Crowdfunding is in a rage, with new platforms appearing more and more often. Many see this as the future of investment, others warn that its risks are often underestimated. And there are different types of crowdfunding: reward-based, capital-based, debt-based, flexible, fixed, and so on. All of this may seem confusing, but like most things, the underlying logic is simple.
The most important benefit of crowdfunding is that it makes investing in small businesses and startups accessible to everyone. For this reason, it is more important than ever for people to fully understand this new world, as most of the negative publicity surrounding crowdfunding is mostly focused on abuse and misunderstanding of the platform. In this article, I will cover the different types of crowdfunding platforms, along with the main holders in each category, and explain some of the primary pitfalls that many newcomers catch.
But first, the definition.
What’s the crowd?
Ordinary, everyday people. And that’s what the “crowd” in crowdfunding is all about. You see, fundraising isn’t really in business plans, market pulls, or financial forecasts: it’s ultimately about trust. And in life, the higher the risk of injury, the more important trust becomes. For that reason, most people don’t mind investing a few pounds to sponsor a charity or borrowing a friend for a few pounds; it is generally accepted that you should not expect to see that money again, and as such the level of trust in the person to whom you are giving money does not have 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 money they can afford to lose. Therefore, most people are locked out of the world of investing where small businesses need thousands of pounds to invest them.
It is therefore logical that the traditional directions of founders who finance business are channels such as loans from banks, high-value individuals and friends and family. The ability of the founders to raise money depended heavily on their collateral in the case of a bank loan or on their personal network in the case of individual investments, and consisted of a large portion of the money of a small handful of people who trusted and / or thoroughly checked them. The alternative – raising a small portion of the money from a large number of people – was largely impossible unless the founder happened to know hundreds of people and was willing and able to cope with the enormous administrative costs of dealing with so many people.
Get on the internet, with its well-established history of removing administrative headaches and connecting large groups of people. Crowdfunding basically makes it easier to match between ordinary people who are interested in investing in things and ordinary founders who happen to not have access to collateral or large networks of wealthy individuals. The software that runs the crowdfunding platform deals with the entire administration, while the internet itself provides a huge potential of people that the founder can place on the market.
In short, crowdfunding allows you to raise a small amount of money from a large amount of complete strangers. That’s why it’s great.
The main types of platform for crowdfunding
There are four main types of crowdfunding platforms, all with different benefits and risks. Below are the main ones, with links to the biggest or most famous officials.
Full award-based funding
Main players: Kickstarter, Indiegogo
Platforms based on rewards closest to traditional charitable fundraising take money in the form of pledges or donations, and in return you get some kind of refund or benefit from the job. For example, you can get a discounted unit of a product that is funded after you produce it, or for a larger amount of donation you can get a personalized version of the same product as a thank you for supporting it. This is the “reward” in question and usually the higher the amount of the pledge the better the reward.
For obvious reasons, you mostly find physical products on reward-based websites, and the money is used to take the prototype concept into first production. They are also popular among creative projects like movies, games or music albums, where fans can support their favorite performers and in turn get benefits like credit at the end of the movie.
The downside of reward-based websites is that they are vulnerable to scams and fraud. There is usually very little or no in-depth analysis of companies or individuals raising money, and with a minimum pledge amount ranging from just £ 1, the barrier to entry and on the investor side is minimal. Scammers will often present fake product prototypes in a video containing conceptual art and renderings, only to disappear with the money after the campaign is over. In this case, investors have few options other than to complain to the crowdfunding platform itself to get a return, but the lines of responsibility around the risk are somewhat hazy.
There are fantastic opportunities to support exciting projects on reward-based platforms, but the risk is greatest and the return is generally not noticeable. Investing in a reward-based platform should be done out of passion for the product you are investing in, not with the expectation of a financial return.
Group financing based on capital
Main players: Seedrs, Crowdcube
Much closer to the traditional notion of investment, capital-based platforms facilitate investment in companies in exchange for capital in those companies. Stock platforms are regulated by the UK Financial Conduct Authority and investors must meet certain legal requirements. These, however, are not particularly stringent and usually involve a simple credit check and filling out an online questionnaire. Minimum investment amounts are still typically available at around £ 10, although some stock platforms have a higher minimum stake.
