Why crowdfund? To obtain funding.
The better question is: “When is investment crowdfunding a success”?
It is possible to complete a crowdfunding campaign that is too expensive, too time consuming and one that possibly creates a liability to the business and its owners that cannot be met.
The answer to the question is: Crowdfunding is successful when the total cost of capital and the total cost of raising the capital is less than the total reduction in the cost of sales.
In a formula it would look like this:
Cost of money + Cost of raising money < Reduction in Cost of Sales.
The cost of money takes many forms:
- Interest paid on principal
- Future profits distributed to investors
- Future revenues shared with investors
- And any combination of the above
And, the principal or investment has to be paid back.
For example, if you borrow $100,000 at 8% annual interest and pay everything back in one year, then your cost of money is $108,000.
If you give up 10% ownership in your business for $100,000 and your business earns $100,000 in profits in one year, then the cost of money is $110,000.
If you give up 5% revenue share in your business for $100,000 and your business grosses $500,000 in sales in order to earn the $100,000 in profits, then the cost of money is $125,000.
The cost of raising money includes any fees paid to prepare for the capital raise, registration fees to any regulatory agency, any success fees paid to a broker/dealer, any direct costs of promotional materials and services and each hour of each employee of the business that is spent in raising capital (calculated at market rates even if they are not receiving any wages).
For example in a crowdfunding campaign, a business may engage a business like mine to assess the potential of the business to raise capital, to recommend a strategy, develop a plan, create the sales offering, submit documents for regulatory approval, and manage marketing subcontractors in supporting the business in engaging prospective investors while communicating the conduct of the capital raise. My fees for these activities may range from $25,000 to $100,000, depending upon the extent of the complexity of the capital raise and to which my client is able to perform some of these activities.
In addition, the business must include the time of their owners, staff and other contractors to gather needed information, prepare cash flow forecasts, report profits and expenses, produce pictures and videos and talk to countless investor candidates. Each hour spent in raising capital is one less hour spent in conducting the business of the business.
Finally, a business will incentivize its customers to become investors by discounting or giving away its products and services. The amount of the discount or cost of producing the product or service must also be included in the cost of raising capital. If a customer is offered a $1 dollar discount on a $5 dollar product when they make an investment, the discount will impact the cash flow of the business and will be a cost of conducting the capital raise. A business may decide to offer discounts and premiums that represent a significant percentage of or equal to the capital to be raised.
The benefit of a properly designed and executed investment crowdfunding campaign will be a reduction in the cost of sales of its products or services.
The money and time in expended in promoting the capital raise will generate new sales. New customers will become aware of the business and its products or services through publicity.
Customers of the business who are upgraded to investors will share information about the business and its products and services within their personal and business networks. This distribution of information will lead to new customers that would not have heard about the business otherwise or that the business would only have reached through expenditure for advertising dollars. However, these customers were reached through existing customers so that the communication takes the form of an endorsement with higher credibility than can be attained in a simple advertisement.
The business may also pay a commission or affiliate fee to its customer/investors to act as sales representatives and bring qualified customer prospects to the business.
As a result, the business will spend less money on sales salaries, on commissions and sales representative fees, on advertising and on travel, meals and events and other expenses related to sales.
A calculation of the costs of capital and of raising capital when compared with a calculation of the costs of sales should show that the crowdfunding campaign not only provided the needed capital, but it did so while reducing the costs of sales.