Venture capital vs crowdfunding: What’s the right call for your business?
- •What is venture capital, and what is its background?
- •How do venture capitalists work?
- •Pros and cons of venture capital
- •What is equity crowdfunding?
- •How does crowdfunding work?
- •Pros and cons of equity crowdfunding (ECF)
- •Examples of crowdfunding
- •Venture capital vs crowdfunding
- •Contact Airwallex to streamline your finances
Most start-ups think that venture capital (VC) is the best source of funding available to them. But it may not always be right for your type of business. Crowdfunding is also a viable option.
Whether you’re scaling up to access more resources or you want a buffer for future growth endeavours, there are several reasons your start-up may need to secure more funding.
Here, we’ll take a look at the two most common methods of raising financing: VC and equity crowdfunding (ECF). VC is a traditional source of funding that provides you with large sums of capital from a few sources. But ECF has grown in popularity and provides modest amounts of funding more often than you’d receive through VC.
Depending on your start-up and its financial needs, one may work better than the other. Let’s dig into why.
What is venture capital, and what is its background?
First, let’s discuss the history of VC.
A little background
VC is a subset of private equity (PE). The roots of PE go back to World War II.
Georges Goriot, a Harvard Business School professor, is considered the father of venture capital. He founded the American Research and Development Corporation (ARD) in 1946 and raised over USD3.5 million in funding to invest in companies that created commercially saleable technology during the war.
Goriot’s first investment was USD200,000, which he put towards an X-ray technology company that treated cancer. Once the X-ray business went public in 1955, his original investment ended up growing over USD1.8 million.
What is venture capital?
VC is a subset of PE. It’s a type of financing that investors provide to start-ups and small-to medium-sized businesses (SMBs) that have the potential for long-term growth. Providing VC to businesses considering expansion is also relatively common.
VC typically comes from investment banks and other financial institutions that scout small, young businesses (i.e. start-ups) with potential that need financial help.
VC funding doesn’t always take a monetary form. Your start-up can also receive ‘help’ in a technical or managerial sense. But the bottom line is that providing VC is typically set aside for start-ups and small companies that have highly recognisable growth potential.
Investors also provide VC to companies on the verge of expanding. Such companies will likely start bringing in a substantial amount of capital that will eventually pay back investors.
Although it’s always a risk for investors to fund small businesses (or unknown start-ups), it supports their next endeavour — whether that’s growth or expansion. And those endeavours will likely lead to better profitability.
So, businesses without access to bank loans, capital markets or other monetary sources to fund their operations will typically seek out means through investors. The main downside to VC is that investors usually get equity.
In other words, they own a portion of your company and therefore have a say in the business decisions you make. We’ll explore that a little more later.
How do venture capitalists work?
VC firms establish independent limited partnerships with businesses. In an average deal, businesses seeking funding will distribute or ‘sell’ large portions of the business to a few investors through independent limited partnerships.
Sometimes these partnerships include similar enterprises. In this case, a venture capitalist or VC firm might invest in a particular idea that these small businesses pursue.
However, the greatest difference between VC and other private equity deals is that VC focuses on new businesses that need first-time funding. PE typically focuses on more established, larger companies. PE deals might seek an equity infusion or even a chance for a start-up’s founders to transfer their ownership.
What is the venture capital process?
The first step for any business seeking VC is to create a business plan and submit it to a VC firm or an angel investor. However, the difference between an angel investor and a venture capitalist is that an angel investor is generally an affluent person who invests their own money.
A venture capitalist is usually employed at a firm that invests with risk capital. This means it invests other people’s money rather than its own.
If the investor is interested in the proposal, then they’ll typically thoroughly research the company. This means investigating the start-up’s business model, products and services, management, operating history and more to determine whether it’s worth investing a great deal of money into.
Many investors, both venture capitalists who work at firms and angel investors who work independently, have background experience as equity research analysts. They do so most often through a particular industry, such as healthcare.
So their research into your start-up doesn’t involve deciding whether they think your business has a ‘good idea’. They look into whether your company will realistically see growth, profitability and expansion.
