Crowdfunding: The definitive pros and cons list for investors and businesses

Crowdfunding has become one of the buzz words of business start-ups and potential investors, so if you’re not already an expert in this modern social fund-sourcing process, you may feel like you’ve missed the boat.

But don’t worry; crowdfunding seems to be here to stay, and while it’s providing new opportunities for both business entrepreneurs and those with capital to invest, it’s certainly not the perfect solution for every funding and start-up scenario. Below is an overview of how crowdfunding works, and some of the pros and cons, both for businesses and investors.

What is crowdfunding?
Financing a new business or project traditionally involved asking a few people (such as banks, independent investors etc) for large sums of money.

Crowdfunding turns that situation around, usually by using the internet to promote an idea or venture to thousands of potential investors, who have the option of making much smaller individual investments. Those looking for funds will typically use a recognised website platform to set up a profile of their project, and then use social media as well as their network of family, friends and business contacts to raise the necessary money.

There are three main types of crowdfunding. Donation or reward crowdfunding relies on people investing in a project or creative process because they believe in the cause; donors have a social or personal motivation for putting their money in, and expect no financial return, although they may receive rewards such as exclusive access to content or material, or tickets to events. Although there is no financial investment potential in donation or reward crowdfunding, it can offer a source of sustainable income, particularly for those in creative fields.

Equity crowdfunding offers people the chance to invest in a venture in exchange for equity or shares in the business. As with most other share investments, the value of the shares can go up or down (and the rise or fall in value can be much larger than traditional share investments). Equity crowdfunding grew significantly in the wake of the global financial crisis, and the resulting reluctance on the part of the banks to offer loans to start-up businesses.

Recent high profile examples of successful crowdfunding campaigns include BrewDog (craft brewer now valued at over $1bn), the Pebble smart watch, Oculus Rift (a virtual reality startup that went on to sell to Facebook for $2bn) and Le Col – a designer and manufacturer of cycling apparel having raised £1m – with half of the funds raised by our own Price Bailey Strategic Corporate Finance team. Read more about how we helped Le Col here.

While equity crowdfunding has been the main approach for several years, debt crowdfunding, also known as peer-to-peer (p2p) lending or crowdlending, is now equally popular, and is seen by some as the way forward. This enables investors to gain a financial return, receiving their money back with interest, while also contributing to the success of an idea or project they support.

The pros and cons for investors
There is certainly no shortage of crowdfunding investment opportunities out there, with thousands of entrepreneurs looking for financial support to turn their dreams into reality.

Ideological investments as well as financial

Crowdfunding enables investors to take more control of their investments – often by bidding to make an investment in a specific project or business which may match their ideological aims as well as their financial ones.

Avoiding volatility

Crowdfunding investments aren’t linked to other markets, such as the stock exchange or the Alternative Investment Market (See here: What is the Alternative Investment Market?). This can be particularly beneficial in times of wider economic instability or volatility, where widely-traded shares can be subject to extreme market variations, and also during economic downturns, when investments in products such as bonds and equities can be vulnerable.

The risks

However, crowdfunding doesn’t come without its own risks to investors. The nature of the process means that you may be investing in a company or venture that’s in its early stages of development, and the failure rate of crowdfunding initiatives is significant, so while the rewards could potentially be high, so too are the risks of losing some or all of your investment.

Debt investments tend to carry lower risks than equity investments, but all investments have different risk profiles, so it’s important to read offer documents in full and do your research before investing. And remember, most crowdfunding opportunities fall outside the Financial Services Compensation scheme, so you are making your own assessment of opportunity and risk.

The pros and cons for businesses

Crowdfunding is not just an alternative route to raise finance for those who don’t want to approach traditional lenders such as banks (although this is one attraction for some entrepreneurs); it does offer very specific benefits which other investment sources cannot match.

