Crowdfunding models explained

  • Friday 9th June 2017

Utilising the power of the collective to achieve challenging goals is not a new phenomenon, think the Longitude Prize in 1714 and the crowdsourced creation of the chronometer. However, in a contemporary sense, crowdfunding began gaining real traction in 2008/09 with the birth of reward-based platforms IndieGoGo and Kickstarter, the two US giants, in an industry that has raised more than £2 billion globally. This is a good place to start differentiating the platforms and six key business models I am choosing to focus on. These are reward-based, donation-based, micro-lending, peer-to-peer, peer-to-business and equity.

Rewards-based crowdfunding

Investors on rewards-based platforms like Crowdfunder, IndieGoGo and Kickstarter are often called pledgers or backers. These platforms will most frequently list products, services or projects allowing the backer to pledge an amount of money for a reward, with structures tiered to reward the largest backers to receive the highest value or most unique reward. This could be a high-tech watch like the Pebble watch, a 3D laser printer or a video game like ‘Star Citizen’; which claims to have raised over £100,000,000, the largest crowdfunding campaign to date. Although it’s worth noting that on Kickstarter the average raise size is closer to £16,000.

Often the type of businesses you will find on these platforms is focusing on pre-sales to bring something into creation or prove a concept. According to Kickstarter, music, film and video, publishing and art lead the way by a number of successfully funded campaigns, however, games, technology and design are top of the log by the amount of funds raised, responsible for many of the six and seven figure campaigns.

An important word of caution, whilst many of the successful campaigns meet the timelines of for product or service delivery, some have been known to be late or of poor quality, so one of the key risks is backing something that may never be built or created. That said, the majority of the platforms don’t charge pledgers or backers at all. They simply charge a fee of between 3-5% on the total amount raised for successfully funded campaigns and you can pledge from just a pound and up.

Donation-based crowdfunding

Donation-based crowdfunding is structured almost identically in terms of business model to rewards-based crowdfunding, with one important exception, the altruistic element. Thus, people pledging or backing are typically donating without the expectation of receiving anything in return. This links to the type of campaigns on platforms like JustGiving, which lists personal causes and charitable events most frequently and describe themselves as a ‘tech-for-good’ company, reinvesting profits into tools to make ‘giving’ easier for everyone. Since 2001, JustGiving has raised £3.3 billion, however, in the UK in 2015, excluding community shares, £12 million was raised with an average campaign size of £714.

Validating a common theme, donation-based platforms don’t charge pledgers a fee but will charge circa 5% listing fee, and card processing on the final amount. Furthermore, circa 85% of listings, due to the charitable receivers, are eligible for Gift Aid, a 25% government tax incentive which boosts giving. So for every £10 pledged, the government will add £2.50 to eligible causes.

Micro-lending

One of the lesser known variants of crowdfunding is micro-lending, where the likes of Kiva connect people through lending increments of $25 or more, to alleviate poverty and create better futures. Kiva boasts 2.4 million borrowers, 1.6 million lenders and since 2005, has facilitated almost $1 billion dollars at a repayment rate of 97%. For example, you can lend to someone to start or grow a business, go to school or access clean energy. Typically these platforms are not-for-profit organisations, so all donations go to funding loans - they don’t take any fees.

The remaining categories of crowdfunding are grouped by the Financial Conduct Authority, the industry regulator, as ‘investment crowdfunding platforms.’ Over the last four years, the debt-based crowdfunding platforms have grown remarkably, albeit not without their challenges, with this growth fuelled by institutional investment flowing through the platforms. The debt-based platforms are split into two core categories; peer-to-peer (P2P) and peer-to-business (P2B).

Peer-to-peer Lending

P2P platforms, like Zopa and Ratesetter, enable investors to lend to individuals from annualised rates of between 2% and 6%, although these fluctuate with interest rates changes. Not unexpectedly, with liquidity comes a lower return and the rolling monthly rate of c.2%. The maximum lending term is five years with circa 6% return and you authorise the platforms to invest on your behalf across a diversified number of borrowers. To date, c.£4.2 billion has been lent in the UK by P2P platforms.

