The different flavours of crowdfunding

Crowdfunding is the practice of financing a project or venture by raising small amounts of money from a lot of people. It allows innovators, entrepreneurs and business owners to use their social networks to raise capital. It has come to encompass many types of crowdfunding which can include donations, rewards, debt and equity.

Crowdfunding is usually done via the internet, but the idea of pooling capital or assets to fund a project or enable an enterprise to take-off is not new. Communities have come together to support each other for commercial or creative adventures for centuries. Previously we were more likely to have used other terms for these arrangements, such as consortium, cooperative, co-ownership and mutual rather than crowdfunding.

Non-financial benefits

Crowdfunding not only raises start-up capital, but also brings non-financial benefits to businesses such as product validation, a gauge for pricing and demand, leads pre-sales and provides a defined shareholder structure.

Enterprises can also use the crowd to obtain ideas and feedback on new products, and foster collective decision-making. But the main advantage is that it delivers network marketing.

Funders become ambassadors of the project or business they support, and they help to market and promote it through their own connections.

The four types of crowdfunding – donation, reward, equity and lending – spur different motivations for the funder. Motivations can be social, material or financial.

Donation

A donor contract without material reward. Platforms include Justgiving and GoFundMe.

Reward

A purchase contract for a product or service. Platforms include Kickstarter and Indiegogo.

Lending

Original amount is being repaid plus interest. Platforms such as Funding Circle and Zopa.

Equity

Ownership and revenue sharing in the project with potential capital gain at the exit. Platforms include Crowdcube and Seedrs.

Social return

A social return is associated with donation-based crowdfunding and is used extensively by non-profit organisations to fund projects and core costs. It can also help to fund creative activities and common-purpose activities.

Donation and reward-based approaches tend to target smaller campaigns. They can also focus on a local or community-based project, targeting those funders who can identify with the cause. Funders are satisfied with seeing a project realised.

The ease and speed of setting up fundraisers mean that individuals (with little or no technical experience) can now organise and start their own campaign within minutes.

Material return

Here the funder receives a product or service as a reward for their investment. This business model is called reward-based crowdfunding.

Reward-based crowdfunding is frequently used for creative businesses or smaller consumer products, where basic financing for production is linked to an initial demand-test. If a sufficient number of people enter into a funding agreement, the entrepreneur has market validation as well as the working capital for the project.

Reward-based approaches are commonly used within the film and music industry, and for technology products. Because a product or service is paid for in advance, the business acquires the working capital to get the project started.

Sometimes rewards are given to funders in loan and equity crowdfunding business models as an added benefit to the proposed financial benefit. Rewards can be incentives to give the campaign competitive advantage; other businesses offer products or services instead of an interest or dividend payment.

Financial return

Funders of equity or loan crowdfunding campaigns expect a positive financial return.

Equity-based crowdfunding offers a higher risk/reward return than crowd lending due to the lack of publicly available data and the illiquid nature of non-publicly traded shares.

Lending and debt-based approaches are usually peer-to-peer platforms, where individuals lend money for specific purposes at better lending rates than banks offer.

In the UK, the Financial Conduct Authority now regulates and authorises these crowdfunding platforms. New rules came into force in April 2014 and apply to businesses that operate peer-to-peer lending or investment-based platforms. The rules were implemented to protect investors and to ensure that consumers had access to clear information about the risks of lending or investing money.

Equity-based crowdfunding and peer-to-peer business lending have now become vital and increasingly common sources of capital that are transforming the prospects of small businesses in the United Kingdom.

• This article was first published on AltFi Investor