In other words, if you do well, then the investor does well. So, they look for start-ups with a high potential of performing well in a particular industry.
Once diligent research is complete, the firm or investor proposes a pledge. This pledge is a certain amount of capital they’re willing to invest in exchange for a portion of your company (i.e. equity).
They provide the funds either as one large, individual sum or in rounds. Distributing capital through funding rounds is most common. Once the investor or firm begins distributing funding, they take an active role in advising the company.
By advising and monitoring the progress of the start-up, firms can steer their ‘investment’ in the right direction for a better chance at growth. The firm might also want to see progress and success markers before releasing any additional funds.
Once the start-up has performed well over a period, the investor or firm then exits the company. They’ll initiate a merger, acquisition or initial public offering (IPO).
Pros and cons of venture capital
Let’s look at the pros and cons of VC to determine whether it’s a suitable route for your business.
Venture capital pros
Your start-up will access a large sum of capital in a short period.
VC firms have substantial experience investing in start-ups, so your business has a better chance of growing.
Your start-up gains prestige and credibility if a notable firm decides to invest in it.
Venture capital cons
A very small amount of start-ups receive VC, so if you do, you’re part of an exclusive club — but it’s certainly difficult to get there.
Your investor or investor firm will pressure your start-up to perform well. This might be the push your start-up needs to see growth, but it puts stress on your business model, founders and employees.
You lose control over your business. You won’t lose all control, but venture capitalists seek out terms that are most advantageous to them, often at the founders’ expense. They often force out company founders if the terms aren’t ideal for a long enough time.
What is equity crowdfunding?
ECF involves receiving numerous small amounts of money from many people to fund your start-up.
How many people you can access depends on the extent of your network. If your network is big, you can easily access many people. But even if your network is on the smaller side, many crowdfunding websites and social media platforms bridge the gap between entrepreneurs and investors.
So through crowdfunding, smaller-scale start-ups can expand their pool of investors beyond relatives, founders, owners and venture capitalists.
How does crowdfunding work?
Most jurisdictions have restrictions on who can fund start-ups, as well as how much they’re allowed to contribute. These restrictions are similar to those of hedge fund investing.
Putting regulations in place protects non-wealthy and generally naive investors from putting too much of their money into a start-up that may or may not do well. If an unsophisticated investor puts all their life savings into a start-up that ends up failing, it’s detrimental to that person’s future and financial stability.
Many businesses fail, so it’s reasonable to have restrictions in place.
However, this doesn’t mean that it’s difficult to raise money from crowdfunding. It’s still a viable way for entrepreneurs to find the capital they need to grow. Your start-up has the potential to raise hundreds to millions of dollars. Crowdfunding is a great opportunity, as long as you have a great business idea and a convincing pitch for waiting investors.
However, crowdfunding sites receive a portion of the funds you raise.
[Related: How to calculate opportunity cost]
Types of crowdfunding
There are two traditional types of crowdfunding. Start-ups seeking help via capital funding to bring their product or service to life is one type. People who are dealing with some sort of emergency, such as a natural disaster, medical expense or tragedy (e.g. house fire), do the other.
However, creatives — including writers, artists, musicians and podcasters — also use crowdfunding platforms to help sustain their professional and personal lives. These creative lines of work often don't have steady or stable sources of income. So, crowdfunding is a feasible solution for those needing or offering financial help.
Pros and cons of equity crowdfunding (ECF)
Let’s look at some of the pros and cons of ECF.
Pros of crowdfunding
Start-ups will typically offer common shares (i.e. non-voting) that allow founders to maintain control over their business rather than let investors dictate how founders carry out operations.
Crowdfunding also helps start-ups gain hundreds to thousands of investors who likely later become customers. Many of them also become champions of the brand, which in turn, increases word of mouth.
Crowdfunding also allows start-ups to constantly raise money rather than receive it as one large individual sum or in small gradual sums from investors.
