The role of crowdfunding in entrepreneurial finance

This study examines the relatively new trend of crowdfunding in entrepreneurial finance. Crowdfunding is the financing of a project or a venture by a group of individuals instead of professional parties such as, for instance, banks, venture capitalists or business angels. The study examines how crowdfunding works and compares and contrast this concept with the related concept of crowdsourcing. The study also examines the global market for crowdfunding and the rationale of businesses to crowdfund or crowdsource their new ventures, given the challenges of capital formation for fledgling enterprises. The market for crowdfunding is examined in the context of different crowdfunding models. In this context, the study also includes illustrations of enterprises that have adopted specific models given their strategic objectives. Presently, equity crowdfunding is not legal in Canada and is sought to being legalized in the U.S. under the JOBS Act. These issues are be discussed in the study The Role of Crowdfunding in Entrepreneurial Finance An Introduction to Crowdfunding Crowdfunding can be defined as the financing of a project or a venture by a group of individuals (“the crowd”) instead of professionals such as banks, venture capitalists, or business angels. Typically, in crowdfunding initiatives, funds are raised through relatively small contributions from a large number of people (who represent “the crowd”), mostly through the internet without a traditional intermediary such as a bank. As many businesses have increasing difficulty in gaining access to capital, entrepreneurs are seeking alternative financing venues. This phenomenon has spurred the global growth of crowdfunding websites that provide platforms for entrepreneurs to raise funds (Griffin, 2012). As Griffin points out, crowdfunding is akin to posting a classified advertisement on a website like Craiglist.com with the difference that, through crowdfunding sites, entrepreneur can also advertises a business concepts and requests for funding from “the crowd”. Entrepreneurs provide a pitch, usually a business plan, detailing the businesses’ activities and objectives and the entrepreneurs’ plans for using the funds that are sought to be raised. The platforms also inform funders what, if anything, he or she will receive in return for the capital contribution . This is typically done through a terms sheet. Crowdfunding vs. crowdsourcing In this context, it would be interesting to examine a related concept, that of “crowdsourcing”. Through crowdsourcing, a firm outsources specific tasks essential for the making or sale of its product to the general public (the crowd) with the aid of an open call over the internet.Consumers “volunteer” to contribute to production processes and create value. Indeed, in one respect, crowdfunding can be considered to be an element or sub-set of crowdsourcing as volunteers are sought to provide financial help. Why crowdsource and or crowdfund? What are some benefits of crowdsourcing? A major benefit is thought to be the voluntary taskforce of consumers that often helps save costs. Also, to the extent that the crowd may provide more insights faster than a small team of employees, this can in effect reduce the length of new product development. Crowdsourcing can also be very beneficial from a marketing standpoint since involving a committed crowd is likely to result in better customer acceptance, and also more awareness of the “newness” of a product. The central idea is that “collective intelligence or wisdom” creates efficiency, more so for diverse crowds (Schweinbacher and Larraide, 2011). However, there are differing views on the extent to which a crowd provides such collective wisdom. A related question is how does crowdfunding work? Essentially, the process is as follows.The entrepreneur publishes a request for funding on the crowdfunding website, describes the proposed product and provides a business plan. The entrepreneur also indicates what, if anything, individuals who contribute money to finance the business will receive in return. An essential ingredient of crowdfunding is the internet and, therefore, the crowdfunding platform (website) facilitates all exchanges of funds. Types of Crowdfunding In this section, I examine various models of crowdfunding that have been adopted by different platforms. For an excellent detailed discussion of the different types of crowdfunding models, see Bradford (2012). Donation Sites: Contributors donate funds mostly for charities and other non-profits and sometimes for-profits as well (Griffin, 2012; Bradford, 2012). These represent a small proportion of overall crowdfunding activity (about 22% in 2011). For instance, GlobalGiving.com, enables donors to directly contribute to development projects worldwide and takes a 15 percent fee. Another example is EpicStep.com which is a donation platform for financing billboards. One of EpicStep’s well known successful initiatives