Essay: Crowdfunding

Crowdfunding is now a global phenomenon and has proven to be effective in different sectors of the market. It has become inter alia a mechanism to garner funds or a financing mechanism for start-ups and small and medium sized enterprises (SMEs). In India, however, crowdfunding is still at a nascent stage. There exists no legal framework to address the problems that are presented as a result of this new funding mechanism. In light of the current government’s policies to encourage the development of start-ups and the proactive role being taken by the Securities and Exchange Board of India (SEBI) to help start-ups and SMEs to acquire funds from capital markets, it is imperative to understand thoroughly this new financing mechanism, by contrasting it with the existing capital funding routes. SMEs historically rely on traditional financing, particularly bank lending, and bank loans are more likely to be given in full to the largest companies. Despite trends predicted by analysts, the crowdfunding industry has been sustaining exponential growth: equity crowdfunding in Europe grew by 116% between 2012 and 2014 and the reward-based version grew by 127%. Thus, the business model demands attention and introspection. It becomes imperative to determine whether crowdfunding is feasible to the Indian economic market, it is essential to understand and analyse the pros and cons of this mechanism and assess its viability.
3.1 Capital Financing
Capital financing is a broad term which refers to methods of infusing capital into the business for funding various activities or expenses of the business. For a new business, the importance of raising capital is crucial, since it may need working capital, inventory, a plant, equipment, or various other machinery essential for the running of the business. Similarly, existing businesses also may need capital for expansion or modernization. Thus, it becomes imperative to understand the various routes through which capital is raised by businesses.
Some of the traditional routes adopted by companies to garner capital are as such:
• Debt Financing
• Equity Financing
• Angel Investing
• Venture Capital
• Joint Ventures
• Commercial Paper
• Letters of Credit
• Private Placement
• Initial Public Offerings (IPOs)
• Convertible Debt
For the purpose of clarity to the concepts in this paper, Equity Financing, Private Placement and IPOs shall be explained in further detail:
• Equity Financing- refers to an exchange of money for a share of business ownership. It is generally undertaken by businesses with fast and high growth potential. The major disadvantage to equity financing is that one’s ownership interests is dissolved and there exists a possible loss of control that may accompany a sharing of ownership.
• Private Placement- is the general term for several kinds of stocks or bonds that are sold directly to investors; cannot be resold on the public share market; and are not required to be registered with the regulatory body. A private placement is a method of raising capital with a small group of investors (typically less than 35).
• IPOs- It is the process of making shares of a private company available on the stock market for the general public for the first time. IPOs are forms of stock offerings that let you raise more money by trading in the capital markets.
3.2 What is Crowdfunding
The term “crowdsourcing” was first used by Jeff Howe in 2006 in an online article. It was used to denote a new management philosophy, that is, to solicit funds from an easily approachable “crowd”, or to bring up new ideas, or to appraise opinions. Along similar lines, the term “crowdfunding” was coined by Michael Sullivan in the fall of 2006 when launching a videoblog incubator project.
Crowdfunding as a new-age entrepreneurial phenomenon conveys a generalized recourse to the crowd, in order to replace bureaucratic and traditional fund providers, such as banks, financial markets, venture capitalists, governments, etc.
There have been three key developments which have contributed to the boom and rapid development of crowdfunding, they are as follows: First, there has been a growing tendency of the younger generation to trust their peers, rather than institutions. The rise of the peer-to-peer marketplace is emblematic of this development. New technologies effectively eliminate unnecessary middlemen when it comes to all sorts of financial transactions, establishing direct funding channels between people. Second, there has been a growth in the sharing economy. Collaborative efforts are the hallmark of this phase of business dealings. Crowdfunding is uniquely suited to innovative endeavours. On a fundamental level, the industrial revolution was hallmarked by consumption and the digital age is about creation. The emphasis in this age is on the process of creation itself. People are now beginning to take back control of the means of production. Third, democratization of the process. Crowdfunding, particularly equity crowdfunding promises to level the financial playing field by making high-level, top-of the line services accessible to a varied cross-section of consumers, and not just to institutional clients or the top one percent. Crowdfunding is aiding in in raising the financial literacy of the general public while lowering the barriers of entry to the world of venture capital, angel investing, and stock trading. It has encouraged greater financial inclusivity.