For companies looking to raise, the entry process is much more difficult. A proper legal in-depth analysis is conducted in each company, and the application process usually consists of several rounds of iteration and approval before the campaign can begin. The obvious benefit for investors is an extra layer of protection for their investments. It is much less common for fraudsters or fraudsters to launch on proprietary platforms, and FCA regulations require companies ’claims to be backed up by evidence that the platform itself will verify before allowing the campaign to launch. For this reason, as many as 90% of all capital-based platform applications fail to pass the campaign launch.
The advantages for fundraising companies are access to a more sophisticated group of investors outside their own networks (traditional investors are increasingly flocking to such platforms), as well as a simplified procedure for working with – generally much smaller than other group financing platforms – a group of investors. There is also a growing trend for stock platforms to act as nominated shareholders on behalf of investors, meaning that the business takes on one new shareholder instead of several hundred, which greatly simplifies administration and makes future investments far simpler. Companies often want to overlook this particular point, but the main reason is that we chose Seedrs for our own fundraising campaign.
Stock platforms will usually hold funds under warranty until the campaign is over, adding another layer of protection for investors. Of course, the usual risks apply in terms of the expected return: most investments will not yield much, if anything, but ones that promise huge financial gains compared to other investment opportunities. Generally speaking, this type of crowdfunding is talked about in speculations about the impact of the format on the future of general investment.
Crowdfunding based on debt
Main players: Financial Circle, Zopa
Otherwise known as peer-to-peer lending, debt-based crowdfunding takes the basic benefits of crowdfunding – administrative benefits 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 money to companies seeking capital. Investors can either choose which companies they want to invest in or let the platform automatically choose on their behalf.
The main difference is obviously that the investor should expect a refund with interest. The appeal of putting money into a lending platform instead of a capital-based one comes down to a reduced risk factor, ensured by the fact that companies go through the same rigorous vetting procedures as they would when borrowing from banks and returns are often much higher than a simple ISA. and or pensions. For a company that meets the criteria for lending, the advantages are better rates than a bank with greater transparency.
While generally not ideal for early-stage collateralless beginners, for the elderly who want to grow, it offers access to cash without having to give up capital or take on hundreds of investors. For risk-averse investors, a safer alternative is capital financing, at the cost of missing out on potentially large returns that successful startups can sometimes bring.
Main players: Smith + Crown, Waves
The newest and least known type of crowdfunding, blockchain crowdfunding uses the power of cryptocurrencies like Bitcoin to generate money from creating new tokens in a process called Initial Coin Offerings (ICOs), favoring the more traditional Initial Public Offering (IPO) process we are used to on exchanges.
The way it works is quite complex to explain here, and understanding how blockchain and cryptocurrencies work is essential before you even think about this route (you can read my article “A Short Guide to Blockchain … for Normal People” here). As such, companies that raise money along this route are mostly associated with blockchain, and investors who accumulate on ICOs tend to take very high risks.
The appeal is in the potential return of investors from the cryptocurrencies themselves. For example, the cryptocurrency Ether doubled in just three days during March 2017, while the Monero currency increased in value by 2,000% last year alone. Of course, this level of volatility can go the other way as well, which will be confirmed by anyone who has recently invested in Bitcoin.
Blockchain’s decentralized architecture and distrustful approach, making it an obvious candidate for the preferred crowdfunding approach in the future, but the technology as a whole is still in its infancy and as such prone to fraudsters and frauds, as well as huge currency volatility. Not for the faint of heart.
Which one should you choose?
As an investor, deciding which crowdfunding platform to invest in depends largely on your risk appetite. If your goal is to get any refund, reward-based platforms should be completely excluded. In addition, if you are only looking for a better interest rate than ISA can offer, debt-based platforms can be a good option, otherwise choose a capital financing option if you want to be a “real” investor. Blockchain is for gamblers.
As a business, stick to reward-based platforms for consumer products that are in the concept or prototype phase, perhaps moving across major platforms when your product is launched. Debt-based platforms are a better choice for bridging financing if you are more established, and blockchain is an obvious option if you are a blockchain startup.
Whatever stage you are in, be sure to explore and explore before you dive, and as long as you have a reasonable head, there are exciting opportunities available to you that would probably never have existed before. For this reason alone, crowdfunding is a wonderful innovation.