The trend towards entrepreneurship in Spain is growing considerably, boosting the creation of numerous technological startups. According to a study by Startupxplore, the growth rate of this type of company in the Spanish market was 26% in 2015 compared to the previous year (equivalent to the creation of 2,551 new companies) and the pace continues to be maintained.
However, founding a company involves facing many challenges and one of the most important is to obtain funding. Few newly created startups are able to finance themselves through their clients right from the start, so most of them must seek some type of external funding. Entrepreneurs tend to focus exclusively on seeking private funding from professional investors as well as public funds, but there is a third way to obtain funding at very early stages: crowdfunding.
Crowdfunding modalities
The concept of crowdfunding (born in the USA in 2003) refers to the process of funding projects based on contributions made by a multitude of people online, with the objective of achieving a pre-established investment volume. Two types of crowdfunding can be distinguished: (i) crowdfunding based on rewards (kickstarter model) and (ii) equity crowdfunding.
- Rewards-based crowdfunding (kickstarter): modality in which individuals can pre-purchase products or simply make donations. Donors cannot invest and become partners. Pebble E-Paper (a company that produces customizable “smartwatches”) is a clear example of a successful campaign: it managed to raise more than 10M€ in just 37 days through Kickstarter.
- Equity crowdfunding: mechanism that allows large groups of people to finance startups online in exchange for a part of the company's shares. In some countries such as the United States, there are legal difficulties in practicing this activity unless it is carried out through regulatory financial institutions. The regulation surrounding equity crowdfunding seeks primarily to protect investors from the risk associated with investing in very fledgling projects.
Rewards-based crowdfunding
In addition to allowing money to be raised, crowdfunding campaigns based on rewards (the most common) they generate a series of additional benefits for Startups which may be even more important than the money raised itself:
- Market validation: Market validation is a critical stage for any startup that is just starting out, in which it must demonstrate that there is a potential market willing to pay to obtain its product or service. Crowdfunding platforms allow entrepreneurs to establish “pre-orders” for their MVP (Minimum Viable Product) and thus reduce the risk associated with creating a company, knowing in advance that there are people willing to pay for the startup's service or product.
- Proof of Concept: In order to try to attract potential investors to close a future round, this type of campaign is very interesting. If a good volume of pre-orders is achieved and public interest is generated, the task of attracting private investors becomes much easier as it increases the credibility of the project.
- Consumer Feedback: In addition to being able to validate the business model, crowdfunding platforms allow entrepreneurs to easily access a community of highly engaged potential consumers. They are willing to ask about the project, give feedback and propose possible modifications that could help improve the offer.
- Coverage and promotion: These types of campaigns are also of great help when it comes to promoting the project (another important challenge for most entrepreneurs). The user communities of these platforms have a high level of commitment to the projects they like and are a great help when it comes to promoting them. Thus, startups are able to secure a portfolio of potential customers right from the start.
Despite the advantages provided by crowdfunding campaigns, there are also certain limitations that start-up companies must take into account. It is important to note that not all projects uploaded to the platforms are funded (only 40% are) and rarely the full amount desired is achieved. In addition, it should be considered that the vast majority of projects are in very early stages of life, so the risk that they will not be able to consolidate is very high. The following are a series of limitations that entrepreneurs must consider before launching a crowdfunding campaign:
- Low amounts: The average amount achieved through a crowdfunding campaign is approximately €5,000. In addition, implementing a campaign of this type involves a lot of work at the preparation level. The entrepreneur must dedicate weeks of work to be able to present his project in a way that generates a high level of interest for the public. Thus, if the only objective is to raise money (without considering the other benefits provided by this methodology), crowdfunding is not an optimal solution. The risk of obtaining a far from expected amount is very high, and in addition, part of the amount achieved has to be waived since the platform charges a commission.
- Difficulty in managing to finance the growth of the startup: In most cases, users looking to help with certain projects do so by placing pre-orders. So, they pay in advance for a certain product that they will receive in the future. This strategy allows startups to finance their production costs, but they rarely get enough funds to cover the financial needs associated with the company's growth (expanding the team, investing in marketing, etc...).
Equity crowdfunding
On the other hand, the Equity crowdfunding modality allows entrepreneurs to cover one of the limitations of the other modality (based on rewards): easy access to capital to finance growth needs since anyone can be an investor making small investments. Thus, this type of financing offers the following advantages for entrepreneurs:
- Streamline the capital raising process: The investment process is much more agile compared to the more traditional methodology (looking for professional investors), since professional investors are much more demanding than the public present on crowdfunding platforms. As individual investments are much smaller, companies are not required as much in terms of metrics, as the risk is distributed among the many partners.
- Greater control of the company: By attracting professional investors, entrepreneurs may run the risk of losing some control over the company due to the dissolution of the share capital. However, equity crowdfunding makes the opposite happen since it is minority (small) investors who invest in the business.
- Less red tape: since investments are made online, the entrepreneur avoids the bureaucratic procedures associated with traditional funding rounds and manages to receive the money instantly.
However, the Equity crowdfunding can create certain complications for investors since most people who invest are not professionals or experts, so they often do not take into account the following risks:
- Dilution risk: For investors who have invested through an equity crowdfunding system, if the company decides to make a new capital increase and they do not participate in it, their investments are diluted (the% of the startup's share capital is reduced).
- Difficult liquidity: Investments in startups don't offer quick liquidity to their investors. This means that an investor must wait a long period of time (usually years) before having the option of selling their shares. This is a concept that the investing public does not take into account when investing in startups.
- Difficult to receive dividends: In most cases, startups that have just started are not required to pay dividends to their investors. They seek to reinvest profits in the company to continue growing, so investors have to wait a while before receiving dividends.
- High probability of failure: The probability of failure in new startups is very high (80% of projects do not exceed two years). The risk of losing an equity crowdfunding investment is very high due to the incipient state of the projects.
