowdfunding?

“What is crowdfunding?” A short definition would be “a method of raising money from a “crowd” of people.” In return, the investors, otherwise known as backers, receive rewards or even equity in the project or company. Sometimes, the backers also contribute to campaigns in the form of donations, receiving only the kind words of project owners in return.

Crowdfunding campaigns almost always have a goal amount and a deadline for the end of the funding period. They feature a bar chart showing the progress and amount of money raised at any present moment. Whether you reach the goal or not, campaigns always last for the duration of the funding period.

Ultimately, any entrepreneur with a good idea could raise it through crowdfunding. Beware of the standard regulations. Some platforms also require thorough checks and qualifications if you want to be featured on their platform. In any case, if you’re not a scammer or raising for illegal activities, you’ll be good to go. Also, keep in mind that crowdfunding usually works best for new tech gadgets, independent books, and new inventions in general.

There are 4 main types of crowdfunding, but before we choose which is best for you, let’s discuss some benefits and risks of crowdfunding.

Benefits of Crowdfunding

Crowdfunding is a favorable funding option for startups and genius projects that need to get off the ground. Even though it has minor risks, they are definitely worth taking. To truly understand what is crowdfunding and how does it work, you must know its main benefits. If you’re still debating it, here are some cool benefits you can get.

Idea validation & feedback

Crowdfunding is not simply a way of raising funds but also an amazing tool for understanding whether there is demand for your product. One of the most common reasons that cause startups to fail is building a product nobody wants, so you should validate your idea before going all-in on it. If the response from potential backers is promising, you will be more confident knowing that it’ll work.

Crowdfunding platforms also allow you to receive feedback from backers. There’s a chance that they could suggest an additional feature or a modification in the product that makes sense for you. Listening to your customers is essential to your success, and crowdfunding gives you that channel.

Raising awareness & exposure

Crowdfunding platforms like Kickstarter or IndieGoGo often feature well-performing campaigns on their landing page, giving them exposure to millions of new visitors. These people come to such sites to discover new and amazing products, and your project could be the one they fall in love with. Often, visitors to crowdfunding platforms or previous backers of other projects are early adopters of new tech gadgets. So, you can create a buzz and build a name for yourself in those communities.

Build a community around your project

Convincing potential backers to invest even a small amount of money into your project is not easy. You, as the creator, must inspire and excite them about your product. If you succeed, you’ll be able to create a community of loyal customers and backers around your product. This means they won’t only invest in you but will also become advocates and spread the word about your cool project.

Platforms allow you to post updates about your progress and let your backers in on the process. This way, they’ll be more invested and excited about your product.

Raise funds and generate pre-orders

Let’s not forget about one of the biggest benefits of crowdfunding – the funding system. Ultimately, you’ll get investment from people who clearly want your product and will buy it in the future. In return, you have to simply keep up your promise and create the product. Of course, the benefits vary by type, but the whole nature of crowdfunding lies in trust and an absolute belief in the product. We will discuss the types of crowdfunding, along with their pros and cons, later in this article.

Risks of Crowdfunding

Now that you know the main benefits of crowdfunding, it’s time to talk about the other side of the coin. If you’re still asking yourself “How does crowdfunding work?” learning about its risks will help clear some things up. Whether you want to raise funds for your project or want to back a project, here are some risks of crowdfunding to keep in mind.

What happens if you don’t reach your goal

To answer this question, you must know about the 2 types of funding that crowdfunding platforms offer – fixed and flexible.  With fixed funding, the project owners only receive the raised funds if their goal is reached. If a campaign doesn’t meet its goal, they don’t receive any funds but doesn’t need to pay any fees. In the case of flexible funding, the campaign owners receive funds regardless of whether they reach the goal. Payments happen periodically, but platform fees must be paid in any case.

If you don’t reach your goal with fixed funding, the funds are simply returned to the backers. However, if you’ve chosen to go with flexible funding, you are obligated to keep your promises to those who already backed you. This is a key nuance you should know when learning how to do crowdfunding.

Fixed funding is a safer option for both backers and project owners since neither has anything to lose. If you have a minimum amount needed to start production, go for this option. On the other hand, if you’re raising for a charity or a cause, the goal amount doesn’t have a crucial meaning.

Raise only funds, no expertise from investors

When raising funds through traditional ways, you deal with individual investors who play bigger roles in your project. Most of the time, investors will not only provide a startup with funds but will guide the team behind it to bigger success. With crowdfunding, you are dealing with many investors but smaller amounts of money. Ultimately, you don’t receive any special expertise from your backers.

Crowdfunding gives you an easier way to raise funds by taking small amounts of money from a larger number of people. You don’t have to convince investors to go all-in on your product. This is one of the bigger risks of crowdfunding for startups or newcomers to entrepreneurship, considering that nobody will hold your hand throughout the process.

The product might not get rolled out

If you are backing a product, the risk of it not getting rolled out is always there. If you’re backing a project that’s already reached its goal, you can be less worried about this risk. In any case, issues other than funding can also stop a product from getting manufactured and launched into the market. As a product owner, it is your responsibility to ensure that you live up to the backers’ expectations and deliver what you promised.

Types of Crowdfunding

The funding system features different types of crowdfunding, each fit for a different type of project. From donations all the way to equity-based funding, let’s talk about the 4 main types of crowdfunding. If you’re unsure which one fits you best, we will also discuss their pros and cons to make your choice easier.

