A Brief Guide to Crowdfunding For Normal People

Crowdfunding is all the rage, with new platforms popping up ever more frequently. Many consider it to be the future of investing; others warn that its risks are often underestimated. There are different types of crowdfunding: reward-based, equity-based, debt-based, flexible, fixed, etc. It can all seem bewildering, but like most things, the underlying logic is simple.

The most important benefit to crowdfunding is that it invests in small companies and startups accessible to everybody. For this reason, it is more important than ever for people to fully understand this new world, as most of the negative publicity around crowdfunding is primarily focused on misuse and misunderstanding of the platforms. In this article, I will cover the different types of crowdfunding platforms, along with the leading incumbents in each category, and explain some of the primary pitfalls that ensnare many newcomers.

But first, a definition.

What is the crowd?

Ordinary, everyday people. And that’s what the “crowd” in crowdfunding refers to. You see, raising money is not really about business plans or market traction or financial forecasts: it’s ultimately about trust. And in life, the higher the risk of being hurt, the more important trust becomes. For this reason, most people don’t mind putting a few pounds towards sponsoring a charity run or lending a friend a few pounds; there’s a general acceptance that you shouldn’t expect to see that money again, and as such, the level of trust in the person to whom you are giving the money doesn’t need to be exceptionally high. But if somebody asks you to invest several thousand pounds, the situation is radically different. For most people, this is not an amount of money that they can afford to lose. Therefore, most people have been locked out of the investment world, where small businesses need thousands of pounds to be invested.

Therefore, it’s logical that the traditional routes for founders financing a business have been channels like loans from banks, high net worth individuals, and friends and family. A founder’s ability to raise money has depended mainly on their collateral in the case of a bank loan, or their network in the case of investments from individuals, and consisted of big chunks of money from a small handful of people who trust them and have thoroughly vetted them. The alternative – raising small pieces of money from a large number of people – has mainly been impossible unless the founder happens to know hundreds of people and is both willing and able to deal with the enormous administrative overhead of dealing with so many people.

Enter the internet, with its well-established history of removing administrative headaches and connecting large groups of people. Crowdfunding essentially facilitates the matchmaking between ordinary people interested in investing in things and familiar founders who don’t happen to have access to collateral or large networks of wealthy individuals. The software running the crowdfunding platform handles all of the administration, while the internet itself provides a vast potential pool of people for the founder to market to, at scale.

In short, crowdfunding makes it possible to raise small amounts of money from a large number of total strangers. For that reason, it’s great.

The main types of crowdfunding platform

There are four main types of crowdfunding platforms, all with different advantages and risks. Below are the main ones, with links to the largest or most well-known incumbents.

Reward-based crowdfunding

Leading players: Kickstarter, Indiegogo

The closest sibling to the traditional charity fundraiser, reward-based platforms make money in the form of pledges or donations, and in return, you get some kickback or perk from the business. For example, you might get a discounted unit of the product being funded once it’s manufactured, or for a higher donation amount, you might get a personalized version of the same product as a thank you for supporting it. This is the “reward” in question, and usually, the higher the pledge amount, the better the reward.

For obvious reasons, you tend to find primarily physical products on reward-based sites, where the money is used to take a concept prototype to the first production. They also tend to be popular with creative projects such as movies, games, or music albums, where fans can support their favorite artists and get perks like credit at the end of the film in return.

The downside to reward-based sites is that they are vulnerable to scams and fraud. It is usually very little or no due diligence on the companies or individuals raising money, and with the minimum pledge amount starting at as little as £1, the barrier to entry on the investor side is minimal. Scammers will often present fake product prototypes in a video featuring concept art and render, only to disappear with the money once the campaign is over. The investors, in this case, have little recourse except to complain to the crowdfunding platform itself to get a refund, but the lines of responsibility around risk are somewhat hazy.

There are fantastic opportunities to back exciting projects on reward-based platforms, but the risk is highest, and the return generally not appreciable. Investing on a reward-based platform should be done out of a passion for the product you’re investing in, not with an expectation of financial returns.

Equity-based crowdfunding

Leading players: Seedrs, Crowdcube

Much closer to the traditional notion of investing, equity-based platforms facilitate investments in businesses in exchange for equity in those businesses. The Financial Conduct Authority regulates equity platforms in the UK, and investors must meet specific legal requirements. These are, however, not particularly stringent and usually involve a simple credit check and completion of an online questionnaire. Minimum investment amounts are still very accessible at around the £10 mark usually, although some equity platforms have a higher minimum stake.

