It’s a difficult time for small business owners. As the coronavirus crisis has disrupted business operations, more banks are tightening their standards for lending, making it harder for small businesses to access crucial capital.
While the Coronavirus Aid, Relief, and Economic Security (CARES) Act established several temporary programs designed to provide relief to businesses during the pandemic, including a paycheck protection program and debt relief program, many businesses are still struggling. A Main Street America survey found that almost 7.5 million of the nation’s 30 million small businesses will be at risk of permanent closure within the next five months.
As a result, many small business owners are turning to crowdfunding. Both equity crowdfunding platforms and donation-based crowdfunding platforms have seen a surge in campaigns in recent months. And the SEC has loosened restrictions around equity crowdfunding, allowing eligible businesses affected by COVID-19 to access the money they raise sooner.
What is crowdfunding?
Crowdfunding is a way for businesses to raise small amounts of money from a large number of people to meet a fundraising goal in a short period of time. There are several types of crowdfunding:
- Rewards crowdfunding: The issuer provides rewards, such as VIP access to a product, in exchange for different pledge amounts.
- Equity crowdfunding: Investors provide capital in exchange for shares of the small business, which can later be converted to equity.
- Donation crowdfunding: Small business owners request charitable donations without offering anything in return.
- Debt crowdfunding: Business owners raise funds from peer lenders, which they repay over a specific term with a fixed interest rate.
The type of crowdfunding that is right for your business will depend on your goal. Donation crowdfunding might work well to manage cash flow issues during emergencies such as the pandemic, while rewards crowdfunding might work well for a product launch.
5 surprising truths about crowdfunding your business
- It costs more than you might expect
When all is said and done, a traditional small business loan may be less costly than launching a crowdfunding campaign. You can expect to incur expenses for the following:
- Platform fees: Rewards-based platforms often take a percentage of the total funds raised (usually about 5%) and also charge for payment processing. Equity crowdfunding platforms typically either charge commission or require a monthly fee, and additional fees can add up as well.
- Advertising costs: While sharing your campaign to your social network is a good start, you’ll need to reach more people if you want to meet your fundraising goal. Facebook allows you to set your own budget, but you’ll likely need to drop a chunk of change to see success. The average small business spends around $1,000 to $2,000 per month advertising on Facebook.
- Video and photography costs: High-quality images and videos that tell a story about your product or service come at a cost. If you need to hire a professional, expect to pay hundreds or even thousands, depending on what you need for your campaign.
- Manufacturing costs: If you’re building a new product, you’ll need to at least present donors/investors with your design for the product, if not a manufactured prototype. This can come at a high cost.
- You might have to pay taxes on your earnings
Depending on how you raise money for your business, you may face certain tax implications. Here’s what you can expect.
- Donation crowdfunding: Funds are considered nontaxable gifts
- Rewards crowdfunding: Funds are considered taxable business income, but the amount can be divided into part gift and part sale
- Equity crowdfunding: Exempt from income tax
- Debt crowdfunding: Loans are not considered taxable unless the debt is canceled
If you can use the funds towards business expenses in the same year, you’ll be able to reduce your taxable income. However, you may also be subject to self-employment tax. The effective tax rate can climb pretty high in this case; one entrepreneur ended up with a $21,000 tax bill for about $70,000 in earnings from a potato salad campaign.
- You may face reputational repercussions
If you’re considering using crowdfunding for your business, you should be prepared to deliver. If your campaign fails to meet its fundraising goal, your product falls short of expectations or your business otherwise fails, that may make you appear unfavorable in the eyes of investors. That means you may have difficulty raising funds for future ventures, since investors typically do research into the background of a company’s founders.
- It’s going to require time and effort
If you’re planning to launch a crowdfunding campaign, you’ll need to put in a lot of work before you even begin collecting cash. You’ll want to build awareness about your business and prove that you’re going to deliver something worthwhile before you start fundraising.
Once you start the clock on your campaign, expect to get busy very quickly. If you don’t have a team to help you out, you may end up biting off more than you can chew. Investors/donors are likely to have questions about your business, so you may end up flooded with emails. Depending on your timeline, the work may be too much to handle on your own, especially if you have prior commitments.
- Your business may fail even if your campaign succeeds
Raising enough startup capital is just one of the many challenges you’ll face as a business owner. You should be aware that a successful crowdfunding campaign does not necessarily indicate a successful business. Even if you meet your fundraising goal, your business could fail due to competition or other factors.
Therefore, crowdfunding shouldn’t be used as a way to test whether or not your business will gain traction. You’ll need more than just a good idea to inspire confidence in your investors/donors; you should be able to prove the value of your business before attempting to raise funds.
When to turn to crowdfunding
If your business is struggling as a result of COVID-19, you should first check your eligibility for relief from the Small Business Administration. In most cases, relying on these programs will be less costly than launching a crowdfunding campaign.
If you’re not eligible for temporary relief, or it isn’t sufficient to bridge the gap in revenue, consider a traditional business loan. You might have trouble getting approved, especially if you have fair credit, since lenders are tightening their standards in the wake of the pandemic. If that’s the case, crowdfunding may be the best way to keep your business afloat.
Many business owners have also turned to crowdfunding to help employees recover lost income. While the CARES Act boosts unemployment benefits by $600 per week, that’s not enough to cover lost wages in some states. If your employees are furloughed and struggling to make ends meet, crowdfunding can be a great way to help them weather this crisis. Workers can also share your campaign on their social media networks to increase your chances of meeting your fundraising goal.
It will take time for the economy to recover, and many business owners will need assistance in the meantime. It’s possible crowdfunding could help your business survive the upcoming recession. Just be aware of the potential drawbacks and know what to expect before you launch a campaign.