In part one of our topical CF101 series, we outlined the basics of crowdfunding: the “what”, “who”, “why” and “how”. Today’s post will delve into more detail about the different types of crowdfunding platforms.
As depicted in the infographic above, the alternative finance/crowdfunding industry started with essentially four types of models: (1) reward-based; (2) donation-based; (3) debt-based ; and (4) equity-based.
With its roots in donation and reward-based crowdfunding, alternative finance began as a seed-stage endeavour. More recently, however, given the industry’s ability to successfully challenge more traditional institutions, there has been a number of newer entrants to the market. They are designed to complement the existing players and include liquidity and exit based models, real asset models and wealth management models.
Before we overwhelm you with the details of the later type of crowdfundingmodels, let us first define and outline how the four basic crowdfunding models work.
1) Reward-based Platforms
Contribution in exchange for a perk or a pre-order of a product.
Popularised by Indiegogo and Kickstarter, reward-based funding allows users to make donations to companies or non-profits raising capital in return for an incentive. Those incentives include early access to products, gifts, or an increased sense of self-worth. Compared to equity and debt-based models, reward-based crowdfunding applies mainly to firms in the idea or early prototype phase, or organisations that wouldn’t seek traditional financing like not-for-profits.
Kickstarter is perhaps the best known reward-based platform. As of July 2015, Kickstarter had $1.8Bn in pledges by 9Mn+ total backers. Platforms like Kickstarter have proved particularly beneficial to companies who are developing products. The platforms provide an important portal through which issuers can market their product directly to consumers, gain feedback on initial prototypes and validate their ideas, essentially de-risking the process of starting a business. In turn, this makes it more likely that they will go onto raise Angel/VC rounds in the future.
However, with the present capital gap for enterprises in both the start-up and early growth phase discussed above, alternative finance solutions have rapidly moved upstream. No longer are issuers solely looking for seed capital. Companies in the early stage and growth phase are all tapping funding platforms as a means to raise capital.
2) Donation-based Platforms
Philanthropic donation or gift, no return expected
Similar to reward-based platforms, donation-based crowdfunding is non-financial. Donations are given with no expectation of a financial return. Owners of non-financial crowdfunding campaigns typically solicit funds for independent projects or initiatives that appeal to others with similar interests. For example, an NGO may launch a campaign to build a school for children in a rural district. As long as there is no expectation or legal obligation of a return for the money provided, the transfer is considered a donation or a gift, and is thus referred to as donation-based crowdfunding.
3) Debt-based Platforms
Capital repayment, most often with interest
With lending-based crowdfunding, investors receive a debt instrument that specifies the terms of future repayment. This is essentially an obligation of the campaign owner to repay the funds provided by the investor, which typically consists of the principal plus a fixed rate of interest. Note that interest is not always included in lending-based crowdfunding contracts, leaving room for impact investors to support budding entrepreneurs and businesses that require patient, low-cost capital to get started. Lending-based crowdfunding can include peer-to-peer (P2P) and peer to business (P2B) lending.
Currently, the largest debt-based players include Funding Circle, Lending Club, and Prosper. As evidenced by Lending Club’s recent IPO, this sector of lending continues to gain traction on both the consumer and commercial side. This includes more than $9.2Bn of loans issued by Lending Club and $1Bn issued by Funding Circle. Morgan Stanley estimates that the P2P lending market, which it says is a “misnomer” because of increased institutional activity in the space, will be worth $290Bn in five years.
As it stands, debt-based alternative funding appears more popular with more mature and well-established SME’s, many of whom prefer the cost benefits of an alternative-funding model.
4) Equity-based Platforms
Investment with an ownership stake in the business
Equity-based crowdfunding provides investors with an equity instrument that confers a share of ownership or a share of future earnings. A crowdfunded’s return is therefore essentially tied to the future success of the business they invested in. While this exposes the investor to the potential for greater returns, it also presents a greater risk should the venture fail, as equity holders are subordinate to creditors in line for repayment.
Equity crowdfunding has been on the rise for some years, with the UK leading the charge. Other countries like Australia and New Zealand also made early regulatory moves in the area. Both the US and UK began discussing crowdfunding rules in 2010, but the UK has been faster in allowing broad public access. In 2012, with the passing of the JOBS Act in the United States, equity crowdfunding was made available to accredited investors.
Numerous platforms have emerged to serve this market segment and there is now an increasing array of companies at various stages of the funding cycle and operating different business models. These include businesses in the growth equity, private placement, M&A, secondary, and wealth management markets. These platforms are now able to provide a holistic solution for businesses at all stages of the funding cycle. Equity crowdfunding models provide young businesses with a platform that allows them to reach a wide range of investors.
5) Royalty-based Platforms
Crowdfunders invest in campaign owners and receive a share of revenue earned in return for their investment
Besides lending- and equity-based crowdfunding, a third model of financial crowdfunding that has emerged recently and started to gain more traction in 2013 and 2014 is royalty-based crowdfunding. This method generally involves investors receiving a percentage of revenue derived from a license or a usage-based fee for the other parties’ right to the ongoing use of an asset, rather than interest on a loan or appreciation in capital stock (equity).
What About the Risks?
In terms of risk, donation and reward-based crowdfunding are lower on the risk spectrum when compared to the financial crowdfunding models. As with all types of crowdfunding though, crowdfunders are exposed to the risk of fraudulent campaigns and, as any ecommerce systems, include risks of cybersecurity.
For reward-based campaigns, crowdfunders are exposed to fulfilment risk (the campaign owner may not fulfil the promise to deliver a reward). The downside of P2P is that loans are not contract-based and that consequently, legal guarantees for either party are not easily obtained. For equity crowdfunding, the venture could not take off, leaving investors with nothing (as they are subordinate to creditors).
In essence, over time, one would expect a broad swath of financial services currently carried out at bricks and mortar institutions to transition to alternative models as business and cultural support is gained. This growth will more than likely mean the market will stratify leading to niche players before an eventual shakeout occurs.
The article was originally published on DealIndex. Interested in reading more insights on the equity crowdfunding landscape? Please download DealIndex’s “Democratising Finance” research report or register to DealIndex Dashboard.