For businesses looking to raise, however, the entry process is much more challenging. Proper legal, due diligence is performed on every company, and the submission process usually consists of several rounds of iteration and approval before the campaign can go live. The obvious benefit for investors is the added layer of protection for their investment. It is much rarer for scammers or fraudsters to launch on equity platforms, and FCA regulations require claims by the businesses to be backed up with evidence which the platform will verify themselves before allowing the campaign to launch. For this reason, as many as 90% of all applications for equity-based platforms fail to make it through to campaign launch.

The advantages for businesses raising money are access to a more sophisticated group of investors beyond their networks (traditional investors are increasingly flocking to such platforms) and a streamlined process for dealing with the- generally much smaller than other crowdfunding platforms – group of investors. There is also an increasing trend for equity platforms acting as nominee shareholders on behalf of the investors, which means the business takes on a single new shareholder instead of several hundred, making administration much more accessible and making future investments far more straightforward. This particular point is often overlooked by businesses looking to raise but is the main reason we chose Seedrs for our equity fundraising campaign.

Equity platforms will generally hold the funds in escrow until the campaign is over, adding another layer of protection for investors. Of course, the usual risks apply in terms of expected returns: most investments will not return much, if anything, but the ones that promise huge financial gains compared to other investment options. Generally speaking, this type of crowdfunding is what is referred to in speculations about the impact of the format on the future of investing typically.

Debt-based crowdfunding

Leading players: Funding Circle, Zopa

Otherwise known as peer-to-peer lending, debt-based crowdfunding takes the core benefits of crowdfunding – the administrative advantages and access to large groups of people – and applies it to business lending. In simple terms, investors put their money into a fund managed by the platform, and the platform loans the money to businesses looking for capital. Investors can choose which companies they wish to invest in or let the platform choose automatically on their behalf.

The main difference is that the investor should expect to receive the money-back with interest. The appeal of putting one’s money into a lending platform instead of an equity-based one comes down to the reduced risk factor, assured by the fact that businesses are put through the same rigorous vetting procedures as they would do when borrowing from banks, and the returns are often much higher than a simple ISA or pension. For a business that meets the criteria for lending, the advantages are better rates than a bank with more transparency.

While generally not ideal for early-stage startups with no collateral, it offers access to cash for more established ones looking to grow without having to give up equity or take on hundreds of investors. It is a safer alternative to equity crowdfunding for more risk-averse investors at the cost of missing out on potentially significant returns that successful startups can sometimes yield.

Blockchain crowdfunding

Leading players: Smith + Crown, Waves

The newest and least well-known crowdfunding type, blockchain crowdfunding, leverages the power of cryptocurrencies such as Bitcoin to generate cash from the creation of new tokens in a process called Initial Coin Offerings (ICOs), a nod to the more traditional Initial Public Offering (IPO) process that we are used to with stock markets.

The way it works is pretty complicated to explain here, and an understanding of how blockchain and cryptocurrencies work is essential before even contemplating this route (you can read my article “A brief guide to blockchain… for normal people” here if interested). As such, the businesses raising money via this route are mostly blockchain-related themselves, and the investors piling into the ICOs tend to have a very high-risk appetite.

The appeal is in the potential returns for investors from the cryptocurrencies themselves. For example, the Ether cryptocurrency doubled in value in only three days during March 2017, while the Monero currency increases 2000% in value last year alone. Of course, this level of volatility can go the other way, too, as anybody who has invested in Bitcoin recently will attest to.

Blockchain’s decentralized architecture and trustless, crowdsourced approach make it an obvious candidate for the preferred crowdfunding approach in the future, but the technology as a whole is still in its infancy and, as such, is prone to scammers and fraud, as well as massive volatility in the currencies themselves. Not for the faint-hearted.

Which one should you choose?

As an investor, the crowdfunding platform’s decision to invest depends mainly on your risk appetite. If your goal is to receive any return, then the rewards-based platforms should be ruled out entirely. Beyond that, if you’re looking for a better interest rate than an ISA can offer, debt-based platforms may be a good option; otherwise, go for the equity crowdfunding option if you want to be a “real” investor. Blockchain is for gamblers.

As a business, stick to the rewards-based platforms for consumer products in the concept or prototype stage, perhaps moving on to the equity platforms once your product is up and running. Debt-based platforms are a better choice for bridge finance if you are more established, and blockchain is the obvious option if you are a blockchain startup.

Whichever stage you are at, make sure to shop around and do your research before diving in, and as long as you keep a sensible head, there are exciting opportunities available that would likely never have existed before. For that reason alone, crowdfunding is a beautiful innovation.