A closer relationship

Crowdfunding can bring both market validation – in the shape of a financial commitment to your product or project from investors who have the belief that it will succeed – and also invaluable market insight and feedback. Those who invest through crowdfunding are often keen on building a relationship with the business they are investing in, and that interaction can be instant. By suggesting changes or improvements to products, asking sometimes difficult questions, and delivering honest feedback, crowdfunding investors can help SMEs to fine-tune their products or projects before hitting the market.

Loyal followers and extra PR
By their nature, crowdfunding campaigns also generate major publicity and PR for your product or your brand, which in itself can help to attract significant investors. The use of social media platforms and investors looking at ideological investments can be a powerful combination in gaining traction in the media and producing a snowball effect for more investors.

More accessible
It is generally easier/less burdensome than raising finance via traditional means such as via banks (who may not support an early-stage company with a limited trading history). However, it is notable that crowdfunding platforms do have minimum standards when conducting due diligence on companies looking to raise funds – with some platforms turning down around 80% of prospects due to their stringent requirements.

Further reading: How to create a business plan to raise investment

Low cost
Depending on the platform chosen, crowdfunding can represent a relatively low-cost method of raising finance. Typically, platforms charge a modest upfront fee, a success fee (a percentage of the funds raised – often in the range of 5%-7%) and in some instances, an annual monitoring fee (to cover the costs of administrating the investment agreements and statutory filings, etc.).

Ease the risk
Where investments are on the low-side raising finance from a large number of investors can provide diversification of risk for those investing. It is notable, however, that some investors do make large-scale investments (particularly so when they are leading an investment round).

Anyone can see it (and steal it)
Perhaps the biggest downside to crowdfunding is that the project requiring funding must be disclosed in the public domain – often this is at a time-critical stage where the idea could be replicated and brought to market by a competitor with better access to funding. This is most likely to occur if the crowdfund fails and the company has to explore alternative means to raising finance.

A contrary argument to this is that while ideas are important, it is the actual execution of the idea that is the issue. Indeed, large competitors are generally slow at launching products – most would prefer to wait to see if an innovative product or service is successful before launching a rival.

In such a situation, it is not uncommon for a larger competitor to buy the company. Furthermore, once an idea is in the public domain it is almost inevitable that the idea will be copied (at least to a certain extent unless intellectual property rights preclude this).

Rate of return time
With 5 years being the typical exit window considered as reasonable for a lot of investors, if you’re developing a new technology requiring extensive R&D and long lead times then crowdfunding may not be the best approach.

€5m max
There is a limit on the amount that can be raised via a crowdfunding campaign: €5m. However there are a number of ways to work around this limit such as via multiple investment rounds – Series A, B, etc.

Growing regulation
The growing trend towards crowdfunding has not gone unnoticed by regulators –the Financial Conduct Authority (FCA) has since begun to regulate the industry. For instance, new rules require “inexperienced” investors to certify that they will only invest a maximum 10% of their portfolio into crowdfunding campaigns (the extent to which this can actually be monitored is debatable).

Lots of investors = Admin

Taking in investment from the crowd can result in a company having 1,000s of investors – which can be burdensome from an administrative perspective.

A work-around this is for crowd investors to be listed under a nominee structure. This is where a nominee acts on behalf of other individuals, or a group of individuals, to carry out administrative related tasks related with holding investments.

Now win, no funds
If the funding target is not met, any funds pledged will typically be returned to investors. In this situation the company seeking investment will not receive anything but may well incur a modest administration fee.

As well, these failed projects are in the public domain and may damage the reputation of the company seeking investment.

While there are pros and cons of crowdfunding for both businesses and investors, it seems pretty clear that as an approach to launching new products or services, or financing business developments, crowdfunding is here to stay. Success for both sides in the relationship will often depend on looking for the opportunities or investors that match your own aims and ideals, doing the research, and getting expert advice.

Further reading: 12 steps to maximise the value of your company

We always recommend you speak to a qualified financial advisor before making a decision. As such, you can speak to our qualified advisors by filling in the form below.

The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

Courtesy of Price Bailey