What is crowdfunding? The new alternative finance

Crowd of people overwashed in blue.

Crowdfunding is a new concept based on the idea of using the power of the internet to amass small amounts of funding from lots of individuals to raise a meaningful amount of use to an entrepreneur.

Related: List of crowdfunding platforms

How it works

There are two main types of crowdfunding – equity-based, in which investors receive a sliver of equity in return for their funding; and loan-based, where private individuals lend the money in return for interest. In both cases the entrepreneur seeking investment pitches for funding via a website, explaining what they do and what they would use the money for.

Equity-based

The main provider to date is Crowdcube (crowdcube.com), where individuals can invest as little as £10 and businesses can ask for an investment of at least £10,000, with no maximum limit. Individuals invest in the hope of getting a return on their investment if and when the business is sold for a profit in the future. To date, Crowdcube has raised £2.8 million for 18 small firms.

Loan-based

Providers include Funding Circle (fundingcircle.com), where individuals can lend a minimum of £20 and businesses can borrow up between £5000 and £250,000 for a period of one, three or five years. Lenders receive a fixed rate of monthly interest agreed in advance by the two sides. To date, Funding Circle has lent a total of £32 million to 750 firms at an average annual interest rate of 8.4%. Other providers include Zopa.com, which lends to private individuals who can then use the money for business purposes.

Who can crowdfund

Anyone with a UK-based limited company can apply for funding on Crowdcube. Those seeking funding via Funding Circle must be either partnerships or limited businesses, have at least two years of published accounts and have no outstanding County Court Judgements over £250.

How much can you get

Crowdcube will facilitate investments of between £10,000 with no upper limit; Funding Circle will enable loans of between £5000 and £250,000.

Advantages

Crowdfunding accesses untapped funding resources and effectively bypasses the banks, so providing useful competition. It can also be a much quicker way of securing funding – Funding Circle says that once posted on their website, funds can be available within days rather than the weeks or months it can take for a bank to make a decision.

Disadvantages

Crowd funding is not currently regulated by existing UK financial services legislation, leaving both borrowers and lenders potentially vulnerable to rogue players entering the market in future. Equity-based crowd funding is a particularly risky proposition for investors – with two in every three start-ups going bust, and few businesses successful enough to eventually be sold, the chances of individuals getting their money back are uncertain at best.

Things to consider

Under Crowdcube rules, start-ups seeking money have to secure investor backing for the full amount asked for by the deadline to get the money. If they only manage to get pledges for some of that amount, they won’t get any of it at all. The reasoning behind this is investors are investing their money on the assumption that the entrepreneur will be able to use the total investment specified to grow their venture – if they don’t actually get much of the money, that makes the prospects for the business a very different proposition. Crowdcube makes its money by taking 5% of any successful fundraising as a fee.

The practicalities

Be prepared to have lots of small investors believing they have to right to offer advice to – and get involved in – your business, and at the very least expect regular updates in return for their £10 investment. Be careful about making you and your business too accessible to them in the early days – it may be charming at first but will quickly become irritating and hard work.

Case study

Alex Kammerling became one of the first British businesses to secure finance via crowd funding when he raised £180,000 through Crowdcube from 85 private investors in return for a combined equity stake of 23%.  He will use the money to grow his small business, Kamm & Sons, which makes and sells a ginseng-based alcoholic drink.

Alex said crowd funding was a model which really appealed to him: “I would much rather give equity away than take out a bank loan. I have opened myself up – my business plans are on the website and all my projections of what I am doing. That kind of honesty is a very modern way to do business. It means you have to be completely transparent. I was very nervous about it, but it has been brilliant.”

Top tip

Do your homework. Look at how much other businesses have raised – and for what – using crowd funding, and pitch your proposition accordingly.

If this sounds like something for you, have a gander at our top tips to ensure crowdfunding success.

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