Crowdfunding goes pro

Banking Insight, June 2014. Original article.

Screen Shot 2014-05-23 at 12.58.12How 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.

Enter Asia
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].”

Success factors
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.

Technology is the winner in banking innovation

Banking Insight, 2013. Original article.

BI_June2013Technology is the winner in banking innovation
The most exciting innovation in financial services right now are coming not from the banks, but the technology providers. And it is collaboration, not competition, that will win the game.

Banish jargon, be fair on fees, and ensure full investment transparency – these were key features when Nick Hungerford set up Nutmeg, the UK’s first online discretionary investment management company. Sure, the fintech startup is cute and clever, but as a true David in a world of Goliaths it begs the question: in times of financial uncertainty, why would Nutmeg be the customer choice over an established, proven financial institution?

For today’s adult banking customers, a company like Nutmeg may not come across as a serious contender. But by 2020, the still-under-30 Generation Y will match their older peers in terms of income, according to estimates by Javelin Strategy & Research. And these are the customers who may well look to a company such as Nutmeg and find it is exactly up their street: a no-nonsense option in a stuffy industry, the ability for each user to personalise the experience while at the same time, the option to do it all online without time-consuming meetings with financial advisors.

“We are proud that we are reforming an industry that has grown so bloated on its own profit margins that it has not always put the customer first. … We are proud to have helped so many people get one step closer to their financial goals,” said Nutmeg co-founder and chief financial officer Nick Hungerford, a former Brewin Dolphin stockbroker and Barclays wealth manager. Nutmeg’s social responsibility is a refreshing touch for younger customers, whose money are safeguarded by a custodian bank holding the investments on behalf of the regulatory-approved business. This leaves Nutmeg to focus on creating the sort of personalised and transparent service its next generation customers are looking for.

As the internet revolution continues to change the financial industry, Nutmeg has understood something vital: banking no longer exists in a vacuum. In a world where plane tickets can be bought online at midnight and tax returns can be filed in the same way, people are no longer willing to accept a banking system that requires taking time out of a busy work day to go and queue at a till. Especially those who have grown up with multitasking smartphones and retailers with one-click ordering are going to be looking for the same ease when it comes to choosing their banks and investment providers.

“Customers judge across their entire set of experiences rather than just comparing your organisation to others like it. We want our technology to be as intuitive and user-friendly as Apple products, the service we receive to be as thoughtful as we might get from Nordstrom, and personalisation and ease of payment as good as Amazon’s,” Rita McGrath, associate professor of management at Columbia Business School, wrote in Forbes. This seismic shift means a bank’s main competitor is not necessarily other banks anymore, but a telecoms provider which has picked up clever new technology to service its clients. Just consider that 55 million Africans use basic mobile phones to transfer money, resulting in an industry worth USD 61 billion last year, according to research from Gartner.

What customers want
Peers of Nutmeg include mobile-optimised banking solution Moven, social banking outfit SmartyPig, and next generation money transfer expert Dwolla, to name only a few. These will not be the names found on in the rankings for the most innovative banks, but their presence is a vital influence when the big players set out their innovation strategy.

“For four years since the financial crisis, banks have been heads-down focused on efficiency, cost cutting and in the worst cases, simple survival. But the rest of the world is not waiting for banks to bounce back,” Jeff Carter, chief development officer of technology company EyeLock and founder of the Center for Future Banking, wrote in American Banker. Carter acknowledges how innovation was in part to blame for the financial crisis, in the sense that it inspired hard-to-understand financial products, but while the industry licks its wounds, the world is moving forward at breakneck speed and old rules are being rewritten.

For example, 43% of US and UK Apple product owners would dump their current bank for Apple, according to a survey by research consultancy KAE. This may seem like an odd statistic, but it says a lot about the kind of ease of use people are looking for across all their services. The trend for banking to become more fragmented and decentralised leaves room for also smaller players to make their mark. Noted Lee Powney, marketing chief at KAE: “It would take a remarkable display of discipline [for Apple] to resist” moving into banking; “This research tells us Apple customers perceive a fit where at first glance we would assume the brand could not travel.”

Tipping points

Digital banking is set to overtake branch networks as the main way customers interact with their bank by 2015, according to findings in PwC’s 2012 report ‘The New Digital Tipping Point’, but commercial banks have been slow to step up to this challenge, said Robin Roy, associate director of financial services of PwC India.

“The lack of investment is perhaps even more surprising considering banks are struggling to grow revenues at a time of increased regulation and an increasingly volatile economic environment. Digital products are a significant opportunity for banks to grow revenues and serve their customers in a way that they want,” said Roy, noting that although banking customers are increasingly willing to pay for innovative services, the majority of banks still only provide basic mobile and internet banking services. 69% of customers said they use the internet to purchase financial products, and 33% do this via their mobiles, the latter being a rapidly growing segment.

It is perhaps no surprise then, that FastCompany’s shortlist of the world’s ten most innovative companies in finance only contained one traditional financial group: American Express. First on the list is Square, the little piece of hardware that enables vendors to take credit card payments straight onto a mobile device. Lending Club has been credited with bringing peer-to-peer lending to the mainstream, while OpenGamma is praised for its open-source risk management software. PayPal makes the list for its new in-store payment initiative, where customers can pay via the system even if they have forgot their wallet. PayPal, which was originally set up to handle online transactions in a time when standard banks deemed them too risky, now boasts 125 million users and processed USD 14 billion worth of transactions just via mobile last year; mobile payments are just 10% of the total.

