Posted: Tuesday 17 April 2012
I have been aware of murmurings about crowdfunding from some time although had not taken any particular notice until I attended a recent networking event, where the guest speaker was incredibly passionate about its merits. As seems to be the case with many aspects of life, crowdfunding started in the US and like numerous US concepts, from burgers to sub-participation, eventually the ripples stretched across the pond to the UK.
The concept is a simple one. The founder of an idea needs cash to make the dream reality - a target amount is set and once reached, the project is fully funded and can proceed. Each ‘crowdfunder’ receives a reward for their investment and these can vary greatly, from free cakes to a free magazine advert, depending on the purpose of the project. Regulation ensures that the issue of shares is not a realistic option in the UK, although the newly signed Jumpstart Our Business Startups Act in the US will allow equity issue there so we know where the wind may carry us next.
The reward principle allows crowdfunding to differentiate itself from a donation structure, even although some of the rewards may be low in monetary value. Given the current market and the unsurprisingly result that charity givings are down, crowdfunding could provide an appropriate compromise, especially in relation to social enterprises and third sector projects.
The golden rule for any new product is to ensure there is a market demand for it. The prudent approach is to carry out appropriate research as any other option is a costly learning curve. It is clear from any Dragon’s Den episode that not everyone takes this approach, leading to a rath of “I’m out” from various directions when the huge gaps in the concept are revealed. Crowdfunding can deal with both research and funding at the same time, as by crowdfunding a project, an order book is being produced at the same time, strengthening demand for the product.
It can also aid future commercial lending prospects. I have read sceptics reporting banks viewing rewards as being “bad debts” but this could be said of any pre-paid order. Crowdfunders are unsecured creditors who will rank behind any bank debt in any future funding (presuming, not unreasonably, that the bank will be secured).
Also, given the drop in funding levels being provided by banks, the financial gap needs to be filled and banks want to see third party investment – it reduces their risk - vitally important to funding in any climate but especially important in a recessionary one.
However, a real concern that cannot be ignored is the possibility of fraud. Given the reward structure and the likely delay between payment and receipt, what happens if the target amount is not reached? Intermediaries facilitating crowdfunding ensure that the funds are not released prior to the target amount being reached and if the target is not achieved in the set time limit (typically between 45-60 days) then the amounts are returned to each funder. Crucially however, the same intermediaries (who as a general rule earn a 5% commission of the target amount) do not take responsibility for the delivery of the rewards. This remains with the project founder and potentially an investor may be duped into making a simple donation. Any potential investor needs to be comfortable with the project being funded and a personal connection would certainly strengthen the chance of the reward being received, which highlights its suitability to financing community projects.
Putting aside the potential fraud issue, I do question whether there is a practical limit to what projects can be crowdfunded. It is more suited to small projects, those with a social angle and the production of consumer goods where the cost per capital can be easily paired with the reward. Also, the rewards must be proportionate and not threaten completion of the project. I heard of one unlucky cupcake maker who offered a limited deal on a well known discount website and now has a full order book – unfortunately making each one at a loss. A terrible example of getting the sums wrong which could endanger a business if repeat orders are not generated at the standard price. A project funder has the same risk.
Crowdfunding is certainly beginning to make progress in the UK and it does indeed have a place in the community and third sector markets. Whether it will impact significantly on commercial lending is yet to be seen – perhaps we should wait and see where the crowd leads us next.