Once upon a time, funding a start-up business was done by using savings or getting a bank loan. Asking friends or family was the next port of call. Perhaps then an entrepreneur might consider pitching to an angel investor or venture capital firm. Dragons’ Den, anyone? Failing these options, and with the economic downturn causing many institutions to tighten their purse strings, it may be necessary to find alternative sources of funding to get a start-up off the ground.

Now, capitalizing on the reach of online social networks, a new and increasingly popular way to fund a small business has emerged. The term ‘crowdfunding’ was first used in around 2006, and since then, close to 500 active crowdfunding websites have become available to help entrepreneurs inject life into their small businesses. These web sites empower anyone, anywhere in the world to raise money for any idea. Crowdfunding is bringing about rapid changes in the world of entrepreneurial finance.

Crowdfunding refers to the collective effort of individuals who network and pool their resources to support efforts initiated by other people or organizations. It is used in support of a broad range of activities, including start-up company funding, software development, disaster relief, citizen journalism, support of artists by fans, political campaigns, movie making, inventions development and scientific research.

One of the main benefits of crowdfunding is that it creates a strong network of support for a start-up.

Led by the recent success of high-profile and high-capital funding campaigns on crowdfunding websites KickStarter and Indiegogo as well as the many thousands of smaller projects, crowdsourcing.org predicts that the amount of money raised by crowdfunding platforms during 2012 will reach £1,735 million, up 91% since 2011. Crowdfunding has the potential to reach a scale that will completely change the landscape for start-up financing.

The aforementioned Kickstarter is the biggest fish in the crowdfunding pond. The US-based platform, which has just launched in the UK, has seen over $350 million pledged by more than 2.5 million people, funding more than 30,000 creative projects. Unlike traditional methods of backing new companies, investors on Kickstarter do not gain a share of the company, nor do they have any say in its future operation.

Although originally launched as a site for artistic projects such as plays or film-making, Kickstarter has become known for attracting a large number of products targeted at the technology community. Every project creator sets a funding goal and deadline. If the project succeeds in reaching its goal, all backers’ credit cards are charged when the deadline expires. If the project falls short of its target, nobody is charged. Project creators keep total ownership of their work. Kickstarter, which charges 5% commission, cannot be used to offer financial returns or equity or to solicit loans.

Similar websites such as Indiegogo also offer crowdfunding to UK businesses, but they have yet to gain the same widespread appeal as the American site. Indiegogo allows people to raise money for absolutely anything, using an optional keep-what-you-raise model with higher fees as well as an all-or-nothing approach with lower fees. Indiegogo’s biggest campaign to date saw a man fascinated by physicist and inventor Nikola Tesla raise more than a million dollars in just a few weeks to see that a museum is founded in Tesla’s name.

According to Slava Rubin, CEO and cofounder of Indiegogo, people contribute to the campaigns for several reasons. Firstly, they care about the person and the cause. Secondly, they want a perk related to the project they are helping to fund. Thirdly, they become part of a community, knowing that they helped make something happen. Lastly, people want to profit. This is not legal now, but it will be in the US in 2013 with the implementation of the JOBS Act, which was passed in April 2012.

One of the main benefits of crowdfunding is that it creates a strong network of support for a start-up. Investors are likely to become ambassadors for a brand, promoting it among their contacts, tracking its progress and becoming returning customers themselves. Supporters of the crowdfunding approach argue that it allows good ideas that do not fit the pattern required by conventional financiers to break through and attract cash through the astuteness of the crowd. They also identify a potential outcome of crowdfunding as an exponential increase in available venture capital.

On the other hand, there is always a risk of copyright infringement when a concept is released into a public domain. Entrepreneurs are exposed to the risk of their idea being imitated and developed ahead of them by better-financed competitors. Moreover, it sometimes proves easier to raise the money for a project than to make the project a success. Managing communications with a large number of possibly disappointed investors and supporters can be a substantial and unpleasant task.

Although crowdfunding can provide an excellent opportunity for small businesses, it should not be entered into lightly, and to be successful, it requires a careful strategy. Crowdfunding functions best for start-ups that have a story to tell, whether a personal reason for starting the business, a passionate vision for what it could become or a social mission. People have to feel inspired to invest, so a charismatic pitch is required to get potential investors’ fired up. Alternatively, a display of evidence of outstanding innovation is necessary. For those with a mundane or complicated concept that the public will struggle to connect to, crowdfunding may not be the right option.