1. Donation-based crowdfunding

The first type of crowdfunding is self-explanatory. This type relies on the altruism of people who will donate out of the good in their hearts. Usually, such campaigns are dedicated to a charity or a cause. The range of such projects is very wide. So, to put this into perspective, imagine that it can be someone raising funds to pay for their tuition or to supply food for the homeless. The key point is that these campaigns don’t offer anything in return to their investors other than kind words and karma points.

On average, such campaigns raised $499.33 billion in 2022 in USA only.

Donation-based crowdfunding can be your best option if you’re raising funds for a community project, a personal need, or just something you care about.

• Pros

You rely on people’s kindness, so you don’t need to give anything back to your investors. Such campaigns are seeking real help.

• Cons

Since backers don’t receive anything in return, they will donate a smaller amount of money. So, this crowdfunding type doesn’t work well if you have an extremely large goal.

2. Debt-based crowdfunding

Debt-based crowdfunding, or peer-to-peer lending, is essentially an alternative banking system. Using this type of funding, you are asking a larger number of people for a smaller amount of debt. In return, your lenders receive a binding agreement stating that you’re obligated to pay them back. Whether you offer an interest rate is up to you, but it’s clearly an incentive for potential lenders.

Such campaigns last for about 4-5 weeks. If you’re thinking of raising money through debt-based crowdfunding, don’t forget to give your lenders a time frame of when you’ll pay them back.

• Pros

There is no need to wait for loan approval from a bank since transactions are done online and faster. Interest rates are not as high as bank loans, plus payment deadlines are on your own terms.

• Cons

At the end of the day, it’s still a loan that you have to pay back.

3. Reward-based crowdfunding

The reward-based system is the most common type of crowdfunding for startups and million-dollar projects. It’s similar to donations, but with reward-based funding, the backers receive a reward in return for their investment. Rewards are divided into tiers based on the Kickstarter pledge amount. The higher the investment, the better the reward. For example, if you invest $75, you can get the product once it launches, but if you invest $300, you’ll get a ticket to the launch party on top of the product.

Reward-based crowdfunding campaigns give the possibility to acquire unimaginable amounts of funding for startups with different marketing tactics. You can offer exclusive deals, secret perks, and post updates to keep backers informed and excited. Implementing an email marketing campaign to nudge potential backers towards finally pledging would also be smart.

If you really want to create a million-dollar campaign, you should leave it to the pros to make it happen. Professional crowdfunding agencies take full control of your campaign and lead it to greatness through effective PR and marketing campaigns. At TCF, we have extensive experience and secret tricks for launching million-dollar campaigns. If you have a genius idea, we want to hear it!

• Pros

You are not just raising money. You are building up a customer base who may later become advocates for your product. Plus, it makes sense for the backers, so you can raise well above your goal if your product is actually cool.

• Cons

After successfully completing your goal, you must live up to your promises and ship out those rewards.

4. Equity-based crowdfunding

This last type is the most similar to traditional forms of raising funds for products or projects. It allows campaign owners to give out shares of their company to backers in exchange for their financial investment. Since company shares become valuable if the company succeeds, you can set a minimum pledge amount of thousands of dollars. Plus, you’ll have investor caps to control the number of shares you give.

Since companies don’t need to go public anymore to give out shares and can simply do it online in many countries, equity-based crowdfunding has become the fastest-growing type of crowdfunding.

• Pros

You don’t need to give any immediate returns to investors, and you’ll be able to raise a larger amount of money. If you have experienced investors, they may mentor you through the process of launching.

• Cons

Giving out equity means you’re indefinitely selling a part of your company.

Crowdfunding Platforms

The last step in knowing how to crowdfund is understanding the popular crowdfunding platforms. Since so many of them exist, we’ll divide them into categories according to their types. The most popular crowdfunding platforms you’ve probably heard of are IndieGoGo, GoFundMe, and Kickstarter, but they might not be the perfect ones for you. If you’ve narrowed down which type your project fits into, it will be easier for you to choose which platform you should use.

• Donation-based crowdfunding platforms

Since donation-based campaigns are the best fit for personal causes or charities, a flexible funding model will work best. The most popular platforms that feature flexible funding for nonprofit campaigns are GoFundMe and IndieGoGo.

• Debt-based crowdfunding platforms

This type of crowdfunding requires its own system, so popular crowdfunding platforms may not feature this type. Luckily, there are platforms that specialize in it. If you’re looking to raise money for your business through debt-based crowdfunding, Funding Circle and LendingClub will do the trick.

• Reward-based crowdfunding platforms

Since this is the most widespread type of crowdfunding, many sites are dedicated to it. The most popular ones include IndieGoGo, Kickstarter, and Patreon.

Also, remember that you can collaborate with a crowdfunding marketing agency to get the most out of your reward-based campaign.

• Equity-based crowdfunding platforms

Since giving out shares of your “non-public” company is not legally allowed in many countries, you’ll have to make sure that this is a viable option for you before going into it. If your country’s laws permit, you can use platforms like Republic, SeedInvest, or Wefunder to raise funds in exchange for equity in your company.

Final thoughts

If you’ve ever asked yourself how does crowdfunding work, this short guide will teach you all you need to know.

There are thousands of crowdfunding platforms worldwide where you can start your dream project. If the benefits of crowdfunding have enticed you and you’re ready to take small risks, crowdfunding can get you off the ground. Millions of early adopters are waiting for your invention.

Find the type your genius project fits into, choose the right platform, get the help of a crowdfunding agency, and run your million-dollar campaign.