Crowdfunding is in vogue, new platforms are appearing more and more often. 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, and so on. All of this may sound strange, but as with most things, the underlying logic is simple.
The most important advantage of crowdfunding is that it makes investing in small companies and startups accessible to everyone. For this reason, it is more important than ever that people fully understand this new world, as much of the negative publicity surrounding crowdfunding is largely focused on the misuse and misunderstanding of the platforms. In this article, I’ll talk about the different types of crowdfunding platforms, the main players in each category, and explain some of the main pitfalls that many newbies fall into.
But first a definition.
What is a crowd?
Ordinary, ordinary people. And that’s what the “crowd” means in crowdfunding. You see, raising money isn’t really about business plans, market traction, or financial projections: it’s ultimately about trust. And in life, the higher the risk of getting hurt, the more important trust becomes. For this reason, most people don’t mind putting a few pounds into sponsoring a charity run or lending a friend a few pounds; there is a general consensus that you should not expect to see the money again, and thus the level of trust in the person you are giving the money to should not be particularly high. But when someone asks you to invest several thousand pounds, the situation is radically different. For most people, this is not an amount of money they can afford to lose. So most people have been shut out of the investment world where small businesses need thousands of pounds.
It is therefore logical that the traditional ways for founders to finance their business were through channels such as loans from banks, wealthy individuals, friends and family. A founder’s ability to raise money was largely dependent on his collateral in the case of a bank loan or his personal network in the case of private equity investments, consisting of large chunks of money from a small handful of people who trusted and/or vetted them thoroughly. The alternative – raising small chunks of money from large numbers of people – was virtually impossible, unless the founder happened to know hundreds of people and was unwilling and unable to deal with the huge administrative costs associated with that many people.
Enter the Internet with its storied history of both eliminating administrative headaches and connecting large groups of people. Crowdfunding essentially facilitates the search between regular people interested in investing in things and regular founders who don’t have access to collateral or vast networks of wealthy people. The software that runs on the crowdfunding platform handles all the administration, while the Internet itself provides a huge potential pool of people that the founder can sell to at scale.
In short, crowdfunding allows you to raise small amounts of money from a large number of complete strangers. For that reason, it’s great.
The main types of crowdfunding platforms
There are four main types of crowdfunding platforms, all with different benefits and risks. Below are the main ones with links to the largest or best-known operating companies.
Major players: Kickstarter, Indiegogo
Closer to traditional philanthropic fundraising, reward-based platforms take money in the form of pledges or donations, and in return you receive some sort of business return or perk. For example, you can get a discounted unit of a product that is funded after its production, or for a higher donation amount, you can get a personalized version of the same product as a thank you for your support. This is the “reward” in question, and usually the bigger the deposit, the better the reward.
For obvious reasons, you tend to find mostly physical products on reward sites where the money is used to prototype a concept into first production. They are also popular for creative projects such as movies, games or music albums, where fans can support their favorite artists and receive perks such as end credits in return.
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 and individuals raising money, and with minimum pledges starting at just £1, the barrier to entry for an investor is also minimal. Scammers often present fake product prototypes in videos with concept art and renderings, only to disappear with the money after the campaign ends. In this case, investors have little recourse but to complain to the crowdfunding platform itself for compensation, but the lines of responsibility for the risk are somewhat blurred.
There are fantastic opportunities to support exciting projects on reward-based platforms, but the risk is the highest and the returns are usually invisible. Investing in a rewards-based platform should be done out of passion for the product you’re investing in, not an expectation of financial gain.
Major players: Seedrs, Crowdcube
Much closer to the traditional concept of investing, equity-based platforms facilitate investments in businesses in exchange for equity in those businesses. Equity platforms are regulated by the UK’s Financial Conduct Authority and investors must meet certain legal requirements. However, they are not particularly strict and usually involve a simple credit check and filling out an online questionnaire. Minimum investment amounts are still very affordable and are usually around £10, although some equity platforms have higher minimum stakes.
