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Introduction

What is Crowdfunding?

In layman's language crowdfunding is the practice of project funding by raising small amounts from a large number of people. However, the medium on which such amounts are collected is the internet. Crowdfunding is an alternative source of finance to traditional means like debt funding or equity.

Earlier crowdfunding used to be through mail subscription also, but this modern crowdfunding is based on internet. This funding requires three major elements:

  1. Project initiator - The entity who proposes the idea
  2. Individuals or groups who support the idea,
  3. The "platform" that brings the parties together to launch

Crowdfunding has been used to fund a wide range of projects like artistic, creative, medical expenses, travel, or community-oriented projects. It can be used by both profit & non-profit organizations.

History

Crowdfunding initially was used during war times or military conflicts. It primarily was used in arts and music communities. The first noteworthy instance of online crowdfunding in the music industry was in 1997, when fans underwrote an entire U.S. tour for the British rock band Marillion, raising US $60,000 in donations by means of a fan-based Internet campaign. (Source: Wikipedia)

Types of crowdfunding

Reward-based

Reward-based crowdfunding has been used for a wide range of purposes such as inventions development, scientific research and civic projects. It is a non-equity based funding and it is not location specific.

Equity

Equity capital is created through the formation of company and the creator should produce the product for which they are raising capital. Equity crowdfunding unlike rewards-based crowdfunding, involves the offer of securities which include the potential for a return on investment.

Debt-based

Online application is filed by the borrower mostly for free of cost and the said application is reviewed and verified by the automated system. It determines the credit risk and interest rate. Investors buy securities in a fund which makes the loans to individual borrowers or bundles of borrowers. Investors make money from interest on the unsecured loans; the system operators make money by taking a percentage of the loan and a loan servicing fee.

Donation-based

Donation-based crowdfunding is the collective effort of individuals to help charitable causes. In charity crowdfunding, funds are raised for social or environmental purposes.

Process of Crowdfunding

Individuals provide inputs related to the project in the crowd which triggers the funding process. Every individual act as an agent of the project initiator, select and promote the projects in which they believe. In some cases, they become shareholders and contribute to the development and growth of the project. Individuals disseminate information about projects they support in their online communities, generating further support (promoters). Additionally, individuals participate in crowdfunding to see new and innovative products before the public. Early access often allows funders to participate more directly in the development of the product. Crowdfunding is also particularly attractive to funders who are family and friends of a creator. It helps to mediate the terms of their financial agreement and manage each group's expectations for the project. Crowdfunding platforms are motivated to generate income by drawing worthwhile projects and generous funders. These sites also seek widespread public attention for their projects and platform.

Platforms

In 2012, there were over 450 crowdfunding platforms operating. In 2015 it was predicted that there would be over 2,000 crowdfunding sites (Source: Wikipedia) Project creators need to exercise their own due diligence to understand which platform is the best to use depending on the type of project that they want to launch. Fundamental differences exist in the services provided by many crowdfunding platforms. For instance, CrowdCube and Seedrs are Internet platforms which enable small companies to issue shares over the Internet and receive small investments from registered users in return. While CrowdCube is meant for users to invest small amounts and acquire shares directly in start-up companies, Seedrs pools the funds to invest in new businesses, as a nominated agent.

Benefits and risks

Benefits to Initiator

The following are non-financial benefits of crowdfunding.

  • Name in Market/Industry - A compelling project can raise a producer's profile and provide a boost to their reputation.
  • Ease of Marketing - Project initiators can show there is an audience and market for their project. In the case of an unsuccessful campaign, it provides good market feedback.
  • Audience engagement - Crowdfunding creates a forum where project initiators can engage with their audiences.
  • Feedback - Offering pre-release access to content or the opportunity to beta-test content to project backers as a part of the funding incentives provides the project initiators with instant access to good market testing feedback.

The following are the financial benefits: -

  • Crowdfunding allows access to low-cost capital.
  • Creators can find funders from around the world
  • Obtain early feedback on the product. 

There are certain risks associated with crowdfunding for the project initiator:-

  • Loss of Reputation - If the project fails to generate interest or fails to meet satisfaction of the public at large the reputation of initiator is at stake.
  • Donor exhaustion - There is a risk that if the same network of supporters is reached out to multiple times, that network will eventually cease to supply necessary support.
  • Public fear of abuse - Concern among supporters that without a regulatory framework, the likelihood of a scam or an abuse of funds is high. The concern may become a barrier to public engagement.

Benefits for the investor

  • Cost Reduction - Cost to investors is reduced because of this type of funding. As investment is done just by using the internet without any documentation requirement as such its beneficial to investors.
  • Neglected sectors Are Focused - Crowdfunding opens some of these neglected markets to individual investors. Crowdfunding doesn't make sense in every industry, but for some, like retail and consumer, it does.
  • Increased Value to New Investors - Another reason why crowdfunding is attractive is that the investors add value to companies. They act as brand advocates and can even be used as a focus group. Crowdfunding allows individual investors to be a valuable part of the company they invest in.

Risks for the investor

  • Due Diligence - In crowdfunding the due diligence procedure cannot take place. Hence such funding can be risky to investors. 
  • Failure of Project Execution - If the project fails to get executed in early stage the whole investment is washed away, as returns of capital from the initiator may not take place.
  • Frauds - In the growing age of technology many unscrupulous activities take place as crowdfunding is majorly through the online platforms or the internet risk of frauds is high.

Author's Take

In modern investment arena crowdfunding can be useful for many organisations in terms of low cost funding, easy accessibility and mobilising funds to those sectors which are mostly neglected by traditional finance institutions. However, the general mindset of the public at large is to invest through safe platforms in safe instruments. Risks related to such funding is to both the initiator and investor and there are no regulations and rules applicable to such transactions. In India Crowdfunding is not see as a potential investing medium but in west it's acceptability is huge. In absence of regulatory monitoring such medium should be used carefully.


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Category Others, Other Articles by - Saumit Patki 



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