Crowdfunding is a system of financing a venture or project by finance from a diverse and wide selection of people, commonly via internet based platforms, but the system is also applicable via other methods like mail order and one-off benefit events. Crowdfunding is, without doubt, the fastest growing method of business financing in the contemporary business climate. As with all other methods of raising finance there are costs and benefits (both financial and non financial) that must be considered when evaluating the advantages and disadvantages of crowd funding.
A Brief History
The term "crowdfunding" entered the lexicon as
recently as 2006, but the concept has roots that go back to the 19th
century. French Philosopher August Comte issued "bonds" of a sort to
fund his academic and publishing career, which led to his work becoming
the cornerstone of the modern discipline of sociology. The iconic Statue
of Liberty was partially funded by Joseph Pulitzer and the New York
World newspaper group. Pulitzer raised the equivalent of $2,500,000 in
today's money, by urging donations from the American public, when the
project failed to secure state funding. However, the advent of the
internet as the world's most popular media in the early 21st century has seen the explosion in popularity of the method, with platforms like Kickstarter and GoFundMe becoming household names.
Advantages of Crowdfunding
- It is a quick way of raising finance with no payment upfront.
- Funding can be secured prior to costs being incurred.
- It serves the marketing function as well as the finance function, attracting positive publicity.
- Innovators and would-be entrepreneurs can receive feedback from the "crowd" whilst pitching it to the public.
- It is an ideal alternative to bank loans, especially if there is "hard capital rationing" in the economy.
- Ethically, it may be more appealing to some people than traditional equity or debt financing.
- Investors can also become customers and advocates for the business.
Disadvantages of Crowdfunding
- It is not always easier to raise funds this way than
via the debt/equity methods. Not all applicants to the online platforms get on!
- Once on the platform, it is very time consuming to build up public interest.
- An unsuccessful project can cause untold damage (both to finances and reputation), and jeopardize future ventures.
- If an idea is not patented prior to offering it to the public, one
of the "crowd" may copy or steal it.
- It can be difficult to decide an appropriate mix of reward, return and risk.
Contrast with Traditional Methods (1): Debt
Debt funding, either via long term bank loans or trading of debt security instruments, like corporate bonds and debentures, on a stock exchange is possibly the most common method of funding a business. It is intended for long term capital investment projects like purchasing or leasing fixed assets. In contrast to crowdfunding, it is quite bureaucratic, and often requires assets to be used as collateral, which could be an insurmountable obstacle to a start up venture. It can be costly, especially if interest rates are high. However, interest payments can be written off against a business's annual tax expense, which is not the case with crowdfunded finance. However, in the light of the 2008 financial crisis and the ongoing aftermath, this method of financing has lost its accessibility for many smaller businesses. Many businesses might prefer not do deal with large lenders, and find crowdfunding a more ethical and holistically satisfying alternative to debt financing.
Contrast with Traditional Methods: Equity (2)
Equity funding is selling a "share" of the business to a shareholder. At first glance it appears to be broadly similar to crowdfunding. If the business is a Public Limited Company (PLC) then it's shares are traded to the public. However, the modern shareholder is a radically different entity to a crowd funding investor. The shareholders are the legal owners of a company, to whom the company directors owe considerable duty of care enshrined in both common and company law. Crowdfunding
investors have no equivalent legal protection (unless a specific
contract stipulating otherwise is negotiated). Equity investors have a
legal right to hold the management accountable at an annual general
meeting, whilst crowdfunding investors may not enjoy such privileges and responsibilities. Equity investors are often "institutional investors" like Insurance and Pension funds which have no interest in the day to day running of a company. However an investor who participates in crowdfunding may see his or her investment in a company as a "labour of love" and
might wish to influence the running of the company.
Dividends and Exiting of Crowdfunding
Traditional equity investors normally receive a dividend, i.e a share of the company's profits. However, dividends are beyond the ability of most start-ups, which would not be overly liquid at the early stages of their business cycles. Traditional dividends would not be the ROI (return on investment) that crowdfunding investors are seeking. Crowdfunding investors must
often be willing to be patient and bear the risks of their investments for an indefinite period of time
or receive a free product or similar in return for their lending.