Crowdfunding: how online capital raising works

Crowdfunding is a tool for raising capital online from a multitude of parties. Heir to a long series of "analog" versions of a centuries-old phenomenon that harkens back to the concept of the collection, it is only with its landing on the Internet in the 2000s that it has made the leap and gradually established itself as a true alternative finance tool.

Let's start with the basics to fully understand crowdfunding: meaning, origins, types, advantages and disadvantages, psychological and financial dynamics.

Crowdfunding: meaning

The English word crowdfunding literally means "funding from the crowd". This concept can be associated with different activities and operations from each other-that is why, for example, we devoted an article to the difference between fundraising and crowdfunding.

The distinguishing characteristics of crowdfunding in its essential meaning are three:

• Operation that takes place online.
• Operation involving a multitude of people.
• Transaction that aims to raise capital for a business, artistic, ethical-social or personal project.

Crowdfunding means going online, pitching a project to the crowd and raising money to fund it.

From this basis we can understand all the various forms in which crowdfunding takes and how and why it differs from traditional means of financing, such as banks.

Origins

In our article on the history of crowdfunding we trace in detail the stages of development and establishment of this type of operation from an informal arrangement to an officially recognized alternative finance tool.

Here we recall that crowdfunding was born out of a need that humans discovered very early on: that of increasing the resources available to them in order to achieve something bigger that they cannot achieve by their own efforts alone. Among the various solutions devised to meet this need, there was one that turned out to be particularly accessible and beneficial: looking for other people who could contribute to the purpose, so as to raise resources while sharing the risk.

The oldest and most rudimentary form of crowdfunding is the actual collection of funds among several people for a common goal, usually with social value. Today this practice has evolved into donation crowdfunding.

But there are also more complex rudimentary forms of crowdfunding, such as the raising of capital by Dutch explorers and traders who in the seventeenth century needed funding for their sea expeditions and began to each put their share into a single project and then split the proceeds proportionally to the share paid: it was the ancestor of equity crowdfunding.

The chronic lack of funding for art and culture, then, is not the prerogative of our time: although patronage has certainly known happier eras than ours, money for artists has often been lacking, and it is in this fertile ground that extraordinary works of art and the practice of reward crowdfunding have taken root. Funding an artistic-cultural creation by promising supporters that they will become a privileged part of it still proves to be a winning choice, one that has among its forerunners none other than Mozart, among others.

Finally, borrowing is perhaps the oldest form of financing of all. The idea of dividing the burden of a loan among several people, so that in the event of a borrower's bankruptcy it is not just one person who loses all the money lent, is actually quite trivial. We imagine, therefore, that it has occurred to several financial wizards in history, but the origins of lending crowdfunding are commonly traced to a charitable-inspired operation: the microcredit for poor families devised by novelist Jonathan Swift with his Irish Loan Funds in the eighteenth century.

The transfer of all these dynamics online, with the advent of the Web, has enhanced them and made them accessible to almost anyone, making true "bottom-up financing" possible.

Types of crowdfunding

The brief historical overview we have just seen brought out four main types of crowdfunding:

• Donation crowdfunding
• Equity crowdfunding
• Reward crowdfunding
• Lending crowdfunding.

Equity crowdfunding and lending crowdfunding are the only two true financial instruments because they result in an economic return on capital. 

Equity crowdfunding, in fact, is the sale of shares in the company to raise capital from people who thus become business partners in the company and acquire the right to share in the profits.

Lending crowdfunding, on the other hand, is the raising of loan capital from people who receive interest in return, in addition to the repayment of the loaned capital.

Those who participate in online lending and equity crowdfunding campaigns, therefore, make an investment, with the prospect of making a financial gain from it. This is why it is referred to as "crowdinvesting."

Donation and reward crowdfunding, on the other hand, are capital collections that do not provide financial remuneration for those who participate. Donation crowdfunding campaigns are for charitable purposes and do not involve any reward. Reward crowdfunding, on the other hand, is used to raise capital to realize a product or an artistic-cultural project and offers supporters a non-monetary but material reward in return, linked to the product or project to be realized.

Over the years, new types of crowdfunding have since emerged for the placement of other financial instruments: for example, Minibonds, Participatory Financial Instruments, and tokens.

Why crowdfunding

Let's go deeper into the topic of crowdfunding by trying to understand why this capital raising tool is making such a splash and is the subject of widespread interest.

There are two main reasons for this:

• Businesses have increasingly realized the need to diversify funding sources in today's complex, dynamic and fast-paced economic environment.
• the capital needs of startups and small businesses are increasingly struggling to be met by traditional funding channels.

With regard to investors or supporters who participate in campaigns, however, the following aspects should be noted:

• The desire for participation and involvement in what is behind the products we buy and the services we use has grown.
• The Internet has opened the doors of financial investment even to small savers and allows them to learn about projects otherwise destined to remain invisible.

From these dynamics we cannot exclude some distortions of reality that have in turn contributed to increased ’interest around crowdfunding’:

• The concept of "bottom-up funding" is often distorted into the myth of "funding for all," which creates in companies or aspiring entrepreneurs the illusion that crowdfunding is some kind of miracle that allows anyone to raise capital with ease. 
• The ease with which it is now possible to go online or open an app and invest money has spawned monsters such as trading portals with a playful aesthetic or improvised financial gurus who delude small savers into thinking they can learn to invest in a few clicks and become rich. The same goes for fundraisers, even charitable ones, bordering on scams.

