Crowdfunding is all the rage, with new platforms emerging more frequently. Many see it as the future of investing, while others warn that its risks are often underestimated. And then there are different types of crowdfunding: reward-based, equity-based, debt-based, flexible, fixed, etc. It may all seem confusing, but like most things, the underlying logic is simple.
The most important benefit of crowdfunding is that investing in small companies and startups is accessible to everyone. That’s why it’s more important than ever for people to fully understand this new world, as most of the negative publicity surrounding crowdfunding focuses on misuse and misunderstanding of the platforms. In this article, I’ll cover the different types of crowdfunding platforms, along with the main incumbents in each category, and explain some of the main pitfalls that trap many newcomers.
But first a definition.
What is a crowd?
Ordinary, everyday people. And that’s what the “crowd” in crowdfunding refers to. You see, fundraising isn’t really about business plans or market appeal or financial projections: it’s ultimately about belief. And the higher the risk of harm in life, the more important trust becomes. For this reason, most people do not hesitate to put a few pounds into sponsoring a charity race or lend a friend a few pounds; There is a general acceptance that you should not expect to see this money again, and so the level of trust in the person you give the money to does not need to be particularly high. But if someone asks you to invest a few thousand pounds, the situation is radically different. For most people, this is not an amount they can afford to lose. Therefore, most people are left out of the investment world where small businesses need thousands of pounds to invest.
So it makes sense that the traditional routes for founders to finance a business have been through channels like loans from banks, high net worth individuals, friends and family. The founder’s ability to raise money has largely depended on their collateral in the case of bank loans, or their personal network in the case of investments from individuals, and large chunks of money from a small handful of people who trust them. or we have thoroughly checked them. The alternative – raising small lumps of money from a large number of people – is largely impossible unless the founder happens to know hundreds of people and is unwilling and unable to deal with the huge administrative burden of working with that many people.
Enter the Internet, with its long history of both eliminating administrative headaches and connecting large groups of people. Crowdfunding essentially facilitates matching between ordinary people who are interested in investing in things and ordinary founders who do not have access to large networks of collateral or wealthy individuals. The software that runs the crowdfunding platform handles all the administration, while the internet itself provides a large pool of potential people for the founder to market at scale.
In short, crowdfunding allows you to raise small amounts of money from a large number of complete strangers. That’s why it’s great.
The main types of crowdfunding platform
There are four main types of crowdfunding platform, all with different advantages and risks. Below are the main ones with links to the biggest or best-known officials.
Rewards-based crowdfunding
Major players: Kickstarter, Indiegogo
The closest sibling to the traditional charity fund, reward-based platforms take money in the form of pledges or donations, and in return you receive some sort of return or reward from the business. For example, you can get a discounted unit of a funded product after production, or you can get a customized version of the same product as a thank you for supporting it for a higher donation amount. This is the “reward” in question, and usually the higher the pledge amount, the better the reward.
For obvious reasons, you tend to find mostly physical products on reward-based sites where the money is used to take the first concept prototype into production. They are also popular for creative projects such as movies, games or music albums, where fans can support their favorite artists and in return receive bonuses such as credits at the end of the movie.
The downside of reward-based sites is that they are vulnerable to fraud and scams. There is usually little or no due diligence on companies or individuals raising money, and the barrier to entry on the investor side is minimal, with minimum pledges starting at £1. Scammers often present fake product prototypes in a video featuring concept art and renderings, only to disappear with the money after the campaign ends. Investors, in this case, have little recourse other than to complain to the crowdfunding platform itself for a refund, but the lines of responsibility around risk are somewhat hazy.
Reward-based platforms have fantastic opportunities to support interesting projects, but the risk is the highest and the return is generally not noticeable. Investing in a reward-based platform should be driven by passion for the product you’re investing in, not an expectation of financial returns.
Equity-based crowdfunding
Major players: Seedrs, Crowdcube
Closer to traditional investing, equity-based platforms facilitate investments in businesses in exchange for equity in those businesses. Stock platforms are regulated by the Financial Conduct Authority in the UK and investors must meet certain legal requirements. However, these are not particularly rigorous and usually involve a simple credit check and filling out an online survey. Minimum investment amounts are still quite affordable, usually around £10, although some share platforms have higher minimum stakes.
