Banking Insight, June 2014. Original article.
How crowfunding is becoming a viable fundraising tool for business
Starting out as a way to throw some cash at struggling musicians, crowdfunding is quickly growing into a fully fledged financing alternative for businesses seeking equity. Traditional banks best take notes.
They say necessity is the mother of invention – this would certainly explain why a brand new way for companies to access capital has emerged from a recession. Crowdfunding is the model that sprung up to fill the void when banks were reluctant to provide development cash for small companies during the economic downturn. For UK businesses, there is now a £84 billion to £191 billion gap in funding over the next four years, according to a government review. But if banks do not want to step up, there are others who might.
Of course, business equity was not what crowdfunding originally set out to do. Born in the creative industries, the first crowdfunding platforms were Kickstarter and Indiegogo, where musicians and artists could reach out to fans for cash for their next projects. Sometimes contributors would be rewarded with a copy of the product, but often the reward was simply to know they had contributed to something they wanted to see exist in the world.
This was the inspiration for equity crowdfunding, or peer-to-peer lending, which is slowly becoming a genuine alternative for businesses to access funding. For investors, the structuring of crowdfunding platforms is also improving to the point where they can offer not just donations but also loans with interest, and get return on equity if and when the company in question performs well.
An increasingly global market
Crowdfunding campaigns across the globe raised nearly USD2.7 billion in 2012 through all crowdfunding business models and platform types, according to the World Bank. USD1.6 billion of this was in North America, financing over a million projects including start-ups, scientific research, community projects and games. USD945 million was raised in Europe, with the remaining USD110 million in the rest of the world. Across all regions, crowdfunding expanded at a 63% compound annual growth rate (CAGR) from 2009 through 2012.
“While the recent global recession has played a part, advancements in technology are also a significant driver of the recent growth of this type of model,” said Yannis Pierrakis, Head of Investments Research at the National Endowment for Science, Technology and the Arts (Nesta), the UK innovation foundation. “The proliferation of internet use and growth in social media has enabled those seeking finance to reach more people with greater ease and at far less cost. The ability to securely transfer money online allows those seeking to back a project or business to safely contribute funds. And the increase in the quality and volume of data available on individuals and businesses finances allow for the creation of accurate credit scores, which allow lenders to set suitable interest rates on the finance they offer.”
It is still early days for crowdfunding, and Nesta’s 2013 report, ‘Banking on each other’, concluded it remains to be seen whether this kind of business lending will be sustainable over time. Still, studies by peer-to-peer lender Funding Circle have suggested companies are increasingly open to considering crowdfunding as a funding option, as long as the platforms provide attractive facilities. While 60% of businesses who approached Funding Circle had tried banks first, 77% said they would go straight to the crowdfunder next time. Speedy processing, good interest rates, clarity of terms, and easy-to-use platform was cited among reasons for preferring Funding Circle over banks.
Crowdfunding goes pro
Last year, UK fund management veteran Nicola Horlick raised £150,000 for her new film finance company, Glentham Capital, in just 22 hours through equity crowdfunding site Seedrs. About 135 investors chipped in to meet the funding target, which represents 10% of the new company. All UK-residing adults are eligible to invest via Seedrs, provided they pass a quiz showing they understand the risks of early-stage investing. Contributions can start as low as £10. Seedrs carries out due diligence on all the companies on the platform, and takes 7.5% of the funds raised, as well as 7.5% of any profit made by an investor through an exit or dividend.
“Having been a fund manager for the past 30 years, I know what a great opportunity it can be to invest in a fund management company. In the old days, there was no way that I could have opened an opportunity like this to the crowds, but Seedrs provides me with the perfect opportunity to do so,” said Horlick, who is now planning her own crowdfunding platform: Money&Co. “Our platform will let people lend to businesses at a rate agreed by both parties. It is a smarter way for businesses to get the capital they need and for people to get a better return on their cash.” said Horlick. “At the moment, banks are not doing enough for credit-worthy businesses. Money&Co will bring together good businesses that need to borrow to expand, with people who want to save at a more attractive rate than the banks offer.”
Money&Co will join Seedrs and Crowdcube in their mission to fund UK companies. SyndicateRooms and InvestingZone are among newer entrants to the market. Specialist platforms include MoolaHoop, focusing on women entrepreneurs, and Trillion Fund, targeting renewable energy projects. In the US, Crowdfunder, CircleUp and RocketHub have joined Kickstarter and Indiegogo in a market that now has over 300 platforms. These include Somolend which specialises in loans for small businesses, and Appbackr which focuses on fundraising for new apps. AngelList is among established names in Silicon Valley, connecting professional investors with startups.
Regulating a young industry
The US crowdfunding market got a boost last year when the Security and Exchange Commission (SEC) changed the rules to allow companies to sell stock via these platforms. Previously, shares could only be sold if they were registered, a process that can be costly for small companies. The SEC’s new rules, politically prompted as a means for job creation, have been well received in the industry as likely to encourage growth. “The way the world has worked in early stage investing has been fairly stable over the last 20 years. The argument is that it is hard to manage investors, time-consuming to communicate with them, and challenging to gather their votes,” said Sherwood Neiss, co-founder and Principal of Crowdfund Capital Advisors. “The data demonstrates, however, that while some investors may be saying negative things about crowdfunding, others are using this new tool for deal flow.” Data from Crowdfund Capital Advisors suggests 28% of companies had closed an angel investor or venture capital round within three months of crowdfunding, while an additional 43% were in discussions with institutional investors.