The truth is that businesses should choose crowdfunding because it is a capital-raising and marketing tool that, when placed within a precise growth strategy and used with awareness, is more affordable and efficient than other avenues and can provide a leg up and an element of distinction from competitors.

The other truth is that users should choose crowdfunding because it is an opportunity to diversify their investments by supporting the real economy in the form of concrete, closely knowable business projects with potentially attractive returns but also a high level of risk. Or because it is an opportunity to make a difference by directly supporting artistic or charitable projects you believe in.

The key is knowledge of the crowdfunding tool: risks, benefits, rules and possibilities.

Who can do crowdfunding

Originally in Italy, equity crowdfunding was reserved for innovative startups, while lending, reward and donation crowdfunding were open to anyone, both businesses and individuals.

Today in Italy all LLCs and spas can do equity and lending crowdfunding campaigns, and the latter also takes the form of a consumer version for individual individuals, although this is not widespread. Remaining devoid of any specific limitation on access-save for the law-are reward and donation crowdfunding.

How online capital raising works: practice

How do you go about crowdfunding? Let's take a point-by-point look at the practical steps that apply to any type of campaign.

1: Prepare a detailed project presentation for submission to the chosen crowdfunding platform. This submission is more informal and free for donation and reward crowdfunding, more structured and obligatory for equity and lending, which require specific financial and legal documentation and some paperwork.

Crowdfunding platforms are the intermediaries that enable the matching of supply and demand for capital. In donation and reward crowdfunding they merely provide a "meeting place" and payment infrastructure, while in lending and equity crowdfunding they also have an important oversight and support role.

2: Pass platform screening. For donation and reward crowdfunding, admission is often automatic or the selection is very loose: it is enough that projects do not have illegal elements or are not suspected of being scams. For equity and lending crowdfunding, on the other hand, selection is strict: about 10-15 percent of companies pass it. Here are our tips for falling within this 10-15%.

3: Organize the marketing strategy and start implementing it to gather expressions of interest with precrowd, to build a following of potential supporters even before the campaign is launched.

4. Launch the campaign and continue the work started with the precrowd, leading to participation all the people already involved, stimulating word of mouth and continuing to implement the marketing strategy on multiple communication channels to reach the collection goal.

5. In case of success: wait for technical time for disbursement of the capital raised. In case of failure: reflect on the reasons for failure and work on them. For some campaigns (keep it all type), it is possible to receive the capital raised even if it is less than the minimum goal stated at the start.

6. Continue to keep the relationship with campaign supporters alive by cultivating the valuable community created.

How online capital raising works: psychology

A crowdfunding campaign is first and foremost a marketing operation by which the company tries to sell itself.

To raise capital from a multitude of people, made not – or not only – from finance professionals and experts in the company's sector, but from ordinary individuals, means you cannot rely solely on numbers, financial statements, business plans, and projections. It is essential to also focus on emotional persuasion, personal engagement, the sharing of ideals and experiences, and trust.

Giving your money to someone else is a difficult action, and convincing someone to do it online is even more challenging. To achieve this, it is essential to reach these preliminary goals:

• Clearly explain the proposal in every aspect by providing clear information not only about the company but also about crowdfunding. 
• Build a relationship of trust by encouraging direct interaction between users and the company's representatives. The entrepreneur or the entire team must put themselves out there.
• Provide concrete and immediately tangible reasons to participate in the campaign. The prospect of a potential (but not guaranteed) future gain, as offered by a lending or equity crowdfunding proposal, or a simple preview of a product, as offered by a reward crowdfunding proposal, is not enough. It is essential to present exclusive, certain rewards that are of definite interest to the target audience.

For all of this to work, it is crucial to target the right audience. Who might be interested in contributing to the success of a company or project and in receiving related rewards? First and foremost, it’s the customers or potential customers, or at least those who will benefit from it.

Lastly, there are two final, important psychological triggers to consider and leverage in order to make a crowdfunding campaign successful:

• “Full restaurant and empty restaurant,” “herd effect,” “social proof”—the same phenomenon can be described by different names. People are more likely to do something if others have already done it. This is why it's so important to launch the campaign only when you already have a following of supporters ready to participate and set an example for others.
• FOMO (Fear of Missing Out) usually applies to events or places, but it also applies to crowdfunding campaigns and their rewards. It must be insisted that Participating in crowdfunding is an unmissable opportunity coming up in a limited window of time. We need to make the rewards unique and exclusive by differentiating them between the most beneficial for those who join the campaign first and the least beneficial for those who arrive later.

Crowdfunding advantages

Everything explained so far highlights the advantages of crowdfunding, which we can summarize as follows:

• Alternative and more accessible funding channels compared to traditional ones.
• A more efficient marketing tool compared to traditional ones.
• Competitive advantage and visibility gained by using a tool different from that of competitors.
• Building a community of supporters, investors, customers, and other stakeholders.