The Different Types of Crowdfunding
The global financial crisis of 2008 was the reason for the birth of the different types of crowdfunding like real estate crowdfunding, donation-based crowdfunding, equity crowdfunding, etc. The global crisis of 2008 affected the banking sector drastically. It caused banks to lose money on mortgage defaults, credit to consumers and businesses to dry up, and interbank lending to freeze. What started as turbulence in the US housing market’s subprime segment mutated into a full-blown recession, with American households losing an estimated $16 trillion in net worth between 2007 and 2009., The stock markets worldwide took a nosedive, and many companies had to file for bankruptcy due to abnormally low demand for imported goods in the US. The world financial markets were devastated, and so were the banking and real estate industries.
The situation worsened when some banks had to shut shop, while banks that were once termed ‘too big to fail’, had to be bailed out by governments with the taxpayers’ money. Many other banks were forced into mergers with bigger partners to prevent their collapse.
Overall, the traditional financial institutions around the world took a tremendous hit. The global economy was left stagnant due to plummeting markets. This led to a downward spiral as traditional banks were less willing to lend to people, making it harder for small businesses and entrepreneurs to raise capital. The conventional financial system was failing, and there was a need for a new system. The platform was set for the ‘Alternative Finance’ industry to emerge as a viable funding source for businesses, individuals, governments, and nonprofit organizations.
When it comes to defining Alternative Finance, The Cambridge Center for Alternative Finance explains: Though a somewhat amorphous term, at its core ‘alternative finance’ includes activities that have emerged outside of the incumbent banking systems and traditional capital markets. In particular, the capital raising alternative finance ecosystem comprises various lending, investment and non-investment models that enable individuals, businesses and other entities to raise funds via an online marketplace. Typically, these fundraisers satisfy their funding needs through pooled monies from a ‘crowd’ or network of retail and/ or professional investors.
Alternative finance itself is part of the larger domain of financial innovations fueled by technological advancements in FinTech. By definition, Fintech is a portmanteau of ‘financial technology’, used to describe new technology that seeks to improve and automate the delivery and use of financial services. In its various forms, online crowdfunding is part of Alternative Finance, an industry with a $305 billion market value as of 2018. By leveraging the power of financial technologies, crowdfunding platforms can provide alternative funding options to people outside the traditional financial system.
The Online Crowdfunding Industry can be divided into two branches— each addressing different socio-economic domains: Non-Financial Return Crowdfunding and Financial Return Crowdfunding.
Non-Financial Return Crowdfunding
Fig 2- Branches of Non-Financial Crowdfunding.
Non-Financial Return Crowdfunding comprises Donation-Based, Reward-Based and Subscription-Based Crowdfunding. As the name suggests, non-financial return crowdfunding occurs without the expectation of a financial return, i.e., the ‘crowd’ contributing to the campaign is not expecting any financial reward for their contribution. In some cases, rewards are involved, but they are not monetary in nature. Let’s explore each of these branches separately.
Donation-based crowdfunding enables individuals, groups, and nonprofit organizations to collect (small) amounts of contributions from a large number of contributors for philanthropic, social, business, or personal projects. In donation-based crowdfunding, the funders contribute to fundraisers with no expectation of financial return. The donors are often motivated by altruistic reasons.
Raising funds for education, community welfare, NGOs, medical expenses, natural disasters, emergencies, recreational projects, socio-political causes, and humanitarian disasters all exist within the domain of donation-based crowdfunding.
Donation-based crowdfunding creates an avenue where people who require monetary help are connected to people who are willing to provide it. The cost burden is shared across a vast network of people, making it possible to raise vast amounts of money for various social, personal, and political causes. At its core, donation-based crowdfunding has the potential to democratize social change.
Under the Reward-Based Crowdfunding model, donors provide financial contributions to individuals, projects, or companies in exchange for non-monetary rewards or products. The donors receive tangible benefits for their financial contributions to the campaign. In simpler words, supporters receive a reward for backing a project, and the rewards can vary on basis of the size of their investment.
There are two modalities through which reward-based crowdfunding platforms work: first is the ‘all or nothing’ model, and the second is the ‘keep it all’ model. Under the ‘all or nothing’ framework, the campaigners can only get the funds when their fundraising goal is attained. As for the ‘keep it all’ framework, the campaigners can keep all the money raised on their fundraiser irrespective of whether the goal is reached or not.