Having said that, this remains a crucial time for the crowdfunding industry to get its foundations right; the theoretical potential for scandal is there if practices are careless or investor education poor. Wrote Neiss in ‘VentureBeat’: “The [SEC] rules need to maintain the ability for investors to sue for fraud, while reducing lawsuits against companies that just fail. Even though the legislation mandates that investors complete an education series on crowdfunding, investors should also be required to sign a document acknowledging they could lose all their money, that they are responsible for reviewing the investment materials prior to investing.”
Also keen to see a solid foundation built for this budding industry, the UK’s Financial Conduct Authority (FCA) announced in March a new set of rules for crowdfunding. This included a requirement that non-professional investors do not invest more than 10% of their savings per year, a move criticised as excessively strict by the industry. The FCA, however, pointed to the “significant risk of failure” on part of the companies seeking funding as a motivator for protecting investors from getting in too deep. “We are trying to strike a balance between on one hand making sure consumers are properly informed and have real clarity about the investments they are getting into, but on the other hand, making sure this […] source of funding is open to businesses and individuals,” Chris Woolard, Director of Policy, Risk and Research at the FCA, told the BBC.
While crowdfunding has yet to make the same waves in the Asian markets, this may only be a matter of time. Singapore, Korea, Brunei and Malaysia have started showing interest in rewards-based portals, as several platforms have launched in South Asia in the last couple of years. Pozible is an Australian platform that expanded into Singapore and Malaysia earlier this year. “We are working to build up our user base in Asia, and these efforts are already starting to show developments, with an increase in Asian projects and Asian web traffic,” Pozible Co-founder and Director Rick Chen told ‘TechCrunch’. Focusing on funding creative projects, the company wants to differentiate itself by becoming a specialist in the region.
Swedish site FundedByMe entered the Singapore market last year, offering the option for local businesses to raise money in exchange for equity. “We see Singapore as the gateway to Asia. We will be reaching a massive new market of potential crowd investors who are eager to help us build on the cross-border investment motion that has made FundedByMe a popular choice for European investors,” said Daniel Daboczy, CEO and co-founder of FundedByMe. “Early feedback tells us that Asian investors are keeping a keen eye on the European start-up scene, and vice versa.”
Earlier in 2013, Singapore’s own Crowdonomic stepped up to provide a professional crowdfunding service for businesses. Leo Shimada, Founder and Managing Director of Crowdonomic, told ‘Fortune’ there are several reasons why the region has yet to fully embrace this funding model. The absence of a high-profile frontrunner like Kickstarter is one, as this means the concept is still alien to much of the general public. Local culture is another reason, said Shimada: “Wherever you are in the world, no one wants to be a loser, but especially [not] in a region like Asia, where there is this thing about saving face and a pronounced fear of failure.” This is different from Silicon Valley, which is unique in its acceptance of trying and failing as a natural part of building a business. As long as he or she works hard and is smart, an American entrepreneur can go to a crowdfunding site and still save face if the target is not reached.
Scholars have however deemed crowdfunding to be Shariah-compliant, suggesting it could become an interesting opportunity for Muslim countries to explore. The World Bank’s 2013 report, ‘Crowdfunding’s potential for the developing world’, pointed to the early success of Eureeca, which helps small companies in the Middle East raise equity, and Shekra, an Islamic finance-compliant site which combines an incubator model with crowdfunding for Egyptian companies. “There is a bias towards real estate and equity in compliant [established companies], you also have some commodity funds, and so on,” Rushdi Siddiqui, Co-Founder and Managing Director of Azka Capital and Shekra board member, told industry site ‘Crowdsourcing’. “But in the area of venture capital, which is what the essence of Islamic finance is supposed to be about – partnership and risk-sharing – there is very little [activity].”
When it comes to determining how successful a crowdfunding project will be, the quality of the project is only one factor. Ethan Mollick, Assistant Professor at the Wharton School of the University of Pennsylvania, found that equally important is the size and quality of the founder’s network, and whether the project has a connection to the founder’s geographic area.
“For entrepreneurs who seek crowdfunding, there are some clear lessons. First, project quality is important, and entrepreneurs should look for ways to signal preparedness. Social network ties have also been found to be important in crowdfunding,” said Mollick in his 2012 research paper, ‘The dynamics of crowdfunding’. “Second, appropriate goals are those that allow a founder to deliver a product on time; achieving significantly more funding than requested is rare. Most importantly, careful planning is required both to set these goals and to prepare for a crowdfunding success, which will entail a need to rapidly execute a promised venture.”
While smaller companies looking for crowdfunding may find there is more competition now as the funding method has become more popular, others may find there is more money to go around. As platforms are being set up to handle larger investments, the bigger guns in traditional finance are increasingly showing interest; US peer-to-peer platform Lending Club spent around USD1.5 billion last year, and has among its directors former US Treasury secretary Lawrence Summers and ex-Morgan Stanley CEO John Mack. Last year US hedge fund Eaglewood Capital sold some of its Lending Club loans in a USD53 million securitisation deal, essentially giving institutional investors exposure to SME loans for the first time.
Of course, this is nothing in comparison to the funds handled by traditional financing outlets, but for an industry that is only a few years old, it is a flying start.