CNBC Explains

You hear lots about crowdfunding, but what is it?

Kickstarter home page
Source: Kickstarter

Crowdfunding is a way to raise money by asking many individuals to contribute funds, often in small amounts, to a specific business venture or cause. The contributions can be in small amounts, say $1, or large amounts such as in the thousands of dollars or even millions.

Crowdfunding can also refer to the funding of a specific company by selling small amounts of equity to investors. It's also been used to raise money for charities, disaster relief, political campaigns and by artists and musicians to raise money for their projects.

The term crowdfunding was reportedly coined in 2006 by a man named Michael Sullivan, who started a fundraising effort to build a video blogging community.

Usually, crowdfunding takes place through the Internet. Those asking for the funds create an online profile to explain their fundraising goals and then share their project with the pubic as well as their friends, family and social networks.

The projects have a deadline and a financial goal when starting out, with the money usually returned if the goal is not reached by the deadline.

Sites such as Kickstarter, founded in 2011, are designed for people to place their requests for money.

An example of a successful and ongoing crowdfunding project is Star Citizen, a combat simulator game for Microsoft Windows that's supposed to be released in late 2014.

Started in 2011, Star Citizen is the largest crowdfunded project ever and highest crowdfunded amount for a video game. The initial target fund amount was $500,000, but so far, more than $21 million has been raised, with $2,134,374 of that on Kickstarter.

Film director Spike Lee (seen here on CNBC talking about his crowdfunding effort) used Kickstarter to raise funds in the summer of 2013 for a movie project. Lee raised more than $1.4 million from 6,421 backers by his deadline, exceeding his $1.25 million goal.

Statue of Liberty 'crowdfunding'

Spike Lee starts Kickstarter campaign
Spike Lee starts Kickstarter campaign

Organized efforts asking for money from the public date to the 1700s. An early U.S. example was in 1884, when the American Committee for the Statue of Liberty ran out of funds for the statue's pedestal.

Newspaper publisher Joseph Pulitzer asked the public to donate money toward the pedestal in his newspaper, the New York World. The effort raised more than $100,000 in six months. More than 125,000 people contributed to the cause.

Fast forward to 1997 and we have what many point to as the first example of modern-day crowdfunding. That's when the British rock group Marillion funded its tour of the U.S. from contributions by fans, who put the effort together and raised $60,000.

Crowdfunding going mainstream

Crowdfunding has gained mainstream status and could become even more popular, thanks to a proposed rule change by the Securities and Exchange Commission.

Private companies are currently allowed to solicit money only from investors deemed to be "accredited," meaning individuals who have a net worth of $1 million, excluding the value of their homes, or an individual annual income of more than $200,000.

However, under a new government proposal unveiled this month, entrepreneurs and start-up companies looking for backing will be able to solicit small investments over the Internet from the general public.

(Read more: SEC offers restrictions on crowdfunding)

The SEC is setting up a crowdfunding plan as part of a requirement in the Jumpstart Our Business Startups (JOBS) Act of 2012. The law eases federal regulations on small businesses.

If adopted by the SEC, the new rule would be a major shift in how small U.S. companies can raise money in the private securities market.

The crowdfunding rule would let small businesses raise more than $1 million a year by getting funds from unaccredited investors.

Companies could sell stakes to small investors without registering the securities with the SEC, with the thought being that by not registering with the SEC, it would be cheaper and less cumbersome for struggling start-ups trying to get their businesses off the ground.

They would still be required to raise the money through regulated broker-dealers such as CircleUp, or through crowdfunding portals like Kickstarter.

—By CNBC's Mark Koba.