Crowdfunding refers to the practice of pooling in of quantitatively small amount of resources by numerous or several people, to fund prospective projects. It is an alternative finance system where funds are raised through mediums like internet-mediated registries, mail-order subscriptions, benefit events, etc.
In the United States the Securities and Exchange Commission defines crowdfunding as an evolving method of raising money via the internet to fund a variety of projects. The Jumpstart Our Business Start-ups (JOBS) Act creates an exemption under the federal securities laws so that crowdfunding can be used to offer and sell securities to the general public. The JOBS Act also establishes the regulatory structure for raising capital through securities offerings using crowdfunding, including limits on the amount of money companies can raise and investors can invest.
The SEBI Consultation Paper on Crowdfunding in India defines crowdfunding as the solicitation of funds in small amounts from multiple investors through a web-based platform or social networking site for a specific project, business venture or social cause.
Crowdfunding can be divided into four main categories depending on the object the money is being raised for, namely:
• Donation Crowdfunding- it implies solicitation of funds for social, artistic, philanthropic or other purpose, and not in exchange for anything of tangible value.
For example, in the US, Kickstarter, Indiegogo etc. are some of the platforms that support donation based crowdfunding.
• Reward Crowdfunding- refers to the solicitation of funds, wherein investors receive some existing or future tangible reward (such as an existing or future consumer product or a membership rewards scheme) as consideration. Most of the websites which support donation crowdfunding, also enable reward crowdfunding.
Kicktstarter, Rockethub etc. are examples of websites that support such a type of crowdfunding.
• Peer-to-Peer Lending (P2P Lending)- In such a form of lending, an online platform matches lenders/investors with borrowers/issuers in order to provide unsecured loans and the interest rate is determined 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 businesses.
P2P Lending has proven to be a major source of financing for business entities in the recent past. A report by the Open Data Institute in July 2013 found that between October 2010 and May 2013 some 49,000 investors in the UK funded peer-to-peer loans worth more than £378m.
Some of the leading examples from the US are Lending Club, Prosper, etc. and from the UK are Zopa, Funding Circle, etc.
• Equity Crowdfunding- in such a form of crowdfunding, in lieu of funds solicited from investors, equity shares of the company are issued. It refers to fund raising by a business, particularly early-stage funding, through offering equity interests in the business to investors online. Businesses seeking to raise capital through this mode typically advertise online through a crowdfunding platform website, which serves as an intermediary between investors and the start-up companies.
In a few jurisdictions (like China), these platforms are restricted to offer this type of capital raising to sophisticated investors or to a limited number of individual investors. In China, an equity raising offer made to less than 200 individuals do not need to fulfil the public equity raising requirements.
Some examples of equity crowdfunding platforms are Syndicate Room, Crowdcube and Seedrs.
3.3 Need for Crowdfunding
Crowdfunding in its present form might be a new phenomenon, however the basic concept that underpins it, which is resource collection from the crowd is nothing new. It is a practice that has been in existence since the eighteenth century. Thus, it is imperative to analyse the following: First, is it a mere fad fuelled by the age of the internet and development of social media. Second, whether turning to the crowd is a sustainable or a temporary social phenomenon.
The Financial crisis of 2008 resulted in the failure of a number of banks and consequently the Basel III Capital adequacy norms were made applicable to banks. As a result, banks became increasingly constrained in their ability to lend money to the ventures or start-ups which may have high risk element. Hence, there is a need for funding for SME through alternative sources. SMEs are able to raise funds at lower cost of capital without undergoing through rigorous procedures in this mode. The viability of crowdfunding provides a much needed new mode of financing for start-ups and SME sector and increases flows of credit to SMEs and other users in the real economy. Thus, it is important to understand the pros and cons of crowdfunding to assess the need for such a nascent mechanism, especially in India.
The benefits that crowdfunding provide to all users are as follows:
• Crowdfunding provides new investment opportunities and provides a new product for portfolio diversification of investors.
• It increases competition in a space traditionally dominated by a few providers (providing finance to Start-ups and SMEs).
