Startups are the key economic unit of the 21st century. Investors and governments all scramble to find and nurture the next Amazon, Bytedance, Canva, or Stripe. But startups are turning to new sources for pre-seed funding. Pre-seed funding has gone social media (crowdfunding) and blockchain (STOs).   

In this post, we look at what crowdfunding and STOs are and which one best suits your company.

WHAT IS CROWDFUNDING?

Crowdfunding is a way of raising money for a company or project from a large group of people using an online social platform. Each person in the crowd provides a small amount. This contrasts with traditional finance such as equity, bonds, or bank loans where large amounts of money are raised from a small group of people or organisations. It is the difference between filling a jar with sand versus filling it with golf balls.

The online social platform part of the equation is key because it enables groups of companies or projects to find people willing to fund such companies or projects. It is what economists call a two-sided market. A stock exchange is also a two-sided market, while a bank is a one-sided market. You have to go to the bank. Bank managers are not out visiting coffee shops looking for you!

The internet is the enabling technology for crowdfunding. It makes it easy to create a two-sided market that connects people and companies from around the world. Funders and founders no longer need to meet or use an intermediary, they can connect directly with one another online. 

The History of Crowdfunding

The term was coined in 2006 by Michael Sullivan for his video blog funding startup. But one of the earliest examples of crowdfunding predates this. British crowdfunding platform JustGiving was founded in 2000 to help raise money online for charities. 21 years later, it has raised over $6 billion for over 450,000 charities worldwide.

The first crowdfunding platforms that you probably heard of were IndieGoGo (founded in 2007) and Kickstarter (founded in 2009).

Crowdfunding took off after the 2008-09 global financial crisis. When liquidity from traditional finance dried up, entrepreneurs began to look for new sources.

Crowdfunding quickly became popular for raising money for specific products like gadgets such as Pebble and board games such as Exploding Kittens.

But soon startups saw an opportunity, and in 2012 the Obama administration introduced the Jumpstart Our Business Startups Act which legally allowed startups to raise $5 million a year from crowdfunding.

Today, the crowdfunding industry is estimated to be worth around $17.2 billion.

HOW DOES CROWDFUNDING WORK?

As a company, you look for a platform that caters to companies like yours with a good track record and price.

Crowdfunding platforms typically charge a percentage fee from the amount raised. That fee can range from 1 to 5 percent. They also charge a payment processing fee for each contribution. This can be a flat fee or a percentage of the transaction. 

Most crowdfunding platforms use a dollar target model. You set a dollar target for the amount of money you want to raise, and you only get the money if you meet the target. Most platforms also apply a deadline. Both are a form of positive social pressure that helps create a sense of urgency for companies and funders.

Just as important as the money side are the marketing and CRM services the platform provides you with to find and connect with funders. Platforms provide an online space for you to tell your story with words, pictures, and video. They also provide a search engine so interested funders can find you. Lastly, they provide a messaging service and database so that you can communicate and keep track of your funders. 

THE DIFFERENT TYPES OF CROWDFUNDING

These are the main types of crowdfunding:

Peer-to-Peer Lending

Money lent in return for repayment and interest

Reward-Based Crowdfunding

Money donated with expectation of receiving a good or service at a future date.

Donation-Based Crowdfunding

Money is donated to a charity, company, or individual with nothing expected in return.

Equity-Based Crowdfunding

Money provided in return for an equity stake. Equity can take a form of preferred or common stock but typically comes as basic convertible notes that can be converted into future stock, for example SAFE and KISS convertible notes. Legal requirements need to be met.

Profit Sharing / Revenue Sharing

Money provided in return for a share of a company’s profits or revenue. Often this is limited to a total dollar amount or a fixed time period. Legal requirements need to be met.

Debt Securities

Money provided in return for a debt instrument issued by the company. Legal requirements need to be met.

PROS AND CONS OF CROWDFUNDING

The Pros

• The allure of crowdfunding is the ability to connect with a larger number of potential funders and to raise more funds than you otherwise would be able to. Without crowdfunding, many startups would be reduced to relying on friends, family, and fools for pre-seed funding. 
• Crowdfunding also allows you to quickly and accurately validate your product. Validation is a key part of the lean startup model. And if you hit upon a good product-market fit, you have the advantage of ready-made customers.
• Crowdfunding can also help you build up a loyal fanbase who will evangelise your product for you.
• Crowdfunding also provides an alternative to traditional financing.

The Cons

• If you don't meet your crowdfunding target, you don’t get your funds and your crowdfunding reputation can take a hit.
• It takes time and effort to build up the foundational fanbase for a successful crowdfunding campaign.
• If you haven’t protected your idea with a patent, copyright, or trademark, someone could steal your idea or branding.
• With reward-based crowdfunding, companies sometimes over-promise, leading to losses or calls for more funding from contributors.

