Innovative approach for projects, organizations, entrepreneurs, and startups to raise money for their causes from multiple individual donors or investors. Four models of crowdfunding exist: donations; reward; lending; and equity.
Kew words: crowd-investing; P2P lending; Equity-based crowdfunding; alternative finance
How does it work?
Crowdfunding is a collective effort of individuals who pool their resources to support initiatives promoted by other people or organizations. Using social networks and the viral nature of online communication, individuals and companies have raised billions of dollars in debt, equity, and donations over the past decade. Crowdfunding emerged from innovation in technologies that made it possible for businesses, NGOs and individuals to secure funding with no or limited intermediation. The market has grown in developed countries, partially as a response to the credit crunch resulting from the 2008 financial crisis. Thanks to a rapid and unprecedented expansion of Internet and mobile access, it soon expanded to developing countries.
Crowdfunding has grown rapidly from a Silicon Valley social experiment to a multi-billion dollar industry- from US$1 billion in 2011 to US$34 billion in 2015. It also expanded from financing charities into enterprise financing and quickly overtook angel investing to become one of the largest sources of financing for SMEs, second only to venture capital. The industry is expected to reach an annual volume of US$100 billion by 2025 and becoming the leading financial channel for SMEs. Crowdfunding in developing countries raised US$430 million in 2015, with India, the Philippines, and Nepal in the top three.
Four different models of crowdfunding have emerged:
- Donations-based: The crowdfunder donates funds without expecting any return. Donations are typically used to support disaster relief, famine, education programmes, etc. JustGiving and GoFundMe are among the largest donations-based platforms. Globally, over US$2.85 billion in donations were raised in 2015.
- Rewards-based: The crowdfunder transfers funds with the expectation of a reward, which may be in the form of a token gift or an early/exclusive release of a product or service offered by the startup company. Kickstarter and Indiegogo are among the most successful crowdfunding platforms built on rewards-based model of crowdfunding. Since its launch in 2009 through April 2017, more than 123,000 projects have been funded through Kickstarter with nearly US$3 billion pledged. All-or-nothing (AON) campaigns require a project to hit 100 percent of its funding target. If the target is not achieved, funds are returned. Keep it all or flexible funding (KIA) campaigns instead allow the project sponsor to keep the amounts raised. AON campaigns have more backers and raise a higher amount of funds compared with KIAs: an assessment of the campaigns run in the years 2011–2013 via Indiegogo found that AON projects’ average funding goal was US$31,397 compared with US$20,478 for KIAs; 34 percent of AON campaigns reached their goal, compared with 17 percent of KIAs .
- Lending-based or Peer-to-Peer (P2P): the fastest growing type of crowdfunding has a 73 percent market share. The crowdfunder lends money to individuals or companies in return for interest. While there are platforms exclusively targeting socially-oriented lending, the majority operate as commercial platforms in direct competition with other financial intermediaries. KIVA is providing small loans (from US$100-US$100,000) to farmers, NGOs and SMEs that make positive impact and has already provided more than US$1 billion in small loans.
- Equity-based crowdfunding: The crowdfunder purchases equity in a company. Equity is a new, yet rapidly growing, model in crowdfunding with over US$2.5 billion invested in 2015. Equity-based crowdfunding could reach up to US$36 billion by 2020 and eventually surpass venture capital by value (Massolution). Equity-based crowdfunding remains highly dependent upon supportive regulatory frameworks, which often restrict equity investment to professional investors.
A successful crowdfunding campaign may draw on a platform with a wide audience, such as Kickstarter, Indiegogo, Kiva, or GoFundMe. New platforms may also be established under certain circumstances. There are numerous resources on crowdfunding, including blogs, books, networks, and training, including guides on running campaigns from Indiegogo, Fundable, Kickstarter, Crowdfunding Guides, and Shopify.