Having said that, there are also plenty of banks who are pushing ahead in the innovation game. The annual ‘Finacle Global Banking Innovation Awards’ from BAI-Finacle and Infosys recognises banks for their innovative breakthroughs, selecting the winners after considering over 150 financial groups from 30 countries. First National Bank, a division of FirstRand in South Africa, was named Most Innovative Bank in 2012 due to its culture of innovation and advancement of retail banking. An internal competition formally encourages and supports new ideas among staff, and business units at the banks are given the power to move forward with ideas through leadership buy-ins.

OCBC Bank in Singapore was awarded for its product and service innovation, due to its practice of designing branches especially to service Generation Y customers. This means locating them in shopping centres or school campuses, using approachable language and playing popular music, and letting customers use interactive touch screens to shop for products. DenizBank of Turkey was also hailed for its channel innovation following its Facebook banking platform, through which users can access their personal data and perform financial transactions. Lastly, Alior Bank in Poland received the award for disruptive innovation due to its virtual bank which offers full financial services to Generation Y users, including the country’s first fully online credit checking process.

Joint efforts

PayPal, which blossomed by taking a chance where traditional banking would not, may justifiably be the sort of example that creates a source of stress for bank managers keen not to miss out on the next big thing. At the same time, banks face stricter regulatory pressures with Basel III in Europe and Dodd-Frank in the US, forcing them to deliver certain minimum capital and liquidity ratios, new data protection requirements and the challenges of balancing the threat of cyber fraud in an age where customers want quick and easy digital access to their money. In its 2012 report, ‘Optimising banking operating models’, KPMG issued the stark conclusion that for the foreseeable future, banks must acclimatise themselves to negative or low growth in the developed world: “To overcome inevitable loss of scale and cost issues, … [a]n imaginative approach is needed to cut costs and control a disintegrated value chain.” Fragmentation has already started to happen, noted report author David Sayer, global head of banking at KPMG UK, with financial groups across the world already having started disbanding its central operations in favour of into individual business units.

The adaptation of new technology will play a core part in the future of banking. Ramesh Nair, partner in the financial services team at Booz & Co, spoke of technology as an opportunity to provide customers with convenience, control, recognition, and transparency in a 2012 report on how banks can use emerging technologies to provide better service. Identifying the key areas of mobility, high end analytics, big data management, next generation data processing, cloud computing, and service-oriented architecture, said Nair: “To make use of these key enablers, organisations will need to refine their operating models, governance, data and application management, and technology architecture.”

In other words, some pretty major change is required. Investing in ageing IT systems will be a key challenge for banks, however there is no reason to reinvent the wheel with every new feature. For example, Visa is using cloud computing to access fraud data models from Google, noted Booz & Co; this cuts down model- building time from one month to 13 minutes. As cloud computing becomes more secure, this kind of outsourcing is becoming increasingly common. As is the pairing up of mature financial companies with smaller technology companies with good ideas – why compete if you can collaborate?

One example of how this can be done is PermataBank in Indonesia, which has teamed up with mobile money technology expert Monitise to launch a payments service for BlackBerry. Owners of the smartphone, which is popular in Indonesia because Messenger is free to use, can use the service to transfer money directly between handsets, bypassing branches or even banking apps. Monitise Asia Pacific Chief Executive Darren Sugden said:
“This launch is a ringing endorsement for how businesses with different commercial needs can collaborate in the fast-growing mobile, payments and banking space.” Vodafone India also has years of experience teaming up with local banks, starting with HDFC Bank in 2011 and now ICICI Bank, to provide mobile money transfers and payments. The M-Pesa scheme targets rural areas where bank branches are few and far between, meaning mobiles are often customers’ only banking tool.

A cultural shift
Considering the magnitude of the challenges faced by banks as they strive to stay innovative in tumultuous times, no one claims to have the definitive roadmap to how this should be done. CEOs are acutely aware that innovation is necessary to stay in the game, knowing the tech-savvy Generation Y customers are growing older every day, but at the same time the banks face stricter regulation and constant demands from shareholders for reassurance about strategy, and ultimately, cold hard cash.

The good news is that new and clever fintech companies are being incubated every day; Accenture launched the FinTech Innovation Lab London last year to help promote new solutions for the industry. Support and mentorship for the new companies are provided from world-leading finance names such as Barclays, Credit Suisse, Deutsche Bank and HSBC, who can bring experience, scale and global customer networks to the table. While banks need their own internal programmes to support innovation, looking around to see what else is going on may prove to be a fruitful solution – pairing up with a cool new startup with a great idea is after all a great way to tap into some of those Generation Y sensibilities of simplicity, transparency and social responsibility.

“As a critical component of the transformation now facing them, banks should take the time to examine their cultures carefully across four dimensions to ensure they are fostering value creation,” Toos Daruvala, a director of risk management wrote in McKinsey’s annual review of the banking industry. Not as easy as it sounds, this, as it requires a willing heart to reassess issues that lie at the core of the financial industry. It also requires, noted Daruvala, the balancing of the interests of shareholders and society as a whole, creating value for customers, ensuring the soundness of internal processes, and influencing the mindset of employees. But as the internet revolution roars ahead, anyone who thinks these changes can be kept to the sideline must think again: “Directors and senior managers should view cultural transformation as a strategic issue, not a public relations problem.” In other words, the world has changed, and banks must change with it. Innovation is the word, and there is no alternative.

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