• The operators of a crowdfunding platform may engage in vetting or due diligence of projects to be included on their website, to maintain the reputation of the website. Thus, we find an in-built check and balance mechanism in the system.
• Crowdfunding is an easy way for an emerging business to garner goodwill and brand loyalty without incurring a high cost.
The risks that this model presents to all stakeholders are as follows:
• There are some systemic risks which are inherent in the model: First, due to the “individual” nature of crowdfunding, there is a possibility that investors may not practice good diversification principles. Second, there may be no secondary market in which investors can sell their investments and exit and hence, there is a risk of illiquidity. Third, there exists the possibility of money laundering. Fourth, these platforms could expose other financial sectors to the risk of default, as occurred during the subprime mortgage crisis. If the rapid growth rate in P2P Lending continues, these risks could become systemic. Fifth, there are cross-border implications, if the funds are solicited through the medium of the internet, as there exists disparities in the application of contract law or securities law in different jurisdictions. Sixth, there is high chance of information asymmetry associated with these platforms, where one party invests/trades based on some information which is unknown to other set of investors. Since there is lack of hard information, there is too much reliance on soft information based on the social networking platforms in this model, which increases the risks.
• The risk of substituting from investment risk to retail risk: currently, the risk in financing start-ups and SMEs are borne by the Venture Capital Funds (VCFs) and Private Equity (PE) Investors. In crowdfunding, these entities solicit investments in smaller sums from large number of investors. Hence, the risk taking by VCF/PE (informed investors) is substituted with retail investors, whose risk tolerance level may be very low, that is they tend to be risk averse. Retail investors may not be able to comprehend the risk in these investments and will be unable to bear the loss of investments. This may turn out to be more dangerous, considering the fact that investments in SMEs and start-ups involve high risk and low liquidity and are generally treated as aggressive and long term investments. VCF/PE Investors will be able to negotiate a better pricing and some influence on management, which would be absent in the crowdfunding route, where smaller contributions are sought from multiple investors. Uninformed and unsophisticated investors (retail investors) may act with a ‘herd mentality’.
• Risk of Default: There is no or less recourse to the investors against the issuer, in case of default or fraud. Funds are not directly solicited by the issuer and the issuer also does not come out with any offer document. Funds are solicited by the platform and such platform may or may not conduct proper due diligence of the issuer. If a platform is being temporarily shut down, or closed permanently, no recourse is available to the investors. Further, there is no collateral (even in case of P2P lending), as in the case of Corporate Bonds. In P2P lending, there are no investor protection mechanisms by way of a compensation scheme to cover defaults like deposit guarantee schemes for bank deposits.
• Risk of Failure: This is heightened by the fact that the funding is potentially by participants who do not have the skills and experience needed to assess the risk before investing/lending, as compared to the VCF/PE Investors, banks or other financial institutions who provides funds under the traditional business model.
• Risk of Fraud: This is the red flag that keeps all regulators weary of this mechanism. There is possibility of genuine websites being used by fraudsters claiming to be promoters of projects or of false websites being established, simply to defraud the investors or to entice individuals to provide credit card details etc. Thus, there is a risk of misuse as well as cyber-security and/or identity theft.
3.4 Crowdfunding vis-à-vis other sources of capital financing
The 2008 Financial Crisis 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 became increasingly constrained in their ability to lend money to the real economy. 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 crowdfunding 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.
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. Since the crowdfunding phenomenon is gaining popularity, its importance cannot be ignored. To regulate crowdfunding, 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. While some regulators have been criticized by the media from “taking the crowd out of crowdfunding”, there also exists several media reports explaining the risks in the model and stating that regulators who are today denounced for their intervention will then be castigated for their neglect.
IOSCO Paper states that “A risk posed by moving to regulate a previously exempt sector is the perceived rubber stamping of the industry through regulation, creating credibility in the P2P lending and equity crowd-funding markets. This could attract less experienced investors to these markets who may not understand the risks involved in these types of investment.”
Therefore, it would be appropriate for regulators to take appropriate stand in this regard and send out a message to the various stakeholders recognizing this emerging route of funding. India, so far, does not face a significant exposure to crowdfunding but given that this mode of fund raising is growing at a scorching pace, it is important that regulators keep an open eye and a vigilant attitude.