I hope it's alright if I including links to products on various online stores to demonstrate the type of equipment I'm talking about in the 'how' portion of the article. I'm not in any way affiliated with any of the websites to which this article is linked, nor am I trying to promote any particular product. I merely wish to prevent misunderstanding of types of gear I'm referring to.
The reasons to record a demo quickly become obvious to any band or artist attempting to go anywhere beyond their bedroom, basement, garage, or a party (friends/family). A demo, even of fairly shoddy quality opens the doors to gigs, gives fans something to remember you buy (whether you sell them or just give them away), and allows labels to better evaluate the risks of signing you.
If you go far enough to record a couple solid tunes on your own, and promote them hard enough to establish even the smallest of followings, and follow that with a complete demo of your to-be album getting a labels on your side will be much easier. Try empathizing with a record label for a moment: even if a band has a great single and a local following do you really want to take the risk of tossing them 5K to record an album you've never heard? Even when the record is finished the label will have to spend thousands of dollars pressing copies... even without advertising, big budget artwork, or any spectacular promotional stunts, you're asking the label to risk thousands of dollars on you. I'm not a label representative, nor am I taking their side, but as someone who's tried to put out even just a record or two, it's tough!
How - The Gear
Obviously how is the tricky part. Studios are always an option but unless you are extremely well rehearsed (always a good thing anyway) and have a budget running close to a grand to cut just a couple quality tunes I wouldn't recommend it. Quality studios run upwards of $20/hour, and you'd be amazed how many hours you really need between laying down the rhythm tracks, overdubbing and doubling instruments, and putting down vocals; not to mention mixing, mastering, and running off a copy or three.
What I want to recommend is how to get out a recording on your own without sounding like it was done with an old cassette player. For a full-band this often becomes tricky, as drums are extremely difficult to capture properly. But even drums can be captured beautifully on this kind of budget.
The method I recommend is track-by-track digital recording using a fairly basic digital interface and microphone. This method will run you around $300 minimum for the gear; which shouldn't really be a problem if you're willing to save a little or have a few people to raise the money. I'm also making the (hopefully reasonable) assumption that you own/have access to a computer on which you can record any all instruments (either by moving the computer, or bringing the instruments to it- with piano the computer will have to move, with drums it's a toss-up).
Some examples of the kind if interface I'd recommend: M-Audio Fast Track MKII USB Audio Interface PreSonus AudioBox USB 2X2 USB Recording System ART USB Dual Pre Two-Channel Preamplifier/Computer Interface
I'm suggesting these interfaces because they're fairly decent 'budget' options that still have phantom power, which will allow you run run condenser microphones. This is particularly important if you wish to record drums, acoustic guitar, piano, or any other instrument that's best picked up with some 'ambiance'. Condensers also work better for recording vocals, because they pick up on vocal subtleties and respond more naturally to changes in volume on the part of the vocalist.
The decision of microphone, sadly, is probably based more on cost than anything else; however, there are many inexpensive options that have been highly reviewed. I recommend purchasing a large-diaphragm condenser as they're usually more versatile and capture sounds more naturally. They are, however, more fragile and their use should be accompanied with a shock mount and (for vocals) a pop filter. A few well reviewed condenser mics:
From there don't forget accessories. These "hidden costs" are often the bane of any recording project and when you're on and trying to keep a tight budget can easily push you far above and beyond your available cash.
Microphone Cables: quality cables run $25-50. Anything beyond that is overpriced, anything below that is fine for live applications but is likely to be noisy or attenuate (lower / quiet) your signal when recording and should be avoided.
Mic stands: You're very likely going to want a tripod boom stand similar to this. It'll afford you the necessary range of motion to place the microphone intelligently for any situation.