Potential in monetary terms (revenues, realignment or cost-savings)
Crowdfunding has grown substantially, from US$1 billion in 2011 to US$34 billion in 2015 (Massolution). P2P lending (US$25 billion), donation (US$2.9), rewards (US$2.7 billion) and equity crowdfunding (US$2.5 billion) make up most of the market. These amounts are already comparable with venture capital, which is investing an average of US$30 billion each year. The market may surpass the US$100 billion threshold before the World Bank’s 2025 estimate. Donation and reward crowdfunding have historically taken the largest share of the market and were only recently surpassed by P2P lending. Equity-based and lending-based crowdfunding platforms are expanding at the most rapid rate, in the UK at nearly 300 percent in 2015 (NESTA). The shares of the different crowdfunding models are different between developing and developed countries: in 2015 43 percent of crowdfunding in developing countries was classified as donation, 38 percent as lending, 11 percent as equity, and 7 percent as reward (Allied Crowds).
Crowdfunders invest mostly in business and entrepreneurship (40 percent), social causes (20 percent), films and performing arts (12 percent), and real estate (6 percent). In addition to the above, specialized platforms have also emerged, targeting subsectors like agriculture, retail, food, and housing and services (UNEP). Environmental projects are at the periphery; while platforms like Indiegogo and Kiva have started to enlist green projects, they remain a minority. An exception is renewable energy with an estimated €200 million in crowdfunding transactions that is facilitated by 25 specialized platforms.
The different crowdfunding models and platforms’ own strategies have produced a broad range of results in the amount of resources mobilized. Kiva, which serves small entrepreneurs through a network of microfinance organizations, has facilitated the disbursement of 1,6 million loans to the tune of US$1 billion as of October 2017. Of the Kiva borrowers, 749,149 have come from least developed countries, 81 percent being women. Kickstarter has allocated over US$815 million from 4.9 million backers to nearly 50,000 projects. To date, the most successful project was the video game “Star Citizen”, which collected more than US$145 million. In Nepal, where a devastating earthquake killed over 8,500 and affected 5.6 million people in 2015, US$23 million was raised from individuals sending money to their families, diaspora groups supporting their communities, and other international donors, much of it through crowdfunding.
When is it feasible?
Each crowdfunding model is tied to different regulatory requirements which may vary substantially between countries. Legal requirements can be cumbersome depending on the model pursued (e.g. equity based crowdfunding is most demanding), the crowdfunding platform location, the project sponsor or beneficiary, and if it entails an international transaction.
The Cambridge Centre for Alternative Finance identifies four main regulatory regimes:
- Lack of of legislation. In some instances, generic provisions that protect investors may apply.
- Intermediary/platform regulation–controls are established on some forms of crowdfunding—e.g. equity and lending—with registration and other governance and reporting requirements.
- Banking regulation–lending and equity platforms are considered banks, requiring a banking license for certain crowdfunding operations.
- Two-tiered regulation–crowdfunding platforms are monitored at the federal level (such as the Securities and Exchange Commission in the USA) along with state-level agencies. Some US states impose bans on some forms of crowdfunding, e.g. equity, while others may provide exemptions.
Some countries have more favourable legislation—e.g. the UK, the Netherlands, Germany, and the USA. Regulatory reforms are advancing and more countries have updated their regulatory framework to facilitate crowdfunding. The UK and Sweden have already completed more than one round of reforms. A short summary of existing regulations is provided:
- Europe: Member states have country-specific provisions with limited harmonization. The European Commission helps by assessing national frameworks and identifying best practices. The Current State of Crowdfunding in Europe and Sustaining Momentum reports provide detailed information.
- United States: Reward based or donation based crowdfunding are widely accepted. If a company offers equity investment, SEC oversight rules apply. Further information may be found in Hitting Stride and Breaking New Ground.
- Asia: The regulatory environment is diverse and rapidly changing. Some countries, such as Singapore and Thailand, have opted to regulate alternative finance using pre-existing regulatory frameworks, but others, like Malaysia, New Zealand, and South Korea have created bespoke regulations to govern equity and debt-based operations. Further information may be found in Harnessing Potential.
- Latin America and the Caribbean: Latin America and the Caribbean lags behind, with two-thirds of surveyed platforms in Breaking New Ground reporting no regulations or that crowdfunding is illegal. Mexico does not have supportive legislation, while others, like Brazil, are discussing reforms.
- Middle East & Africa: Israel and the UAE offer the most progressive regulatory environment. In Africa, South Africa and Kenya are the most advanced but still with crowdfunding activities not clearly regulated. Further information may be found in Africa and Middle East and Crowdfunding in East Africa.