Under the reward-based model, contributors have the ability to pre-purchase the products/services. Sometimes, it can even be in the form of tokens of appreciation like a personalized handwritten note. For entrepreneurs, reward-based crowdfunding also serves as a tool to test the future market potential of their products. A lack of support for the project can serve as an indicator of its grim future in the market. Even though it is not an absolute indicator of whether a product will be successful or not, it does provide feedback to gauge the interest levels of the crowd. By taking advantage of the crowdfunding platform’s popularity, a new product will have access to an initial audience. These are people who are most likely to be interested in the product, and if they like the product, they can even help with the word-of-mouth publicity.
From supporting the development of an artificial beehive that allows the extraction of honey without disturbing the bees to funding the development of virtual reality headsets that provide people access to alternate realities, reward-based crowdfunding has changed the way creative projects are financed. It has also modified how creators interact with their consumers, as many project creators implement the recommendations made by the people participating in the funding. The creators and contributors also use crowdfunding platforms to share creative ideas, search for inspiration and connect with other like-minded individuals. Thus, reward-based crowdfunding platforms allow people to get their creative ideas recognized in a favorable market, where they can receive valuable feedback and support.
Subscription-based crowdfunding is a financing model where donors make recurring contributions to a person, usually an artist, to support their work or their various projects. Contrary to one-time payment crowdfunding models where donors contribute to fundraisers in a singular transaction (like donation-based crowdfunding and reward-based crowdfunding), subscription-based crowdfunding adheres to a recurring contribution model— often on a monthly basis. Simply put, subscription-based crowdfunding allows artists to obtain funding from their backers regularly.
The donors are often called patrons, referring to the old days of patronage when artists received monetary support from the royal court. Traditionally, patronage for artists depended on the benevolence of aristocrats, but in subscription-based crowdfunding, artists receive patronage from the crowd who contribute in small amounts to subscribe to their favorite artists’ content.
The subscription-based crowdfunding model follows the same basic procedure wherein creators and artists ask people for small donations in exchange for rewards. Only in this case, both the rewards and the funding are recurring. A subscription-based crowdfunding model is designed to fund content creators regularly instead of funding a single project that requires lots of money.
Financial Return Crowdfunding
Financial Return Crowdfunding models use crowdfunding as a financial instrument. Here, capital contribution to a crowdfunding campaign generates a financial return for the investors/lenders in the future. Under these models, the crowd can be seen as investors or lenders who make micro-investments or offer micro-loans to a project/business/campaign and expect a financial reward in return for their investment. The models offer promises of possible capital gains, equity, or interest on loans to contributing participants.
Fig 1- Four funding models of Financial Return Crowdfunding
There are four funding models under the domain of financial return crowdfunding that have emerged as viable alternatives to traditional sources of financing: 1.) Debt-based 2.) Equity-based 3.) Real-estate, and 4.) Royalty-based crowdfunding. Let’s explore each of these models separately.
Also known as lending-based crowdfunding or P2P market-based lending, Debt-based crowdfunding has emerged as an alternative to the traditional lending options that involve banks. In debt-based crowdfunding, the crowd lends money to borrowers in return for repayment of capital and interest payments over a period of time. The lending and repayment are facilitated through online P2P lending (crowdlending) platforms that arbitrate between the lenders and the borrowers.
With debt-based crowdfunding, investors receive a debt instrument that specifies the terms of future repayment, which serves as a contract for the campaign owner to repay the lender’s funds, typically consisting of a capital repayment and a fixed interest rate. However, interest is not always included in lending-based crowdfunding contracts, leaving room for impact investors motivated by altruistic purposes.
Depending upon the motivation behind lending, debt-based crowdfunding can be classified into the three categories of nonprofit lending, socially oriented lending, and commercial lending. Funders on nonprofit lending platforms (for example, Kiva) lend without expectations of a financial profit and actively reach out to unbanked communities. Socially oriented lending platforms are driven by both profit opportunities and socio-economic development goals, often going out of their way to make their services available to marginalized communities, but nonetheless, driven by profit motivations. Finally, commercial lending platforms are purely driven by for-profit motivations.
Fig 2- Branches of debt-based crowdfunding.
Debt-based crowdfunding can include peer-to-peer (P2P) lending, peer to business (P2B) lending, or property lending wherein loans are provided, secured against a property, to a consumer/business borrower.
