5.1 Modalities 241. In the case of crowdfunding, individuals provide the firm with financial help. Crowdfunding generally takes place thro...
5.1 Modalities 241. In the case of crowdfunding, individuals provide the firm with financial help. Crowdfunding generally takes place through social networks, internet especially, with the entrepreneur detailing the business activities and objectives, in some cases in the form of a business plan, and requesting funding under specific terms and conditions. This represents the main innovation of crowdfunding with respect to other forms of finance, as the entrepreneur does not need an intermediary, such as a banking institution, to seek funding and can source directly the savings of a large audience.
242. Crowdfunding is not only a mean to raise funds, but can also represent an important mechanism to share information with a large public, increase awareness about projects and products, seek feedback to improve them, and get recognition which may help in future commercialisation (Metzler, 2011). 243. The type of contributions by the investor – and related rewards - may vary, depending on the internet platforms, the type of firms and the projects. Indeed, as new platforms are created across countries, in a context of low regulation, new features and business models are continuously emerging. The types of funding may range from donations to equity, thus giving rise to processes with different degrees of complexity and different contractual relationships between the firm and the individual investor. 244. In broad terms, crowdfunding can take the form of (Hemer, 2011; Mitra, 2012):
1. Donations, whereby contributors donate funds, mostly for charities and non-profit organisations, although for-profit organisations can also receive donations through this channel; 2. Reward or Sponsorship, whereby contributors receive a pre-defined reward, such as a small token of appreciation or some type of service, like a public acknowledgment for their contribution and marketing; 3. Pre-selling or pre-ordering, whereby investors provide funding to help produce some product or service and in return receive an early version of the product, or the product at a reduced price;
4. Lending, whereby investors receive the interest and the principal at the end of the lending period. There exist also crowd-lending forms based on the revenue-sharing principle, that is, where creditors are not paid interests at the end of the defined lending period, but rather an amount which includes an agreed share of the earnings, in case of good performance of the debtor.
5. Equity, whereby a privately-held company offers securities to the general public, through the medium of an online platform. Investors receive a share in the business and may acquire voting rights. 245. Donations, rewards and pre-selling (i.e. the so-called “non-financial” crowdfunding) represent the most widespread forms of crowdfunding and constitute an important share of the funding raised by private companies through this channel, providing also non-financial benefits to companies and investors. While these forms currently lead the industry, lending and equity based crowdfunding are expected to play an increasing role in the future.
246. Lending-based crowdfunding, or peer-to-peer lending (P2P), has started as a form of loan transactions in which individual consumers borrow from and lend money to one another, by means of unsecured personal loans, without the mediation of a financial institution. This community lending implies direct contact between the parties and, often, exchange of information that, through the internet platform, is visible to other current and potential borrowers, and may help to broaden the creditor base. In fact, P2P lending communities operate on the principle of “full financing,” i.e., the loan request gets funded only if it receives enough bids to cover the entire amount requested by the borrower within an established pledging period, which may range from a few weeks to several months (Herzeinstein et al., 2008) 247. However, over time, crowd-lending has become increasingly mediated by online intermediaries. In the case of lending platforms, typically the lenders purchase notes issued by the sites, which use those funds to lend through Paypal or WebBank to borrowers (Mistra, 2012). Thus, the online platform acts as an intermediary, for instance, collecting loan pledges from the crowd for private projects, releasing them at the moment a target is reached, according to a threshold principle, collecting repayment instalments from the debtor, and forwarding them to each crowd-lender25. In some business models, the pledged amounts are transferred to an escrow account26, which is managed by the platform or a partner bank. Once the threshold pledge is reached, payments are transferred from the escrow account to the project’s account (Hemer, 2011).
248. Peer-to-peer loans are usually unsecured loans, i.e. no collateral is required on borrowers, although, in some cases companies may offer secured loans. Nevertheless, transaction fees and interest on loans are charged by the online intermediary, which depend on the borrowers’ credit risk, as assessed by accessing credit information from third parties or on the basis of information submitted by the borrowers themselves. The online platforms typically develop credit models for loan approvals and pricing, and perform credit checks of borrowers. Indeed, P2P platforms make profits from commissions instead of the spread between deposit and loan. The longer repayment period that a loan lasts, the higher fees the borrower has to pay (Lin, 2009; Chen and Han, 2012). 249. In the case of equity or investment crowdfunding, a firm offers a certain proportion of its equity for a set amount of capital it is aiming to raise. Crowdfunded businesses do not have to adhere to the strict accounting standards required of public companies and, at the same time, unlike other risk capital providers, crowdfunding investors may have no experience in making such investments. As Collins and Pierrakis (2012) underline, as the model taps into the sub–section of the public with an interest in entrepreneurship, in many cases investment will also be motivated by non–financial aims, such as becoming part of an entrepreneurial venture or supporting a particular individual or business. 250. The business model of equity platforms typically implies that entrepreneurs or project initiators define with the partner platform a funding threshold and a time period for reaching the target, which is divided into equal shares. These are offered as equity shares through the platform and, in a similar way as the threshold model for crowd-lending, once the threshold is reached the investment takes place (Helmer, 2011).
251. A key step in this process is the valuation of the business, in order to establish the amount of equity to be offered in exchange for the target capital to be raised. In most cases, it is the entrepreneur him/herself that performs this valuation, although the platform may allow for some upward flexibility in the amount of equity that is offered, as the fundraising progresses and if the observed investment rate does not allow reaching the threshold within the agreed timeline. Some platforms operate a market–driven approach to setting valuation, whereby the entrepreneurs set out the amount of equity and number of shares they are offering, and, through a bidding process, investors who are willing to pay the most for the shares get in on the deal. Some platforms also provide to entrepreneurs training on how to value a business, engaging ex–investment bankers, fund managers and venture capitalists (Collins and Pierrakis, 2012).
