A number of banks failed in 2008 on account of financial crisis existing in the western world including US and Europe. As a consequence, new capital adequacy regulations such as Basel III were implemented for banks. Due to such norms in place, the credit providers restrained in lending money to risky startups and SMEs. As per a consultation paper by SEBI, the number of bank loans disbursed to the SMEs by US and western Europe reduced significantly at the beginning of the financial crisis.
This was on account of reduced liquidity of banks in western Europe and the US . Thus, it became quite challenging for the small scale enterprises to obtain loans owing to new bank regulations. Such a situation gave way to crowdfunding platforms and Peer to Peer lending.
Crowdfunding has offered potential benefits to the financially excluded and under served people. This is achieved by giving them access to finance offered on web based portals . These web portals help in bringing the lenders and borrowers together.Furthermore, such a source of finance is relatively cheap as compared to the traditional financial institutions and intermediaries.
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However, there are certain areas within such web based community network that require attention of policy makers.
So let’s first understand what is crowdfunding before acknowledging the benefits and risks associated with such a financial innovation.
Meaning of Crowdfunding
As per IOSCO,
“Crowdfunding is an umbrella term that describes the use of small amount of money obtained from a large number of individuals to raise funds for a project, business or other financing needs through online, web – based platforms.
Similarly GPFI defines crowdfunding as:
“ a market based financing technique where funds are raised from a large number of individuals or legal entities in small amounts bypassing traditional financial intermediaries and using mobile phones and online web based platforms to connect with borrowers whether to find a business, a specific project or other needs.”
Thus, crowdfunding tabs the savings or resources of a vast community. Furthermore, it brings together the individuals or entities who are in need of funding and the community members who are willing to contribute.
Further, global financial crisis gave boost to the crowdfunding industry. This is because the confidence in the banking sector reduced significantly at that time. Since then the crowdfunding industry has been growing rapidly and is driven by technological, macroeconomic and regulatory factors.
Now, the most important aspect of a crowdfunding ecosystem is a web based platform that matches demand with supply. Depending upon a particular model or category, there can be varied types of funders and fundraisers.
Types of Crowdfunding
There are typically four main categories of crowdfunding:
- Donation based crowdfunding
- Reward based crowdfunding
- Debt based crowdfunding
- Equity based crowdfunding
These categories are based on the return that funders expect for the money invested by them as well as their basic objective behind such an investment.
1. Donation Based Crowdfunding
This type of crowdfunding involves raising of funds for social, philanthropic, artistic or other purpose. Thus, the donors provide money to the beneficiaries with no monetary consideration in return. This type of crowdfunding is used by non profit organizations in order to support social, environmental, political or charitable causes.
Furthermore, the crowdfunding platform generates revenue through the fee collected from each donation.
Following are the benefits of donation based crowdfunding:
- This form of crowdfunding is quite transparent as it offers opportunities to the donors to keep a close eye on the projects they support. This means that donors are allowed to observe the way their money is spent.
- Along with money, donors give their opinion or views regarding the projects or cause they support.
- The support provided by a donor on a public platform does not impact the social relationship between donor and the fund raiser. Moreover, it can give additional benefits such as tax savings to the donor.
The risks attached with Donation based crowdfunding are as followed:
- The donors have to face fraud in terms of fake campaigns run by institutions that are not publicly registered.
- Beneficiaries face the risk of cost of the campaign. This is because they have to spend the money in designing and running the campaign.
- The beneficiaries may also have to face the currency exchange risk. This is because the crowdfunding platforms perform transactions in major global currencies only.
2.Reward Based Crowdfunding
This refers to obtaining funds wherein the investors or funders receive some tangible or a non financial reward in the future. These rewards can be in the form of pre-purchase of product or service or a memento of appreciation that would be in the form of a t-shirt, an artist autograph etc.
Thus, the donors under reward based crowdfunding expect a more tangible outcome of their investment as compared to donation based crowdfunding. Again the crowdfunding platforms earns revenue from the fees deducted from each contribution made by the owners. Therefore, the reward based crowdfunding is used to fund development of new products or innovations and some form of art like movies, music, etc.
Following are the benefits of reward based crowdfunding:
- The investors or donors seeking investment opportunities come in contact with the innovators or developers of the products quite easily.
