CROWD--FUNDING: AN ALTERNATE SOURCE OF CAPITAL FORMATION

CROWD--FUNDING: AN ALTERNATE SOURCE OF CAPITAL FORMATION

Vinod G*

Dr. Biju S K**

 

*Assistant Professor, Government College for Women, Thiruvananthapuram.

**Assistant Professor, Government Arts College, Thiruvanathapuram.

1. Backdrop

The financial crisis from 2008 resulted in failure of number of Banks and, consequently, the new capital adequacy regulations for banks, such as Basel III were implemented. As a result, credit providers have become increasingly constrained in their ability to lend money to the real economy. IOSCO Paper states that the amount of bank loans made in Western Europe and the USA dropped significantly at the beginning of the crisis. While there have been some signs of recovery in the US (although the growth rate is still below pre-crisis levels), in Western Europe the growth rate in loans to the non-financial corporate sector has been negative, especially to SMEs in the EU. In this funding vacuum, peer-to-peer lending and other Crowd-funding Platforms are growing in popularity, as bank liquidity is reduced and new regulatory requirements make obtaining loans for small and medium enterprises and individuals difficult. (IOSCO, 2014)

In India, during the last few years, the IPO market has not been very active. Though, SEBI, has been at the forefront in facilitating fund raising by SMEs through measures like SME segment in Stock Exchanges, Category I- SME funds under AIF, Institutional Trading Platform, etc., still there is need to encourage innovative way of fund raising to provide an impetus to genuine SMEs/Start-ups and to explore other alternative models of fund raising with appropriate framework in consonance with retail investor protection. (Tilt.com, nd).

Since the "Crowd-funding" phenomenon is gaining its popularity, its importance cannot be ignored. To regulate Crowd-funding, it is very important to take note that while it is necessary to ensure that Start-ups/SMEs could raise funds at ease, it is equally important to ensure that no systemic risks are created wherein retail investors are lured by some unscrupulous players by substituting the existing framework, which has been developed over a period of time through experience and observation.  Hence, there is necessity to strike a proper balance between investor protection and the role equity markets can play in supporting economic development and growth.

2.      Crowd-funding – A Prologue

Crowd-funding is a way of raising finance by asking a large number of people each for a small amount of money. Until recently, financing a business, project or venture involved asking a few people for large sums of money. Crowd-funding switches this idea around, using the internet to talk to thousands – if not millions – of potential funders. Typically, those seeking funds will set up a profile of their project on a website such as those run by our members. They can then use social media, alongside traditional networks of friends, family and work acquaintances, to raise money. There are three different types of Crowd-funding: donation, debt and equity.

Crowd-funding is solicitation of funds (small amount) from multiple investors through a web-based platform or social networking site for a specific project, business venture or social cause (CMAC, 2013). Crowd-funding is a form of alternative finance, which has emerged outside of the traditional financial system.

The Crowd-funding model is based on three types of actors: the project initiator who proposes the idea and/or project to be funded; individuals or groups who support the idea; and a moderating organization (the "platform") that brings the parties together to launch the idea. In 2013, the Crowd-funding industry raised over $5.1 billion worldwide (Ibid.).

Crowd-funding is essentially the opposite of the mainstream approach to business finance. Traditionally, if you want to raise capital to start a business or launch a new product, you would need to pack up your business plan, market research, and prototypes, and then shop your idea around to a limited pool or wealthy individuals or institutions. These funding sources included banks, angel investors, and venture capital firms, really limiting your options to a few key players.  You can think of this fundraising approach as a funnel, with you and your pitch at the wide end and your audience of investors at the closed end. Fail to point that funnel at the right investor or firm at the right time, and that’s your time and money lost.   

Crowd-funding platforms, on the other hand, turns that funnels on-end. By giving you, the entrepreneur, and a single platform to build, showcase, and share your pitch resources; this approach dramatically streamlines the traditional model. Traditionally, you’d spend months sifting through your personal network, vetting potential investors, and spending your own time and money to get in front of them. With Crowd-funding, it’s much easier for you to get your opportunity in front of more interested parties and give them more ways to help grow your business, from investing thousands in exchange for equity to contributing $20 in exchange for a first-run product or other reward.

3.      History

Crowd-financing as an alternate source of capital formation is a recent origin. The first online Crowd-funded project is occurred in 1997. Rock band Marillion were unable to afford to travel around after the release of their seventh album so American fans used the then hatchling internet to raise $60,000 so they could play in the US. Although the band wasn’t involved in the first round of fundraising, they have since used the same techniques to successfully fund the production of their following three albums. Other creative projects soon followed suit, such as films and journalism. The first Crowd-funding website appeared in 2001. In 2012, there were over 500 Crowd-funding platforms online, and February of that year saw the first Crowd-funded project raise over £1,000,000 ( Tilt.com, nd).