However, for businesses that want to raise, the entry process is much tougher. Due diligence is done for each campaign and the submission process usually consists of a series of iteration and approval stages before the campaign can be launched. An obvious advantage for investors is the added level of protection for their investment. Fraudsters or fraudsters are much less likely to start on share platforms, and FCA rules require businesses to back up their claims with evidence, which the platform will independently verify before allowing the company to run. For this reason, 90% of all applications for equity-based platforms do not make it to the launch of the company.
The advantages for companies raising money 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 streamlined process of working with a – usually much smaller than on other crowdfunding platforms – group investors. There is also a growing trend for investment 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 much easier. Businesses looking to raise money often overlook this point, but it’s the main reason we chose Seedrs for our own fundraising campaign.
Equity platforms will typically hold funds in escrow until the company closes, adding another layer of protection for investors. Of course, the usual risks apply in terms of expected returns: most investments won’t pay much, but those that do promise huge financial gains compared to other investment options. Generally speaking, this type of crowdfunding is what is mentioned in speculation about the format’s impact on the future of investing in general.
Key Players: Funding Circle, Zopa
Otherwise known as peer-to-peer lending, debt crowdfunding takes the main advantages of crowdfunding – administrative advantages and access to large groups of people – and applies them to business lending. Simply put, investors put their money into a fund managed by a platform, and the platform lends money to businesses looking for capital. Investors can choose which business they want to invest in or let the platform make the selection automatically on their behalf.
The main difference, obviously, is that the investor must expect to get the money back with interest. The appeal of putting money into a loan platform instead of equity comes down to the reduced risk factor provided by the fact that businesses go through the same rigorous vetting procedures as bank loans, and returns are often much higher than a simple ISA or pension. A business that meets the lending criteria benefits from better rates than a bank with more transparency.
While generally not ideal for early-stage startups without collateral, for more established startups looking to grow, it offers access to cash without having to give up equity or raise hundreds of investors. For more risk-averse investors, it’s a safer alternative to equity crowdfunding at the cost of missing out on the potentially large profits that successful startups can sometimes bring.
Crowdfunding on the blockchain
Key players: Smith + Crown, Waves
The newest and least known type of crowdfunding, blockchain crowdfunding uses the power of cryptocurrencies such as Bitcoin to generate cash from the creation of new tokens in a process called initial coin offerings (ICOs), which resembles the more traditional initial public offering (IPO) process. which we are used to in the stock markets.
It’s quite complicated to explain how this works, and understanding how blockchain and cryptocurrencies work is essential before even considering this path (if you’re interested, you can read my article “A Quick Guide to Blockchain… for the Common Man” here). Therefore, businesses that raise money this way are mostly blockchain-related themselves, and the investors involved in ICOs tend to have a very high risk appetite.
The appeal lies in the potential returns for investors from the cryptocurrencies themselves. As an example, the Ether cryptocurrency doubled in value in just three days in March 2017, while the Monero currency increased in value by 2,000% in the past year alone. Of course, this level of volatility can go the other way, as anyone who has recently invested in Bitcoin will attest.
Blockchain’s decentralized architecture and trustless crowdsourcing 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 as such is prone to scams and fraud, as well as the high volatility of the currencies themselves. . Not for the faint of heart.
Which one to 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 profit, you should avoid reward-based platforms entirely. Alternatively, if you’re just looking for a better interest rate than an ISA can offer, debt-based platforms can be a good option, otherwise go for the crowdfunding option if you want to be a ‘real’ investor. Blockchain for gamblers.
As a business, stick to rewards-based platforms for consumer products that are in the concept or prototype stage, perhaps moving to equity platforms once your product is launched. Lending platforms are the best choice for transitional funding if you are more established, and blockchain is an obvious option if you are building a blockchain startup.
Whatever stage you’re at, be sure to shop around and do your research before you take the plunge, and as long as you keep your wits about you, you’ll be presented with exciting opportunities that you’ve likely never seen before. For this reason alone, crowdfunding is a great innovation.