However, the entry process is tougher for businesses looking to upgrade. Due diligence is done on each company, and the submission process usually involves several rounds of iterations and approvals before the campaign goes live. The obvious benefit to investors is an added layer of protection for their investments. Fraudsters or fraudsters are less likely to start on share platforms, and FCA regulations require companies to back up their claims with evidence that the platform will validate themselves before allowing the campaign to begin. Because of this, up to 90% of all applications for stock-based platforms fail to launch a campaign.
The advantages for businesses raising money are access to a more sophisticated group of investors outside their network (traditional investors are increasingly flocking to such platforms), as well as a simplified process for working with groups that are smaller than other crowdfunding platforms. of investors. There is also a growing trend for equity platforms to act as nominee shareholders on behalf of investors, meaning that a business takes on one new shareholder instead of several hundred, making management much easier and future investments simpler. This particular point is often overlooked by businesses looking to raise money, but it’s the main reason we chose Seedrs for our fundraising campaign.
Equity platforms will typically hold funds in escrow until the campaign ends, adding another layer of protection for investors. Of course, normal risks apply in terms of expected returns: most investments will return nothing, if not much, but those that promise great financial gains compared to other investment options. In general, this type of crowdfunding is what is mentioned in speculations about the impact of the format on the future of investing in general.
Debt-based crowdfunding
Key Players: Funding Circle, Zopa
Debt-based crowdfunding, otherwise known as peer-to-peer lending, takes the main advantages of crowdfunding—administrative advantages and access to large groups of people—and applies it to business lending. Simply put, investors put their money into a fund managed by the platform, and the platform lends the money to businesses seeking capital. Investors can either choose the business they want to invest in or let the platform automatically choose on their behalf.
The main difference, obviously, is that the investor should expect to get the money back with interest. The appeal of putting one’s money into a credit platform instead of an equity-based platform is due to the reduced risk factor provided by the fact that businesses go through the same rigorous due diligence procedures as they do when borrowing from banks, and the fact that returns are reduced. often much higher than a simple BSA or pension. For businesses that meet the lending criteria, the benefits are better rates from a bank with more transparency.
While not generally ideal for early-stage startups with no collateral, for more established startups looking to grow, it offers access to cash without having to give up capital or take on hundreds of investors. For more risk-averse investors, this is a safer alternative to equity crowdfunding at the cost of missing out on the potentially large returns that successful startups can sometimes bring.
Blockchain crowdfunding
Key players: Smith + Crown, Waves
Blockchain crowdfunding, the newest and least known type of crowdfunding, uses the power of cryptocurrencies like Bitcoin to generate cash from the creation of new tokens in a process called Initial Coin Offerings (ICOs), a nod to the more traditional Initial Public Offering. IPO) process we are used to in the stock markets.
It’s quite complicated to explain how it works here, and understanding how blockchain and cryptocurrencies work is important before even considering this route (those interested can read my article “A Quick Guide to Blockchain…for Normal People”) . So businesses raising money via this route are mostly blockchain-related, and investors into ICOs have a very high risk appetite.
The appeal is the potential returns for investors from the cryptocurrencies themselves. As an example, the cryptocurrency Ether doubled in value in just three days in March 2017, while the currency Monero gained 2,000% in value last year alone. Of course, this level of volatility could also go the other way, as anyone who has invested in Bitcoin recently will attest.
Blockchain’s decentralized architecture and trustless, crowd-sourced approach make it an obvious candidate for the preferred crowdfunding approach in the future, but the technology as a whole is still in its infancy and therefore prone to fraud and scammers, as well as high volatility in the currencies themselves. . Not for the faint of heart.
Which one should you choose?
As an investor, the decision of which crowdfunding platform to invest in depends largely on your risk appetite. If your goal is to make any kind of income, premium based platforms should be completely avoided. Additionally, debt-based platforms can be a good option if you’re simply looking for a better rate than an ISA can offer, otherwise if you want to be a ‘real’ investor, go for the equity crowdfunding option. Blockchain is for gamblers.
As a business, stick to rewards-based platforms for consumer products in the concept or prototype stage, perhaps moving to equity platforms once your product is launched. Debt-based platforms are a better option for bridging finance, if you are more established and a blockchain startup, blockchain is an obvious choice.
No matter what stage you’re at, make sure you shop around and do your research before you dive in, and as long as you keep your wits about you, there are exciting opportunities like never before. For this reason alone, crowdfunding is a wonderful innovation.