That should cover it for equipment... At this point, assuming the interface you purchased doesn't come with it you'll need editing software. I recommend the freeware Audacity. It's free, legal, and once you get used to it, nearly as powerful as many of the expensive options for both recording and mixing: Audacity
If your interface comes with recording software, such as Cakewalk, Cubase, or Pro Tools, by all means use those instead. The time it takes to learn this software is well worth the effort because they quickly become indispensable tools for getting down ideas, riffs, and demoing tunes (guitar and vocals, proof-of concept stuff, etc) for your bandmates, if for no one else.
How - The Process
Once you have all these wonderful new toys at your disposal just waste a few hours tinkering around with them to familiarize yourself with how everything works. Professional results NEVER come immediately; even if you follow instructions to a T. The main things are to make sure you're not clipping anywhere along the way, microphone positioning, and not picking up loads of noise. Get familiar with the amplification, reverb, bass boost, hi-pass, and low-pass filters in your recording software as those will likely be your primary tools for mixing your track towards the sound you're after.
The specifics of microphone placement, and the importance of the space you record in (acoustically) are covered quite well elsewhere. Just for basics: never place a condenser mic closer than 6" (10cm) from what you're recording, or closer than about 3' (1 meter) from what you're recording: it CAN be damaged by extreme volumes, particularly impacts. And try to find a space with as little noise (vents, nearby roads, refrigerators, etc) and echo as possible. The room should sound "dead" (this is ESPECIALLY important with acoustic instruments, PARTICULARLY drums, DO NOT record drums in a garage or an unfinished basement!).
If you're doing acoustic stuff, just vocals and guitar, or vocals and piano, you might be able to play around with microphone positioning and find a place that will allow you to record your demo right away and move on to mixing!
If you're recording a band; however, the order in which instruments are recorded becomes critical. The order should go: "core rhythm" track (guitar or bass to be mixed out later) -> Drums -> Most instruments -> Vocals.
The first thing that should be laid down is a rock-solid, very steady, mistake free rhythm guitar, bass, or keyboard track that runs though the entire duration of the song (even if there's stop time, or this instrument is suppose to drop out, just play straight through: this track is supposed to be mixed out or down later). Make sure it's counted in, and that there are NO rhythmic quibbles what-so-ever, and the patterns are OBVIOUS. Then mix it up as loud as it can go and give a copy to your drummer. They should practice to the track through headphones until they can play to it steadily and confidently. Then record the drums.
When you're happy with the drums record the final tracks for the other instruments. The original "core rhythm" track can be left in place here IF it locks into the drums perfectly, or else a new 'core' should be recorded (listening only to the drum track) so it locks perfectly with the drums. Throw / mix out the original core track if you have to record a new one, of course.
From there layer in the instruments in whatever order seems most natural for the song or based on who's available, or whatever. Vocals should go after the bunk of these takes, but can be before sound effects, weird noises, production tricks, and various lead tracks. All "rhythm" tracks (be they guitar, bass, percussion, or keys) should be done before vocals.
At that point make sure to save ALL OF YOUR TRACKS that you intend to use to their own lostless files (.wav, for example) or save a "clean" copy before you start mixing/filtering/reverbing your pristine recordings. If you get too carried away with effects and such you'll want to be able to bring back specific original tracks from clean and work with them again!
Then whomever is most familiar with the recording software should try to work out a mix with input from everyone else. This should take nearly as long as the actual recording process and is often quite painful, but the results are worth it! Once everything is down to one mono or stereo track set up (depending on how you pan, of course) then SAVE IT (again), and bring a copy back into the recording software, experiment with different EQs and mash the volume up to the maximum level without clipping... This approximates a "mastering" process and should make your tunes sound properly "loud" when played next to other recorded material.
Obviously there are a lot of details involved, but this is a decent overall roadmap to cutting that first recording and doing it right. Expect it to take three times longer than your worst nightmare prediction, expect it to be tough, but if you have the endurance you can turn out something to be very proud of with the gear you already have (assuming you're already proud of it) and a budget that can't even by you a MIM Fender anymore.
Best of luck!