Since crowdfunding platforms may operate across borders, international provisions also apply, particularly in relation to money laundering and the fight against terrorism. The largest platforms—Kickstarter, Indiegogo, and RocketHub—have become fully compliant with international anti-money laundering laws.
Credible crowdfunding systems require more than enabling legislation. Their success also relies on supportive ecosystems and other enabling factors. These include forward-looking regulations that balance the need for investor protection with capital formation; effective technological solutions that include reliable broadband Internet or mobile data networks; and supportive institutions that offer training, mentoring, and other services to beneficiaries and investees.
Minimum investment required and running costs
Running costs incurred by beneficiaries/investees to run crowdfunding campaigns can be separated into direct fees paid to the platform used and marketing costs:
In what context it is more appropriate
When launching a crowdfunding project, it is important to understand what the project objectives are and who the target audience is. Different models of crowdfunding are best suited for different types of projects:
- Donation: Projects where the beneficiary cannot offer anything in return for financial support. This is typically reserved for charity and philanthropic activities, such as the Nepal relief efforts that raised US$23 million.
- Reward: Projects where the beneficiary may offer a non-financial reward to supporters. This is typically seen in projects that are creative, social, or entrepreneurial in nature and that serve as a means to pre-purchase a product, such as furniture manufactured from plastic waste. Rewards can also be non-financial, such as an experience or recognition.
- P2P lending: Individuals or businesses needing debt financing. For instance, a solar electricity development project for 31,000 people in Kenya. Usual considerations on lending apply, i.e. capacity to repay, quality of business planning, availability of collateral, etc.
- Equity: Start-ups or businesses needing growth capital, e.g. a company that developed low carbon-bamboo tissue products. Equity crowdfunding is also widely used in real estate.
What are the main risks and challenges?
- An effective way to capture remittances. AlliedCrowds suggests that if 10 percent of the global remittance market were captured, diaspora crowdfunding could grow to US$58 billion in 2015.
- Promote a culture of entrepreneurship, offering new avenues for matching entrepreneurs with investors. It may serve project owners that cannot access traditional or commercial finance.
- It allows project owners to validate ideas and interventions before targeting traditional donors or financial organizations. Eighty percent of social enterprises in a recent survey highly ranked crowdfunding’s non-financial benefits such as marketing and supporter engagement (Crowdfunding Good Causes).
- Crowdfunding platforms may be cost-effective intermediaries as they help individual investors and donors navigate complex foreign legal frameworks, allowing them to invest abroad at affordable rates.
- The financial risk of small projects—that are usually perceived as riskier—can be shared with a wider group of investors.
- Holds the promise of democratizing start-ups’ financing; 85 percent of surveyed social enterprises ranked “allowing investees to raise money from individuals rather than institutions” as moderately to extremely important in their decision to use crowdfunding (Crowdfunding Good Causes).
- Angels and venture capitalist firms can use crowdfunding platforms to discover, communicate with, and invest in start-ups they would not have otherwise found.
- Cyber Security: 76 percent of platform operators believe there is medium to very high risk of a potential cyber-security breach (Hitting Stride).
- Fraud: 64 percent of platform operators associated medium to very high risk (Hitting Stride).
- Use of crowdfunding platforms for money laundering; the risk being no greater than in other international financial transactions.
- Collapse of platforms due to malpractice ranked second highest among perceived risks, with 69 percent of platforms viewing this as a medium to very high risk (Hitting Stride).
- Expected changes in the regulatory frameworks, including tax provisions.
- Political and commercial risks in equity and lending based crowdfunding. Crowdfunding models’ specific risks are not reviewed in detail, e.g. in AON campaigns project sponsors may not reach the funding target.
- Reputation from failure to deliver perks/ rewards to backers.
- Inability to verify the social and environmental impact or related malpractices.
How can the design be ameliorated to improve the impact?
Guidelines and Case Studies
- Guidebooks from Indiegogo, Fundable, Kickstarter, Crowdfunding Guides, and Shopify.
- Crowdfunding’s potential for the developing world
- Allied Crowds’ Alternative Finance Reports
- Nesta Crowdfunding Research Reports
- Crowdfunding Hub European Research
- Cambridge Centre for Alternative Finance
- Crowdfunding Academy
- Dos & Don'ts of Crowdfunding for Development
- ‘CrowdingIn’ Platform Browser