Crowdfunding – The New Way To Raise Capital

Although the crowdfunding industry is still considered to be in its infancy, it has observed impressive growth. Various crowdfunding portals across the globe raised a total $5.1 billion in 2013 for different ventures, as compared to $1.5 billion in 2011. This year, the figure is expected to nearly double to $10 billion. Currently, North America and Europe dominate the crowdfunding scene, with platforms based in the two regions sourcing over 90% of the capital raised from such platforms around the world.

How Crowdfunding Works
Crowdfunding platforms are usually structured on three distinct models. Of these, the reward-based or donation-based model is considered the most popular. It is based on investors making varying contributions to a business or non-profit looking to raise a certain level of capital; in return, investors receive rewards for their contributions. An example where this model was employed is the Veronica Mars Movie Project campaign, which raised more than $5 million for the production of a movie titled “Veronica Mars.”

The project rewarded those who contributed more than $10 with exclusive Veronica Mars stickers, and those who gave over $25 an official T-shirt.

Under the second model, equity-based crowdfunding, contributors become shareholders of the company in which they invest. Prospective businesses publish their business plans on an online platform so venture capital firms, individual investors and business supporters can decide whether they want to take a stake in the business.

Equity-based crowdfunding is a way of democratizing access to capital for small companies. It provides a greater number of options to investors who want to opt for unconventional investment avenues that offer higher rewards. Equity-based crowdfunding can, therefore, be considered a disruptive development in the financial services industry.

The growth of equity-based crowdfunding has been helped by the implementation of the Jumpstart Our Business Startups Act (JOBS Act) by President Obama in 2012, which has lowered the barriers that less-than-a-year-old companies face while trying to raise funds. Under the JOBS Act, even unaccredited investors (as defined by the US Securities and Exchange Commission) can become initial investors in startups if they make a maximum contribution of $2,000 or 5% of their net income each year, whichever is greater. Investing in startups through crowdfunding portals is in line with the US Securities and Exchange Commission’s regulations.

Lending-based crowdfunding, the third type of crowdfunding model we have covered, is the one under which an entrepreneur promises to repay contributors with interest. The timeline of the repayment schedule is usually short, and the interest rate is usually determined beforehand. This sort of funding is better-suited for entrepreneurs who want to retain equity in their company but need to raise capital as well.

The Advantages And Potential Of Crowdfunding
Crowdfunding has bright prospects, as is evident from the fact that in the next five years alone it can provide $5 billion to rooftop solar projects – over 50 times the amount invested in such programs till now. It will also be responsible for creating around 2.7 million jobs in the US by 2020.

Entrepreneurs opting to raise capital by crowdfunding retain more internal control over their company as compared to if they partner with an institution like an investment bank. Crowdfunding also lets investors see which industries and companies other intelligent investors are investing in. Instead of a junior banker calling retail investors with a prospectus of lucrative investment opportunities, equity-based crowdfunding eliminates the middleman and provides businesses direct access to investors, who can then decide for themselves whether they wish to invest or not. Equity-based crowdfunding therefore has the potential to snatch significant market share from institutions like investment banks.

The real estate industry has become a key beneficiary of the JOBS Act, having raised around $135 million through debt and equity offerings conducted via various crowdfunding platforms in the US. Investors opting for crowdfunding find the real estate industry convenient to invest in because of the fewer complications and more tangible assets it offers as compared to, let’s say, tech startups.

The primary risks crowdfunding carries are related to fraud and organizational failure. There are other risks too, most important among which is the lack of liquidity in trading of equity bought through a crowdfunding program, as most equity-based crowdfunding projects require investors to keep their equity in the company for at least a year. Furthermore, it remains highly unlikely that investors will be able to sell their stake later, as there are no regulated exchanges for equity bought through crowdfunding programs.

As most businesses that opt for crowdfunding to raise capital are still in their infancy, returning a profit on such investments takes time. Investment through crowdfunding can also be subject to dilution if the company opts to issue more stock, which has a negative impact on an equity holder’s voting rights, dividends and investment value.

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