Equity-based crowdfunding provides investors with a share of ownership or a percentage of future earnings if they invest in a particular business. Also known as crowdinvesting, equity-based crowdfunding offers promises of possible capital gains through dividends for equity possessed in the business.
The magnitude of the return is tied to the business’s future success, wherein the value of equity (value of the shareholder’s stake in the business) increases per the business’s success. On the flip side, equity-based crowdfunding also presents a greater risk to investors (equity holders) if the business fails. When it comes to repayment, creditors who loan to a business tend to get preference over the investors who hold equity in the business.
Suitable for start-ups and SMEs, equity-based crowdfunding enables companies to sell stock to the general public for equity capital via the Internet. For the investors, which in this case is the ‘crowd’, equity-based crowdfunding empowers them to buy a stake (equity) in the business. If an investment target is reached, the deal is closed between the pool of funders (crowd), the issuer (business), and the crowdfunding platform.
During the pre-seed stage (before the business starts operations) and the seed stage (when the business is still very young), mainly personal funds and insider finance from the founders, family, and friends are exhausted. It is difficult to prove the business’s sufficient market viability and its high-growth potential to formal investors during these early stages. Even if the company has commercial potential, it still represents too much risk to be funded by angel investors, venture capital firms, or banks. Only at a later stage, when businesses are able to demonstrate proof of concept, do these funding sources become available for them. This funding gap between seed-stage and later-stage development of the business is called the ‘Valley of Death’ as many businesses tend to collapse during this time. Equity-based crowdfunding has the potential to bridge this financing gap by turning the crowd into investors, who in return for their micro-investments are able to secure equity in the business. Thus allowing entrepreneurs to evade the dreaded valley of death.
Royalty Based Crowdfunding
Royalty-based crowdfunding provides contributors with a contract that guarantees them a percentage or a fixed percentage of the revenue stream from a project if they contribute towards it. Projects typically range from record albums to mobile applications.
Royalty-based crowdfunding differs from equity-based crowdfunding in a few ways. The risk associated with investing is lower in royalty-based crowdfunding campaigns as the goal amount is lower. The funding is used to support a single project rather than the whole business, more along the lines of reward-based crowdfunding.
Basically, supporters of an idea or a project receive a percentage of the revenue accumulated when the project starts making a profit. It is pertinent to realize that a supporter’s investment does not make them a shareholder in the project in the case of royalty-based crowdfunding. They are only entitled to receive a percentage of income that the company makes from the project. Mobile app developers are usually interested in this type of crowdfunding. The supporters financially support the development of the app, and in return, they can expect a percentage of the profit from its sale.
The biggest drawback of royalty-based models is that it is hard to scale. If the project involves a large number of supporters, the cost of sharing profits with the backers will be high over the project’s commercial life. Companies may stop operating with the intellectual property (project) that was originally funded or sell it to another firm. This makes the royalty-based models more complex and, therefore, unattractive in comparison to other crowdfunding models like equity-based or reward-based crowdfunding.
Real Estate Crowdfunding
Prior to the JOBS Act, people in the United States could only invest in real estate by buying a physical property or by investing in REITs (real estate investment trusts). After President Obama signed the JOBS Act, it opened up a new method for investing in real estate: Real Estate Crowdfunding.
Fig 5- Real Estate Crowdfunding market value from 2012 – 2020.
Post the Act, real estate crowdfunding witnessed an exponential increase. While in 2012, a modest $19.06 million was invested through real estate crowdfunding platforms, the number increased to $396.4 million in 2013 (almost 20x growth). In 2014, over $1 billion was invested through real estate crowdfunding platforms. The real estate crowdfunding market has shown steady growth through the years, and according to an EY report, the market is set to reach the $9 billion mark in 2021.
Real estate crowdfunding allows borrowers to raise money for real estate projects by reaching out to the crowd (investors) who can contribute small amounts of money towards the project. It allows the investor to buy into a small part of a property and become a shareholder in it. The investor can then earn a portion of the profits generated from the real estate. For example, revenue generated from the rental income or the building’s sale would be paid to the backer as per their share in it. Because of this perceived stability of cash flows, there is a high demand for real estate crowdfunding.
Furthermore, real estate projects are also considered less risky as an investment option than publicly traded securities. For non-accredited investors, real estate crowdfunding offers low minimum investment amounts through which they can become shareholders in real estate (sometimes for as little as $5,000). In other words, real estate crowdfunding allows people who can’t afford to purchase an entire piece of real estate to buy a part of it and reap its revenue.