4.      Types of Crowd-funding

Just like there are many different kinds of capital round raises for businesses in all stages of growth, there are a variety of Crowd-funding types. Which Crowd-funding method you select depends on the type of product or service you offer and your goals for growth. The Crowd-funding is basically classified into two Community Crowd-funding and Financial Return Crowd-funding. The Community Crowd-funding includes Donation Crowd--funding and Reward Crowd-funding. Financial Return Crowd-funding includes Peer-to-Peer Lending and Equity Crowd-funding.

4.1.Donation-Based Crowd-funding

Donation Crowd-funding denotes solicitation of funds for social, artistic, philanthropic or other purpose and not in exchange for anything of tangible value. It is also known as ‘social lending’. Broadly speaking, you can think of any Crowd-funding campaign in which there is no financial return to the investors or contributors as donation-based Crowd-funding.  Common donation-based Crowd-funding initiatives include fund raising for disaster relief, charities, nonprofits, and medical bills. For example, Kickstarter, Indiegogo etc are some of the platforms in US that support donation based Crowd-funding.

4.2.Rewards-Based Crowd-funding

Reward Crowd-funding refers to solicitation of funds, wherein investors receive some existing or future tangible reward as consideration. It involves individuals contributing to your business in exchange for a “reward,” typically a form of the product or service your company offers. Even though this method offers backers a reward, it’s still generally considered a subset of donation-based Crowd-funding since there is no financial or equity return. This approach is a popular option here on Fundable, as well other popular Crowd-funding platforms like Kickstarter, Rockethub etc; because it lets business-owners incentivize their contributor without incurring much extra expense or selling ownership stake.

4.3.Peer – to – Peer lending or Debt Crowd--funding

In Peer-to-Peer lending, an online platform matches lenders/investors with borrowers/issuers in order to provide unsecured loans and the interest rate is set by the platform. Some Peer-to-Peer platforms arrange loans between individuals, while other platforms pool funds which are then lent to small and medium- sized business. Investors receive their money back with interest. Examples from US are Lending Club, Prosper etc., and Zopa, Funding Circle etc in UK. In Germany and Italy, peer-to-peer platforms are classified as banks (due to their credit intermediation function) and are therefore regulated as banks (IOSCO, 2014).

4.4.Equity-Based Crowd-funding

Unlike the donation-based and rewards-based methods, equity-based Crowd-funding allows contributors to become part-owners of your company by trading capital for equity shares. As equity owners, your contributors receive a financial return on their investment and ultimately receive a share of the profits in the form of a dividend or distribution.

5.      Benefits

From tapping into a wider investor pool to enjoying more flexible fundraising options, there are a number of benefits to Crowd-funding over traditional methods. Here are just a few of the many possible advantages.

·         Reach – By using a Crowd- funding platform, you have access to thousands of accredited investors who can see, interact with, and share your fundraising campaign.

·         Presentation – By creating a Crowd-funding campaign, you go through the invaluable process of looking at your business from the top level—its history, traction, offerings, addressable market, value proposition, and more—and boiling it down into a polished, easily digestible package.

·         PR & Marketing – From launch to close, you can share and promote your campaign through social media, email newsletters, and other online marketing tactics. As you and other media outlets cover the progress of your fund, you can double down by steering traffic to your website and other company resources.

·         Validation of Concept – Presenting your concept or business to the masses affords an excellent opportunity to validate and refine your offering. As potential investors begin to express interest and ask questions, you’ll quickly see if there’s something missing that would make them more likely to buy in.

·         Efficiency – One of the best things about online Crowd-funding is its ability to centralize and streamline your fundraising efforts. By building a single, comprehensive profile to which you can funnel all your prospects and potential investors, you eliminate the need to pursue each of them individually. So instead of duplicating efforts by printing documents, compiling binders, and manually updating each one when there’s an update, you can present everything online in a much more accessible format, leaving you with more time to run your business instead of fundraising.

6.      Disadvantages of Crowd- funding

As with all financing options, Crowd- funding also has disadvantages. These can include:

• no guarantee that you will reach your funding goal in the set time
• the need to campaign and present your product well to encourage people to fund it
• the need to spend time interacting with your backers and providing them with updates on your product and business development
• providing incentives and rewards to your backers to encourage donations
  the need to deliver the product that has been promised to your backers
• having to compete with other businesses seeking Crowd-funding for their ideas and products.

7.      How does one start Crowd-funding?

Here are some steps to follow if you would like to try Crowd-funding for your business idea or product.

7.1.Plan carefully

Planning is an important part of Crowd-funding. Since you are trying to show people why they should support your product, you need to clearly show them:

• what the product is
• why they should fund your product
• the timeframe for developing your product if your funding goals are reached
• the incentives and rewards you will give them for funding your product.

7.2.Set your goals

You need to set goals so your backers will know what to expect. These goals include:

• how much funding you need
• the timeframe for your funding
• how long it will take to develop your business or product.

