Crowdfunding is revolutionising the way businesses and projects are being funded, allowing small companies to raise funds by through a large number of small investors, customers or lenders.
In more general terms crowdfunding is 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 money for a business, project, product or cause. Within crowdfunding, there are three major models of raising funding that have become popular, these are equity-based, loan-based and reward based.
Crowdfunding platforms offer small companies a way to raise large sums of capital from a variety of minority investors, customers or lenders in a short time frame. This form of business fundraising is proving increasingly popular and is not just used to fund enterprises but also social movements, creative projects and more.
Equity-Based
Equity-based crowdfunding is where individuals and private investors receive a percentage of equity of a company in return for their funding/investment. The main providers to date of equity crowdfunding in the UK are Crowdcube and Seedrs, where individuals can invest as little as £10 and small businesses/startups can raise a minimum investment of at least £10,000, with there being no maximum limit on the amount a company can raise.
These type of platforms offer unprecedented access to the average person to invest in new and growing companies in a way they were unable to do before, they also offer better access to more traditional private investors such as business angels, venture capital funds and angel investment networks or syndicates (most will require you to have SEIS advanced assurance).
What Matters to Equity-Based Investors
Equity Crowdfunding Investors want to know something about the issuer, and its offering, much like a father wants to know about the boy who wants to date his daughter. It’s about the Why. Regardless of the ultimate lack of relevance for a pre-revenue stage company’s financial projections, investors like to see them in excruciating detail. The details of, and rationale for, a Company’s go-to-market strategy is of significant interest.
They also like to measure if the company’s social media activity is commensurate with the type of offering and size of the amount of funding requested. On top of all of that, the Cap Table and exit strategy need to be reasonable.
Raising money from equity crowdfunding investors is a different type of hard. In the world of entrepreneurial finance, backers are smart and quite discerning. Those who will back your company care about resolving the macroeconomic trauma that has prompted this need for alternative finance. The new fact that market acceptance trumps technical risk (for most offerings) means there are benefits of completing a successful crowdfunding round beyond just cash. There are, however, practical implications of this rise of the “presumer” (defined a consumer who interacts in different ways with a product pre-launch).
In all cases the entrepreneur seeking investment pitches for funding via a website, explaining what they do and what they would use the money for.
Loan-Based
This is where investors lend money to startups in much the same way as a bank loan. In this scenario, private individuals combine together to act rather like a bank and lend to a business, though this type of loan is typically much riskier (as the lender is directly exposed to the borrower’s credit risk). This type of borrow cuts out an intermediary and connects lenders and borrowers directly using an online platform.
Providers of this type of crowdfunding include Funding Circle, 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 hundreds of millions of pounds to thousands of companies with an average annual interest rate of 8.4%, which in most cases is a better interest rate than you could hope to get from a bank. Other popular platforms such as Zopa, Ratesetter and Funding Circle are all loan-based.
Legal Requirements for Lending/Borrowing
For this type of crowdfunding, there are also pretty strict legal guidelines that have been in force for a few years in the UK now to protect the lenders and borrowing businesses. The rules for loan-based crowdfunding include the following:
- All information about the platform must be clearly and plainly presented to all investors.
- All communication must be fair and not misleading.
- The lender’s money is ring-fenced from the crowdfunding platform itself, so if the platform suffers financial problems, the lender’s money is safe.
- There must be guarantees in place so that loan payments continue to be made if the platform goes out of business. This could include measures that allow for 3rd parties to bail-out the platform.
- If there is no secondary market for the loan, the investor must be free to cancel the loan within 14 days, with no reason required.
- Investors have access to the financial ombudsman service for complaints.
- Prudential requirements of £50,000 or a percentage of loaned funds imposed on crowdfunding platforms, which must be ring-fenced.
- Crowdfunding remains outside the Financial Services Compensation Scheme (FSCS)
Reward-Based
Reward-based crowdfunding is where individuals pre-purchase products or agree to support a products development, cause or project and in return receive a reward. This reward can be in the form of appreciation, the actual product once development is finished or even dinner with the creators or said product/project among more crazy rewards.
For startups and small businesses, this type of crowdfunding is only really possible if you have a product and some very good marketing skills, as you have to get people to purchase a product that probably doesn’t exist months or even years before they might receive it
To further illustrate the concept, here’s an example of one of the biggest reward-based crowdfunding stories to stories to date; Pebble Watches raised $10.3 million dollars in pre-orders for their Kickstarter campaign for their innovative smartwatch product that took the world by storm.
