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Crowdfunding Models: An Explanation

Rachel Stone writes for Shadow Foundr.

Using donations from lots of people to reach a fundraising goal is hardly a new phenomenon – in fact, even the iconic Statue of Liberty was crowdfunded.

In the contemporary era, crowdfunding is used to help raise funds for small businesses. It became mainstream towards the end of the 2000s, with platforms such as IndieGoGo and Kickstarter.

The crowdfunding industry is now worth more than £2bn globally. There are various types of crowdfunding models and platforms, and this article will look at the following in more detail: reward-based, donation-based, micro-lending, peer-to-peer lending, and equity.

In reward-based crowdfunding, investors are known as pledgers or backers. Examples of crowdfunding platforms in the rewards space include Crowdfunder, IndieGoGo and Kickstarter.

These platforms list products, services, or projects, and allow backers to pledge an amount of money in exchange for a reward. The reward could be anything from a video-game – think Star Citizen – to a product – possibly one that the business is making.

The type of businesses on these platforms are generally concept-based, trying to bring a product into creation.

According to Kickstarter, the types of projects most successfully funded on their platform are music, film and video, art, and publishing. Games, technology, and design are highest however, in terms of the largest amounts of funds raised.

On a side note, while many of the successful campaigns meet the timelines of products, backers run the risk of a product being late, or being low-quality. This is a risk that a backer must be aware of.

The majority of rewards-based platforms don’t charge backers. They simply charge the business a small fee once the total amount is raised.

Donation based crowdfunding is very similar to rewards-based crowdfunding, except that the people backing or pledging do not expect anything in return for their donation. Donation based crowdfunding platforms – think JustGiving – most often list events or causes that are charitable, in order to make donating money easier.

Since 2001, JustGiving has raised £3.3bn, and in 2015, the average campaign size was £714.

Donation-based platforms generally don’t charge pledgers a fee, but they do charge up to 5% for listings, as well as card processing.

In addition to this, 85% of the listings are eligible for Gift Aid, a 25% government tax incentive which boosts giving. This means that on top of the money donated, the government will give an extra 25%, to help eligible causes.

An example of a micro lending platform is Kiva, which has 2.4 million borrowers, 1.6 million lenders and has gathered $1bn at a repayment rate of 97%.

Using these platforms, you can lend someone money to grow/start a business, go to school or access clean energy, with the idea that one day they’ll be able to pay it back.

As these platforms are generally not-for-profit organisations, they don’t take fees.

The other 3 categories of crowdfunding that will be explained here are labelled by the Financial Conduct Authority as ‘investment crowdfunding platforms’, which have grown rapidly over the last four years. They are split into two core-categories: Debt or peer-to-peer (P2P) and Equity.

P2P platforms – think Zopa or Ratesetter – allow investors to lend to businesses/individuals from annualised rates of around 2% to 6% (although these rates change along with interest rates).

The maximum lending term is usually five years with a circa 6% return to investors, who give the platforms permission to invest on their behalf across a number of borrowers.

Around £4.2bn has been lent in the UK via P2P platforms.

The method of repayment differs across platforms, from monthly, to the end of the term. Again, like the method of repayment, the fees for investors also differ across P2P platforms.

As a general rule, no fees are charged to lenders if they see the term of the loan. However, to access the money before the end of the term, fees generally around 0.25-1.0% are charged on the amount of the sum returned.

Certain platforms – Funding Circle for example – also charge you an annual 1% fee on borrower repayments.

Of the P2P platforms, the leading game player is Funding Circle, which has raised £4.7bn in the UK to date.

Finally, equity crowdfunding as an industry has raised in excess of £600m in the UK over its six-year lifetime. Equity is the most complicated of the crowdfunding variants, as it involves giving money to start-ups, early stage and growth companies for an equity stake.

The type of businesses is generally large, giving investors a wide range to choose from. Investments can be made from as little as £10, and have no maximum, which results in pro-rata ownership of the company via shares.

Generally, investors place money into businesses with the end goal of making a return within a 5-10-year timescale, either via a liquidity event such as a trade sale, where the investor sells their shares to another company or investor.

The potential returns of equity crowdfunding are high – but so are the risks, as a high percentage of start-ups fail. Given this, it’s essential that investors look to diversify the companies that they invest in.

If you only invested in a handful of businesses from one industry, and that industry suffered extreme market losses, it would mean that you could lose all your money.

However, if you invest in a range of businesses from different sectors, it stands to reason that you are less likely to lose out.

All sophisticated investors in the equity crowdfunding sector understand the risks, and generally invest in a range of businesses.

The expectation is that while 60% may not earn them any return, 30% may earn them their money back with a small return, and on top of that, 10% could earn them a far larger return.

Finally, the government offers extremely generous tax incentives to people who invest into qualified businesses through equity crowdfunding, providing eligible investors up to 50% income tax relief on their investments, as well as other incentives.

The government does this to mitigate some of the risk of investing in start-up businesses.

The various crowdfunding models offer a multiple of choices for investors, whether they want to be charitable and support worthy causes, or want to buy their slice of the pie in a small business.

Each model has its own risks, reward and returns, and every investor can find the type of investment that works for them.

Crowdfunding has grown and continues to grow at pace, and with the increase of technology and the amount of small businesses on the rise, it’s likely that crowdfunding will continue to gain popularity and further variants may be introduced in the future.

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This was posted in Bdaily's Members' News section by Rachel Stone .