Across the platforms, repayments differ from monthly to the end of the term. Some of them, like Ratesetter for example, offer a ‘Provision Fund’ designed to cover losses for investors and to date, none of the fifty odd thousand investors has ever lost a penny.

The fees for investors differ marginally across the P2P platforms, but typically no fees are charged to lenders if they see the term of the loan. However, to access capital lend before the end of the term, sellout fees of between 0.25-1.0% are charged on the sum returned.

Peer-to-business Lending

Of the P2B platforms, Funding Circle dominates in an industry that has raised £4.7 billion in the UK to date. P2B platforms enable everyday investors, local councils, the government and institutions to invest in businesses across the UK. As with P2P lending, interest rates are based on a myriad of factors including the risk band and term of the loan. As an investor, you can select the business you want to lend to directly or allow the platform to lend automatically using an auto-bid function, on some of the platforms. Typical annual returns are circa 7%, although you’ll receive monthly interest repayments and have the option of accessing your money early for a small fee. A platform like Funding Circle will also charge you an annual 1% fee on all borrower repayments. Unlike the P2P platforms, bad debt must be considered as there is no provision fund to mop this up if repayment failures occur.

Equity

Finally, Crowdcube tops the log in the equity crowdfunding, which, as an industry, over its six-year lifetime has raised about £500 million in the UK, about half of this raised by Crowdcube, with the next nearest competitor just over £100 million. Without wanting to ‘teach grandma to suck eggs’, equity is the most complicated of the crowdfunding variants, facilitating investment into a startup, early stage and growth companies for a pro-rata equity stake. The type of businesses available for investment is broad to ensure investors are given choice. Investments can be made from as little as £10 with no maximum in place, which typically culminates in pro-rata ownership of the investee company via ordinary or B investment shares.

Primarily such investments will be placed into businesses with the end goal of making a return within a 5-10 year timescale, via a liquidity event such as a trade sale, in some cases a share buyback or secondary market or in rare cases an IPO. The potential returns are significantly higher on the equity side of crowdfunding but so are the risks. Given the fact that a reasonable proportion of startups fail, diversification becomes absolutely key. Crowdcube recommends that you diversify across at least ten businesses annually to help protect yourself from sectoral, political and economic shifts. The reality is that most investors in the equity crowdfunding sector are investing across multiple businesses in the knowledge that 60% may not earn them any return whatsoever, 30% may earn them their money back or a small return, and they hope 10% can earn them a far larger return.

A final, rather important consideration on the equity side of crowdfunding is the government tax incentives. Early stage businesses in a large number of sectors are able to apply for tax relief, which affords eligible investors either a 30% or 50% tax relief on their investment with the aim of de-risking investments into startup and early stage businesses.

It’s abundantly clear that the six crowdfunding variants listed offer a plethora of choice for investors, from donating to worth causes or backing pre-concept tech projects, through to investing in equity in start-up companies for long-term returns or lending money to consumers and businesses across short, medium and long-term loans for a pre-defined interest rate. Crowdfunding is a broad spectrum, growing at a remarkable pace, all fuelled by the rise of our digital world, global connectivity and the internet. Thank you, Robert Kahn and Vinton Cerf for the small matter of inventing the internet protocol.

Author: Michael Wilkinson

Michael was one of the first Crowdcube employees, joining in 2012, and has helped grow Crowdcube from idea to the world’s leading investment crowdfunding platform. He is the Head of Equity Investment and manages the entrepreneur journey from due diligence through to successful funding, and has helped hundreds of companies prepare for and execute early stage funding rounds. Coming from an SME background, he is passionate about innovation, the startup ecosystem, and the power of alternative finance to disrupt and improve.