is the WikiLeaks billboard in Los Angeles. Reward and Pre-Purchase Sites These do not offer interest or a part of the earnings of the business. However, depending on the amount of contribution, they could offer different categories of rewards. Rewards could range from notes of thank you for smaller contributions to small tokens of appreciation, such as key chains, to having the contributor’s name on the credits of movies that are sought to be financed through crowdfunding. An increasing number of movies are being financed in this manner. For instance, about 10 percent of movies at the 2011 Sundance Film Festival were financed through crowdfunding platforms. Sites offering the pre-purchase option are very common. The pre-purchase concept enables contributors to receive the product that the entrepreneur is making. For instance, if a music album is being sought to be financed through crowdfunding, through the pre-purchase option, contributors would have the right to buy the album at a reduced price upon completion. Leading Reward and pre-purchase sites include Kickstarter and IndieGoGo. Transaction-Based Compensation Often, crowdfunding sites charge fees only if financing is successful. If fundraising is unsuccessful, entrepreneurs pay no fee. Fees can range from 4 to 9 percent. Sites that charge fees in this manner include Kickstarter and IndieGoGo (Bradford, 2012). Lending crowdfunding sites There are two categories of lending sites; those not offering interest and those that do offer interest. A prominent example of a site that does not offer interest is Kiva, which provides funds to microfinance lenders, or “field partners” worldwide. Entrepreneurs post loan-requests on the Kiva site. Lenders only receive their principal back; the field partners use any interest received to cover their operating costs. There are also a number of traditional lending crowdfunding sites that offer interest. These are known as peer-to-peer lending sites. Two U.S. based examples of such sites are Prosper and Lending Club. Lenders purchase notes issued by the sites which use those funds to lend through Paypal to borrowers. Lenders get paid if borrowers pay back. Transaction fees and interest on loans depend on the borrowers “credit risk”. Loans that charge interest typically are viewed as ‘securities” and, therefore, for regulatory purposes fall within the domain of securities regulation. As we will be seeing in a later section, the issuance of securities by crowdfunding sites is still in the process of being legalized in the U.S. In Canada, at present crowdfunding sites cannot legally issue securities. Equity crowdfunding sites: These exist mostly in some European countries and to some extent in Australia. Equity crowdfunding sites offer investors a share of the profits of the business they are funding rights. Depending on a country’s regulatory regime, equity crowdfunding sites can take different forms. For instance, these may or may not include voting rSuch sites do not exist in Canada because of regulatory issues pertaining to the sale of securities. Indeed, at present, these sites exist mostly outside North America. A prominent German site that has been successful with the equity crowdfunding model is SellABand.com. This site raises funding through donations as well as investments in the form of debt and equity to fund independent musicians seeking to complete albums. A unique feature of the site’s business model is the option to share revenue from album sales with investors. Some pure equity sites include Crowdcube.com from UK or Buzz Entrepreneur from France. The state of crowdfunding globally: According to the website, crowdsourcing.org, as of April 2012, 452 crowdfunding platforms (or CFPs) were operating globally. In aggregate, CFP’s had raised almost $1.5 billion in funds in 2011. By and large, while the United States remains the largest market for fundraising the European market has been growing rapidly. Funds raised through crowdfunding initiatives grew at a 63% compounded annual growth rate (CAGR) over the last 3 years, primarily driven by donation and lending-based platforms. Currently, reward-based platforms are growing at the fastest rate but perhaps this is so because the growth has occurred from a smaller base. As of 2012, most CFP’s belong to the reward-based category of CFPs, although equitybased platforms represent the fastest-growing category in terms of net year-on-year growth. At present, there are no equity-based platforms in Canada or the United States. Not surprisingly, therefore, reward-based and equity based platforms are higher in numbers in Europe than in North America Crowdfunding platforms have been very active and, in 2011, ran over 1 million successful campaigns. The majority of these campaigns were in the donation based category, followed by rewards-based ones but equity-based campaigns were, on average, much larger in size in terms of funds raised. Lending-based campaigns had the smallest share. For instance, on eq