- This type of funding improves the ability of funders to assess the risk associated with the product or innovation they support. This is because there are a huge number of other donors to review or give their feedback on the product in question.
The risks attached with reward based crowdfunding are as followed:
- The entrepreneurs may become too optimistic about the outcome of their campaigns. Further, they may be incompetent in creating a product or dealing with suppliers thereby leading to lower quality products or delays.
- Donors do not undertake proper due diligence and depend on the reviews of other donors to make investment in other campaigns.
- Beneficiaries might face risk of imitation because they showcase their innovations on a public platform.
- Such a platform lacks the knowledge, professional network and status that a venture capitalist or an angel investor can offer.
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3. Debt Crowdfunding
This type of crowdfunding is also referred to as person-to-person lending, market-place lending or lending-based crowdfunding. As the names suggest, debt-based crowdfunding allows the funders or the lenders to lend funds directly to the fundraisers through the web platform. The funders can give money for non-profit, social or commercial purposes.
Further, the debt-based crowdfunding includes peer-to-peer lending, peer-to-business lending and business-to-business lending. Also, there are various models of debt-based crowdfunding that are currently in operation. These include client-segregated account, balance sheet lending, notary, guaranteed return and offline model.
The benefits of debt crowdfunding are as follows:
- This type of crowdfunding provides a new type of asset class in the form of uncollateralized debt. Further, the systemic risk of investment gets reduced as the portfolio is diversified. This is because the funders invest small amount of investments in diversified assets instead of investing the entire money in a single asset.
- Debt based type of funding offers higher returns on investment as compared to the returns earned through savings. Thus, it is a good avenue of investment for those who wish to earn higher returns by undertaking a good amount of risk.
- The debt based crowdfunding acts an alternative to traditional lending. It provides funds to the least profitable and risky segments including loans to SMEs. This is so because traditional lending institutions like banks reduced lending to the SMEs given the restrictions imposed on bank post financial crisis.
- These sources of lending are cheaper as compared to the traditional sources like banks. This is because, unlike banks, the crowdfunding platforms do not invest in physical infrastructure. Moreover, these platforms use algorithms instead of physical credit report in order to determine the credit worthiness of the applicants.
- The use of the technology makes application and disbursement quite easier and quicker.
The risks attached with debt based crowdfunding are as followed:
- Risk of default is high as unsecured loans are disbursed to SMEs, startups and individual consumers. Moreover, the credit assessment methodology utilized by these platforms is new and unproven.
Equity based Crowdfunding gives funders an opportunity to invest in unlisted entities or issuers in return of equity shares in the entity. Thus, the legal entities intending to raise funds can do so by selling their equity.
Once, the investment target is hit the deal gets closed between the platform, issuer and pool of funders. Furthermore, the online platform earns revenue through commission charged on the amount of money raised . However, in some cases the amount of revenue generated is based on the profit earned.
The benefits of equity based crowdfunding are as follows:
- Equity based crowdfunding gives funders an easy access to investment opportunities. These opportunities were earlier restricted to venture capitalists and other traditional financial intermediaries.
- Unlike the debt based crowdfunding, the funders can increase their investment in an unlimited manner.
- Both the funders as well as the fundraiser are aligned in terms of risk sharing and financial losses. Moreover, they have similar options to exit thereby reducing conflict of interest.
- The liability of fundraisers is limited. That is, in case of default, he is not the only one to bear the losses.
- Fundraisers in the underdeveloped markets have the benefit of reaching out to the funders globally.
- Equity based crowdfunding also helps in attracting venture capitalists once the campaign gets successful.
The risks attached with debt based crowdfunding are as followed:
- Equity based crowdfunding is highly risky and illiquid.
- The share of funders gets diluted as the business raises additional capital in the near future.
- Illiquidity makes the exit options limited for the funders.
- Traditional equity investors are able to offer capital at a lower price as compared to equity crowdfunding platforms. This is because they have the ability to assess and calculate risks better.
- Fundraisers are exposed to unnecessary public scrutiny as compared to other sources of funding like non – equity private debt, loans from friends and family etc.
- Disclosure of too much information puts the intellectual property at risk.