Crowdfunding has emerged as a unique method for small and nascent businesses to find the capital they need to grow. As the name suggests, crowd-funding means that the ‘Crowd’ funds your business. Crowd funding is by definition, “raising small amounts of money from a large number of individuals or organizations, to fund a project, a business or personal loan, and other needs through an online web-based platform”. It was estimated that over US $34 billion was raised worldwide through crowd funding in the year 2015.Faircent, Ketto, and Wishberry are some of the best known crowdfunding sites in India.
So why has crowdfunding become so popular? This is mainly because financing has always been a challenge for start-ups and crowdfunding provides easy accessibility of vast networks of people through social media and brings the investors and the entrepreneurs together. There are three main reasons why people unconnected to a project or business would support it:
- They connect to the greater purpose of the campaign
- They connect to a physical aspect of the campaign like the rewards
- They connect to the creative display of the campaign’s presentation
Types of Crowd funding: There are four main types of crowd funding:
- Rewards Based Crowdfunding: Money raised through rewards-based crowdfunding doesn’t have to be paid back, but in return for donations, businesses provide rewards such asa copy of the product or a service. This is one of the least costly ways to raise capital. However, exposing an idea online may put your business at risk of having it stolen and marketed by someone else. Moreover, rewards-based crowdfunding works well for business-to-consumer ideas but is not very effective for business-to-business campaigns.
- Equity Based Crowdfunding: Equity crowdfunding, involves the offer of securities which include the potential for a return on investment. Investors receive a stake in the company. Equity crowdfunding, specifically digital equity crowdfunding platforms, are illegal in India.
- Donation Based Crowdfunding: Social lending/donation crowd-funding is a way of fundraising for charitable causes. These do not provide any financial return in the form of a yield or return on investment. Common donation-based crowdfunding initiatives include fundraising for disaster relief, charities, non-profits, and medical bills.
- Lending Based Crowdfunding: This type of crowdfunding uses an online platform to match lenders/investors with borrowers/issuers in order to provide unsecured loans. The borrower can either be an individual or a business requiring a loan. It is characterized by the ability of lenders to provide money for small fragments of the overall loan required by a borrower; these are called “loan parts”. These loan parts are then aggregated by the online platform and when there is enough to cover the required loan, the loan is originated and paid to the borrower. The interest rate is set by the platform. The borrower then pays back the loan with interest. This interest rate is usually higher than the savings rates available to the lender but lower than a traditional loan available to the borrower, though this depends on the borrower’s evaluated risk.
Benefits to Crowdfunding: Some of the benefits associated with crowd funding include:
- More efficient than traditional fundraising: Compared to applying for a loan or seeking out accredited investors yourself, setting up a successful crowdfunding campaign on an online platform is far more efficient and effective in getting your message out to the right people. With the right platform, you can tell your business’s story, produce a quick video, set up some enticing rewards, and benefit from having everything in one centralized location where potential backers can find you.
- Crowdfunding helps in economic growth through new and increasing flows of credit to SMEs and other users in the real economy. Any mechanism that helps SMEs more efficiently access capital for their development and expansion helps job creation and aids economic recovery.
- Fills a gap left by banks: The tighter restrictions on traditional lenders through higher capital requirements have reduced their appetite to issue uncollateralized credit, for personal loans or other loans. Crowd funding platforms have moved in to fill this gap, and as a result have grown exponentially.
- Lower cost of capital/high returns: Crowd funding provides a low cost alternative for channelling savings to the real economy, usually at lower rates than through traditional funding.
- Convenient: An online platform has the added benefit of convenience. Online platforms are more accessible to users, who may find it easier to manage their portfolio as a result.
Key Risks: There are a number of risks associated with crowd funding, and which challenge retail investor protection. These include:
- Risk of default: In equity crowd-funding, the risk of default/investment failure is estimated to be around 50%. In peer-to-peer lending there has been a concerted effort by the industry to reduce default rates, which reached a high of 30% in 2009. While there has been some success in reducing the default rate, the actual rate of default in many cases is unknown as many of the platforms have only opened in the last three years and the loans originated by them have only recently started to mature.
- Risk of platform closure/failure: Despite the short life of crowd-funding, there has already been a case of a peer-to-peer lending platform closing leaving no data on contracts behind and resulting in 100% investment loss. Investors bear a higher risk than in many other types of investments.
- Risk of fraud: This is compounded by the anonymity created by the online aspect of crowd funding.
- Risk of cyber-attack: The online nature of crowd-funding makes it vulnerable to the risk of cyber-attacks.
- Reputation: Failure to meet campaign goals or to generate interest results in a public failure. Reaching financial goals and successfully gathering substantial public support but being unable to deliver on a project for some reason can severely negatively impact one’s reputation.
Future of Crowd Funding in India
Even though crowdfunding is regulated in India, it will nevertheless flourish. India CorpLaw asserts that even though SEBI may have introduced easier listing, shareholding and disclosure norms for start- ups, the fact remains that quality of investments is much more advanced with investors overseas than in India.
While listing on Indian stock exchanges will ensure a wide array of investors, crowdfunding will ensure that the company receives funds not only from investors across the globe but also from investors who feel for the project. The emergence of India as a start-up hub with wide options on how to raise funds has most business ventures turning to reward based crowdfunding as the best way to raise quick funds.
Member – Alumni Relations Team