In the TV quiz show, Who Wants To Be a Millionaire, contestants have the option of asking the audience for help when they are struggling for an answer to a particular question. There is somehow an understanding that other people combined (the collective), have greater knowledge than the individual; or at least enough of the audience will lean in the same direction to reassure the contestant that the answer they offer is the right one.
You could call it the wisdom of crowds, and while I don’t have the stats to hand, I would guess that the audience is usually more right than wrong. There is something about being part of the pack that is comforting and familiar, where decisions taken collectively seem to have more integrity which in turn allows greater reliability to be placed on the solution offered.
Crowdfunding appears to tap into the same social and democratic instincts and as a result has been used as an increasingly popular way of raising money from individuals over the last ten years or more.
What is crowdfunding and how does it work?
Crowdfunding is the term given to the way in which individuals or organisations raise capital to finance their idea, project or business by asking large numbers of people to each contribute a small amount of money. In other words, matching people who have money with people who need money.
Technological innovation in the financial sector in recent years means it has become easier to request support from the general public through a range of what are referred to as online crowdfunding platforms. These platforms act as intermediaries (‘middle-men’) and in effect provide a ‘matching’ service which connect lenders with borrowers and investors with entrepreneurs.
For example, if you decided to invest in Funding Circle, the largest peer-to-peer lending platform in the UK, you become the lender and are actually using Funding Circle as a conduit to pass your money on to the borrower.
There has been a proliferation of these new platforms over the last ten years, each with their own specialised offering. Some for example, focus on raising funds for community projects or charities, (like Gofundme) others support writers, artists and musicians (Kickstarter).
However, the crowdfunding sector is increasingly dominated by commercial platforms that enable entrepreneurs and businesses to raise money either through debt (receiving loans) or equity (issuing shares).
The process by which money is raised broadly follows the same principles across the different platforms. The individual or organisation that needs capital will create a campaign that sets out the target amount of money needed, the reason for that money, how it will be spent and what the ‘giver’ will receive in return.
The ‘giver’ can be a contributor to a community project, a donor to a charity, a lender to a start-up business or an investor in an innovative new product. They each pledge their support to the campaign organiser, usually in the form of a sum of money but it could also be an offer to commit time or skills to a charity.
The return the ‘giver’ receives depends on the nature of the contribution requested by the campaign organiser. If a loan has been requested, then the return will be in the form of interest. If equity has been requested, then dividends. But it could just as easily be a charity requesting a donation so the return is simply feeling good about giving time or money to a cause that means something to the ‘giver’ personally.
Each platform will have its own rules and regulations around who can raise money, for what purpose and how the campaign or funding pitch should be described. There will be relatively strict vetting procedures in place to reduce the risk of inappropriate campaigns, mis-description and fraudulent requests.
In addition, the Financial Conduct Authority (FCA) regulates certain types of crowdfunding models; specifically, loan-based and equity-based models.
Different types of crowdfunding models
The Financial Conduct Authority recognise four different types of crowdfunding models:
1. Donation based crowdfunding
In this type of crowdfunding model, contributors give money or pledge some other form of support (their time or skills for example) without receiving anything in return from the campaign organiser. Donors would do this because they believe in the idea or support the cause for personal or ideological reasons; usually, campaigns centred around community projects or charities.
This model is NOT regulated by the FCA.
2. Reward based crowdfunding
Here, contributors pledge money in the expectation that they will receive some form of reward from the campaign organiser. The reward to the giver can be anything from being first in line to receive a highly sought-after, innovative new product, to ongoing discounts on existing products.
This model is NOT regulated by the FCA.
3. Loan based crowdfunding
In this model, also known as peer-to-peer lending (P2P), the campaign organiser raises funds by borrowing it from investors (individuals or companies) who lend money to the organiser in the expectation that they will receive that money back in full with interest.
This type of debt-based crowdfunding model is typically used by entrepreneurs who obviously need capital to implement their business plan but cannot secure funding from conventional lenders (banks) and are reluctant to sell shares and give up equity in their business to external investors.
This model IS regulated by the FCA.
4. Equity based crowdfunding
Here, a company or entrepreneur raises capital by selling shares or issuing equity in their business to third party investors. In effect, the contributor receives some form of equity stake in the business and in return will share in all the risks and rewards of ownership. The risks include losing some or all of their capital invested, the rewards potentially include dividends from profits or capital gains on disposal.
This form of raising capital could be used in particular by high-risk start-up businesses as an alternative to using business angels or venture capitalists who might ask for too big a percentage of the business in return for their capital investment.
This model IS regulated by the FCA.
Crowdfunding examples
To learn more about examples of crowdfunding in practice, please follow the link.