252. An emergent business form of equity crowdfunding platform is the “holding model”, as defined by Helmer (2011), whereby the platform creates a subsidiary company, which operates as an individual holding for each of the crowdfunded ventures. In this case, it is the holding company that owns the company shares and sells them to the crowd, acting as a single investor in the firm, alongside other potential investors from the conventional capital market27. 253. As experience and professionalism increase, crowdfunding platforms are evolving into more sophisticated intermediaries, which may offer other services beyond the facilitation of funding, such as due diligence, consulting, search for co-investors or management of a co-investment fund (Helmer, 2011).
5.2 Profile of firms 254. Since the late 1990s, the diffusion of crowdfunding practices has been especially related to nonprofit organisations and the entertainment industry, where non-monetary benefits or an enhanced community experience represent important motivations for donors and investors. To date, projects with a creative or social focus, where non–financial rewards are offered in return for donations, have been the most successful at raising finance from the crowd (Collins and Pierrakis, 2012). 255. Nevertheless, over time, crowdfunding has become an alternative source of funding across many other sectors and it is increasingly used to support a wide range of for-profit activities and businesses. New product-development is an activity for which crowdfunding can provide specific advantages, as the financial dimension is importantly complemented by direct contact and feedback from current and potential customers. 256. In this regard, Belleflamme et al. (2011) highlight the importance of community-based experience for crowdfunding to be a viable alternative to traditional funding. In relation to reward or prepurchase funding, however, they also show that crowdfunding is the most profitable option only for lower levels of finance,
when the entrepreneur can use the mechanism to apply price discrimination, where consumers with the highest expected valuation are willing to pre-order, i.e. to crowdfund, at a higher price than other customers. When the amount required becomes larger, the entrepreneur is forced to distort more the prices to attract a larger base of crowdfunders, which reduces the gains from price discrimination. 257. The crowd-lending, or P2P lending, option can be attractive for small businesses that lack collateral or credit history to access traditional bank lending, as the loans offered are typically unsecured. P2P lending, however, is not only attractive to highly risky or “unbankable” borrowers. Indeed, the main platforms for crowd-lending have been increasingly targeting high quality credit risk, often providing loans to refinance credit-card debt, and incentivising lenders to conduct thorough credit checks of applicants before accepting them,
which has limited default rates. On their side, borrowers can receive lower rates than those offered by banks, since overhead costs and regulatory burdens are lower, as well as benefit from the interaction with customers that these platforms typically provide. 258. Equity crowdfunding can provide for a complement or substitute of seed financing for entrepreneurial ventures and start-ups that have difficulties in raising capital from traditional sources, like bank loans, venture capital, business angels and also public programmes, because they are too innovative to be understood, too complex, too risky or simply because the business plans are poorly presented (Helmer, 2011).
259. Crowdfunding has the potential to deliver equity finance to ventures that have greater levels of risk attached relative to the potential financial gains they can deliver. The non-monetary motivations of crowdfunding investors, such as being part of an entrepreneurial venture or receiving non-tangible rewards, can explain, at least in part, why they may be willing to accept more risk or less return than traditional risk capital investors.
At the same time, the small amounts committed to many ventures may allow them to effectively spread their risk, in a cost effective way (Collins and Pierrakis, 2012). 260. By design and because of regulatory limitations, crowdfunding is suited to start-ups and businesses that request relatively small amounts of funding. However, this depends on the extent to which larger investors participate in the process, as there have been some cases where the potential of the model to raise larger amounts has also been shown (Collins and Pierrakis, 2012). Indeed, large companies have been increasingly investing through crowdfunding platforms, which can offer access to promising start-up ventures. In some cases, crowdfunding challenges have been set up by large firms, offering the most competitive start-ups to match the funds they raised from smaller investors28.
261. According to Collins and Pierrakis (2012), some business models and sectors may be more suited to crowdfunding than others. In particular, consumer–facing businesses may find the instrument more suitable to their needs, as traction with the potential customer base, as shown by the ability to raise fund through the platform, is an integral part of proving to investors the viability of their proposition. Signalling is one of the most important functions of crowdfunding, and a large number of supporters suggests that there exists already a core market for the firm’s product or service, which can be easily mobilised to broaden the market through personal contacts and social networks (Helmer, 2011). Also, crowdfunding can benefit new ventures built on some R&D output, as the interaction with customers may allow the entrepreneur to validate the untested product or service (OECD, 2014c). 262. On the other hand, the crowdfunding channel may be less suited for business models that are based on complex intangibles or innovations in very high–tech and cutting edge areas, which require specific knowledge on the side of investors (Collins and Pierrakis, 2012).
In this regard, however, Helmer (2011) notes that the crowdfunding mechanism may attract a certain group of investors that seek ventures with some degree of innovation in specific fields, such as IT experts, engineers, scientists or people with visions of future applications. Besides funding, they may also bring in knowledge, experiences and networks to shape business strategies and craft products (OECD, 2014c). 263. Furthermore, crowdfunding may not be appropriate to fund firms for which business information and financial details are too sensitive to be shared with a large number of potential investors, as it is either impossible or legally very difficult to arrange non-disclosure agreements with all of them. In addition, crowdfunding may not be suited for businesses that are particularly capital–intensive in early stages or those that require the types of post–investment support that can only be provided by institutional investors (Collins and Pierrakis, 2012; Helmer, 2011).
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