Crowdfunding platforms allow entrepreneurs to use their social networks more effectively by reaching out to a large number of their connections electronically. In some cases, the platforms even allow the entrepreneur to raise funds from people they don't know by allowing them to offer payment in something other than stock.

A Bigger Network

Historically fundraising from friends and family has been the most consistent way new companies raised startup capital. These amounts were typically relatively small, but were easy to come by.

Crowdfunding takes this model even further. By creating a system to support the raise amongst friends and family, an entrepreneur has the opportunity to be more efficient with referrals and other networking techniques that can allow their network to be extended much farther.

With the advent of social networking, many entrepreneurs now have digital networks that extend across hundreds of connections, and sharing their investment opportunity is easier than ever. Crowdfunding takes these networks and activates them for a capital raise.

Who Uses Crowdfunding

Technically anyone can use a crowdfunding model to raise money, but it tends to be most attractive to businesses that don't fall within the traditional funding buckets. For example, if you're looking to raise $10,000 to help finance a book you'd like to publish, a crowdfunding model makes a lot more sense than trying to locate an angel investor.

That's because most investors are looking for the same types of investments in things like software, Internet services and bio-technology. At the same time traditional lenders are looking to finance assets like buildings and equipment, not personal endeavors like a book.

As a result, crowdfunding appeals to folks looking for a smaller amount of funding in a deal that is most likely to appeal to the masses before it appeals to professional investors.

Legal Issues

There are inherent challenges in the crowdfunding model, not the least of which is the legal issues surrounding selling stock publicly - that's what the federally regulated stock market is for.

Crowdfunding platforms try to work around this legal issue in a few novel ways.

Some limit the people that you can raise money from to friends and family, using their platform as simply a way to organize your fundraising effort. In this case there is an argument that you are not publicly raising funds but are doing so through pre-existing relationships. It's a little bit of a gray area since the definition of pre-existing relationships is not 100% specific.

Other platforms avoid the issue altogether by simply not allowing you to sell stock at all, instead offering various other benefits toward making an investment, such owning a copy of the product the company might produce. In this case it's just a clever form of sales and marketing.

Practicality

While crowdfunding can be a great way to create startup capital for companies, it still requires one thing - having an idea worthy of attracting dollars. Not every idea is immediately tasty to prospective investors, no matter how small the asking amount may be.

Additionally, entrepreneurs may suffer from having too small a network to begin with. You may be a college student whose social network doesn't meaningfully extend beyond other college students that are as broke as you are. We don't all have wealthy connections!

Crowdfunding therefore works best on ideas that naturally have broad appeal to lots of small investors whose collective funds add up to a meaningful amount of capital. For ideas that are less appealing to a mass audience, more traditional forms of capital may be a better fit.

Servicing the Masses

The other challenge in crowdfunding is that you're now dealing with a crowd. Dealing with one or two investors and their expectations of your relationships can feel like a full time job. Dealing with dozens of un-sophisticated investors (maybe hundreds) can literally be a full time job.

Think of your crowdfunding investors like a huge batch of new customers that you will need to service for a very long time with no additional payment likely. It's a big task, so make sure you're certain it's worth it.

Summary

Crowdfunding is a new space and while it's exciting, there are still lots of kinks to work out of the system. We haven't had to face too many Madoff-level scandals (yet) so the pushback amongst potential investors and of course regulators is still small.

In addition, the concept of managing a large mass of investors isn't very natural to people, so as entrepreneurs we are still figuring out how to manage these new customers after the deal is funded.

If your idea is something that isn't likely to attract traditional banks, angel investors or venture capitalists, crowdfunding is certainly a good alternative to explore.