It is important to manage expectations, so your backers can track your progress. Some Crowd-funding websites will not let you post your campaign unless you have a set funding goal and timeframe.

7.3.Choosing the websites

There are a number of Crowd-funding websites that let you post your business proposal to attract backers. Hence at this stage choose the websites, where you would like to post your Crowd-funding campaign. The websites differ in:

• the type of business ideas they will accept
• the people they reach
• their requirements (e.g. some will require you to raise funds within a set timeframe)
• their fees (some may have upfront fees, others only charge if you successfully raise the funds you set as your goal)
• how they can help to promote your idea.
• You will need to do some research to find one that best suits your business needs. When it comes to raising capital through outreach to public donors, we have two choices:

Option one : use existing Crowd-funding services such as, Kickstarter, IndieGogo, Spacehive, RocketHub, Ulule, 33Needs, Spot.us, Community Funded, Crowd-cube, Peerbackers, Grw VC, 8-Bit funding etc or

Option two: Utilize our own website, to provide unique campaigns, initiatives and community efforts. This option requires a user-friendly, accessible and stable solution for promoting and processing pledge efforts, as well as the capability to engage, motivate and retain the attention of a sizable fan base that believes in our brand, company or project.

7.4.Post your campaign

To attract backers, you should try to make your campaign stand out! This can be achieved by presenting your business idea in a unique way. If you need inspiration, look at successfully funded campaigns to see what you can learn from them.

7.5.Interact with your audience

You can expand the reach and relevance of your campaign by interacting with your audience on channels such as social media. Keeping your backers informed about your progress will also increase the chances of them marketing your product to other people.

7.6.Thank your backers

Once you have raised the funds you need, you should thank your backers and give them the incentives and rewards you promised them. It's also a good idea to keep them in the loop throughout the implementation of your business idea, so you can keep them interested in your product.

8.      Role of SEBI

The guiding principle behind the policies and regulations of SEBI is protecting the investors’ interests along with developing and regulating the Indian securities market. Therefore, to enable the small issuers  to  raise funds  and  facilitate  the  investors  in  an  informed  decision  making, appropriate safeguards and disclosures are proposed to be put in place. SEBI's role in Crowd-funding, which is proposed to provide a cost effective and efficient method of fund raising, will mainly be limited to:

•   recognition of the Crowd-funding Portals

•   oversight and regulation of the Crowd-funding market in India

•     playing no role in vetting of the Private Placement Offer letter of the issuing companies

•     issuance of guidelines/circular regarding information required to be disclosed in Private Placement Offer Letter or on an ongoing basis or requirements of due diligence and screening or any other matter

•     conduct  of  periodic  inspections  or  audits  of  Crowd-funding  Platforms  and enforcement of Crowd-funding Regulations.

9.      Conclusion

Crowd-funding may provide an alternative source of capital for entrepreneurs that either have limited access to capital or have exhausted other available sources of capital. This also saves the entrepreneur from a lot of effort required in obtaining capital and allows him/her to focus on the business. One of the objectives of the regulations is to reduce the costs involved in raising funds for entrepreneurs. Under the existing regulations, an issuer is required to pay underwriter fees, legal and accounting fees, registrar and transfer agent fees, merchant banker fees, marketing & advertising fees or distribution commissions and other fees some of which may not be applicable in Crowd-funding. Crowd- funding facilitates such entrepreneurs in raising funds without incurring too much of the costs by doing away with the requirement of appointing a merchant banker, marketing & advertising expenses and book building etc. Further, there shall be no listing requirements and no prospectus needs be filed with SEBI. However, a company seeking display in recognized Crowd-funding platform may be required to pay fees to such platform, which is expected to be substantially lower in comparison to the current issue expenditure. The fees to a platform may be dependent on various factors like number of platforms in the market, number of companies seeking display at such Crowd-funding platforms etc. Crowd-funding not only helps the issuers to raise money but also serves as a way of advertising for these companies.  It helps in increasing their visibility which can directly or indirectly lead to the growth in their businesses. Crowd-funding is expected to spur entrepreneurship and benefit the entire economy.

Reference

IOSCO, 2014: International Organisation of Securities Commissions Staff Working Paper on Crowd-- funding: an Infant Industry Growing Fast.

CMAC, 2013: Crowd- Based Equity Funding – Discussion Paper - Corporations and Markets Advisory Committee, Australia, September.

Tilt.com, nd. : "Top Ten Crowd-funding Campaigns Built With Tilt Open". Tilt.com. Tilt.com. https://www.invest4justice.com/how-to-succeed-in-Crowd-funding-your-legal-claim/ Retrieved 28 August 2014.

London loves business, nd.: "Business Owners To Pitch Ideas At Speed Funding Event". www.londonlovesbusiness.com. Retrieved 26 March 2015.