Cons of crowdfunding
Start-ups don’t have any certainty regarding whether they’ll meet their funding goal. When working with a VC firm, they’ll provide the amount of money that you propose you need. However, crowdfunding might not fully add up to what you need.
All money given to start-ups through crowdfunding is public, so your financial reporting will be very transparent. It should always be transparent, but crowdfunding guarantees everyone involved knows when, from whom and how much you receive.
Your crowdfunding campaign typically has marketing costs through the platform you use. You’ll likely also have to pay legal and accounting costs.
Examples of crowdfunding
Here are some popular examples of crowdfunding sites:
Kickstarter: A platform that helps in bringing creative projects to life including film, music, theatre, art, photography, design and more.
GoFundMe: An American for-profit platform that helps raise money for life events including funerals, illnesses, accidents, graduations, schooling and more.
IndieGoGo: A platform that helps in raising funds for innovative ideas, charities and start-up businesses.
Patreon: A membership platform providing content creators with business tools to run a subscription service to earn a monthly income. In return, subscribers earn perks.
Substack: A platform providing payment, analytics, publishing and design help to support e-newsletters received by subscribers. Writers can send e-newsletters directly to subscribers.
Oculus VR, for example, raised crowdfunded capital on Kickstarter in 2012. The start-up specialises in virtual reality (VR) software and hardware products, such as VR headsets for gamers. The founders’ original goal was to raise USD250,000, but they managed to secure USD2.4 million. Four years later in 2014, Facebook (now Meta) acquired Oculus for USD2.3 billion in both stock and cash.
Another successful Kickstarter campaign was for M3D, which manufactures micro-3D printers. The founders were able to raise USD3.4 million for their product in 2017.
And now, you can find their printers anywhere — from Amazon to Staples to Brookstonne and more. No other Kickstarter campaign has raised an amount that high over a 30- or 60-day period.
Venture capital vs crowdfunding
Now that you know the differences between VC and ECF, let’s directly compare the two by examining their key distinctions.
Your control over your start-up
Raising capital through ECF is better for entrepreneurs because doing so gives them more control. Giving up board sets isn’t ideal, which is what often happens when raising VC.
So, if you choose to raise a large individual or a few sums of capital via VC, be ready to accept any terms that your investor proposes concerning your business model and operations. If you choose to raise money via crowdfunding, expect to receive small amounts of capital spanning many investors and to maintain full control over your business.
Your investment network
The value of your start-up (i.e. the product and service you sell) will increase alongside the higher number of buyers, sellers or users you have. This is the ‘network effect’.
With ECF, any person who participates in your crowdfund will essentially increase in value because the network effect creates a positive feedback loop. Your returns will likely increase the bigger your network is.
The network effect isn’t achievable through VC because there isn’t a network attracting another network.
Your business model criteria
VC firms have particular criteria they use to determine what and whom they want to invest in. These criteria are generally much stricter than on crowdfunding sites. Crowdfunding sites allow you to raise small amounts of capital from several sources, but a venture capitalist or their firm will be highly involved in your business, both time- and money-wise.
With crowdfunding, all you need is a story compelling enough to convince people to invest in your business. With VC, you need much more than a good story. You need adequate proof that your business has the potential to grow.
Your investment deal
VC has been around for decades, while crowdfunding is a fairly new phenomenon. Currently, there are many more VC investments than there are ECF campaigns. But analysts don’t expect the situation to stay that way.
In fact, analysts expect crowdfunding campaigns to grow in popularity because their use tripled in 2020.
Start-ups that are more focused on their social impact are better off raising money through crowdfunding sites. Many investors on crowdfunding sites look for campaigns where their money can make a true difference in the world, such as with the environment or healthcare.
VC traditionally funds businesses looking to make a profit — and not a small one, at that.
Contact Airwallex to streamline your finances
Whether your start-up has received funding through VC or ECF, you need a reliable way to manage your money.
So no matter where your funding comes from, you can make sure more money remains available for your business endeavours rather than lost in translation.
If you’re ready to streamline your finances and improve your profit margins, don’t hesitate to sign up today.
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