HOW TO RUN A SUCCESSFUL CROWDFUNDING CAMPAIGN

Preparation, presentation, and good communication are the keys to running a good crowdfunding program.

Many successful crowdfunders recommend building up a following before you start your crowdfunding campaign. Use social media and your professional network to spread the word and garner interest. If you leave this foundational work until you start your campaign, you may run out of time.

Presentation helps you stand out from your crowdfunding competition. While visuals are always important, so is the story around your product and brand.

Once you have your crowdfunding campaign up and running, maintain clear and regular communication to evangelise your funders and attract new funders.

WHAT IS AN STO?

STO stands for Security Token Offering. STOs use blockchain technology and smart contracts to take crowdfunding and equity to the next level. Instead of making a promise on a crowdfunding platform or issuing shares in an IPO, a company can issue a security token.

A security token is a digital token that provides rights to an asset or its revenue or profit. 

The token is a uniquely identifiable set of code that is stored on a blockchain, a special type of database that records who owns each token or fraction of a token. The blockchain also provides a complete history of transfers for each token. 

The code on the blockchain is encrypted with Public Key Infrastructure (PKI). PKI through the use of public and private keys are also used to verify ownership of tokens. Users store their private keys in a digital or hardware wallet.

Unlike traditional share certificates or an entry in an electronic registry, a security token can be programmed with a smart contract. A smart contract is a program that automates payments and rights for holders of the tokens, removing the need for middlemen like transfer agents and custodians.

THE (SHORT) HISTORY OF STOS

The first STOs emerged in 2017. They took the promise of the ICO boom and added regulatory protection and oversight. Security tokens are considered transferable securities in many jurisdictions, including North America, the EU, Japan, Singapore and Switzerland. 

The first-ever SEC approved STO occurred in May 2021. It raised around $85 million from over 7,200 investors. The SEC’s Regulation A allows companies to raise up to $75 million with fewer requirements than an IPO.

A recent report estimates that the market volume of security tokens in Europe will reach €918 billion by 2026. 

HOW DO STOS WORK?

Companies need to create a prospectus for STOs in accordance with their local regulations. But the requirements are generally less than that of an IPO.

Companies then use a service provider such as STOKR to build a campaign for the STO and to issue the token.

Once issued, holders can transfer the security tokens peer-to-peer or through selected secondary exchanges. 

WHAT ARE THE DIFFERENT TYPES OF STOS?

STOs can be used to issue equity stakes in a company. They can also be used to issue revenue or profit-sharing arrangements. STOs can also be used to issue debt instruments.

PROS AND CONS OF STOS

The Pros

• They are much cheaper and faster to implement than an IPO, but have similar regulatory protection. An STO can be organised within three months and with standard legal structures and token architecture can cost as little as €50,000.
• They are recognised as securities by several regulators and thus have regulatory protection.
• Storing security tokens on blockchains provides a complete audit trail of changes in ownership and can be seen by everyone on the blockchain.
• Security tokens are pseudonymous. This means that if you are discrete, only you and the token issuer know about your holdings.
• Smart Tokens provide better compliance and scalability for holder’s rights.
• They allow for fractional ownership.
• They can be traded 24/7.

The Cons

• The secondary market is shallow and still developing.
• While cheaper than an IPO they are more expensive than some other fundraising methods and are not cost effective for small amounts of funding.
• Issuing an STO is relatively complex and generally requires the assistance of a service provider.
• They are not yet well understood by the general public but this will change!

CROWDFUNDING VS. STOS

Advantages of an STO

• STOs are cheaper than crowdfunding for large amounts. This is because most crowdfunding platforms charge a percentage fee on the amounts raised. A 5 percent fee on $5 million is $250,000. STOs cost between €50,000 to €200,000.
• Regulatory protection from being a transferable security in several jurisdictions.
• More easily transferable and transparent than rights secured on a crowdfunding platform.
• More likely to attract larger investors.
• Smart contracts make registry activities more scalable.
• Companies can raise up to $75 million using an STO in the US. With crowdfunding, companies are restricted to $5 million annually.

Advantages of Crowdfunding

• Cheaper than an STO for small amounts e.g. less than $5 million.
• Easier to set up and execute.
• Easier to find large numbers of small and loyal investors.
• Provides a quick way to validate your product.
• Helps you build an early customer base.

FINAL THOUGHTS

Crowdfunding and STOs are funding tools for a new century. Crowdfunding allows companies to take funding to the masses. It provides a much needed new option for the pre-seed phase. For startups selling a limited release of a product or service, crowdfunding provides simple product validation while also helping build a loyal customer base. STOs allow companies to raise serious money without the cost and hassle of an IPO. For amounts larger than $5 million, STOs provide a better and more scalable option for startups. 

STOKR TEAM