Readers may well ask what is crowd funding. This new form of equity financing enables a company to raise funding through small contributions from a large group of individuals via an online platform. So, is this relevant to us when the high street banks have traditionally ruled the roost and acted as a lender to all types of funding? Can we ignore it as a passing fad or a novelty that is making the headlines only to pass away unsung and unnoticed? Well, novelties are what make the finance wheel go round and ever since the industrial revolution there have been a number of novelties that characterized and contributed in no small way to improve our quality of life.
Crowd funding is the application of a new concept to the collection of funds through small contributions from many parties in order to finance a particular project or venture. For instance, equity crowd funding will help local businesses get access to capital. Historically, it attributes its growth in Europe to a number of factors. Now the Commission is endearing itself to the novel idea of how start-ups and SMEs can access finance at a time when like in Malta mainstream banks tend not to be interested in assessing the risk profile of small companies traditionally full of enthusiastic ideas but poor on collateral. One may question whether crowd funding can ever take root and flourish in Malta because being a new concept it will undoubtedly meet with many obstacles and is as yet unregulated. On the other hand, at a time when cash flow is tight, most local companies, with some adaptation of the crowd-funding model, can help them to fill the financing gap.
Not all budding entrepreneurs are born possessing property or have rich uncles with fat wallets. Can this source of funding also help philanthropic, artistic and social projects? What are the opportunities and risks in crowd funding and if properly monitored can it protect contributors and lenders?
During an economic slowdown when GDP growth is weak, it stands to reason that starting up a company takes one on a very risky and challenging journey. Besides finding sufficient funding, there are always expenses that are impossible to forecast, challenges in market projection, assessing correctly customer preferences, and competition from others who, under the pretext of helping, would want a piece of your venture. Yet, embarking on a crowd funding campaign hedges these risks and serves as a valuable learning experience.
To start with it is interesting to observe how crowd funding has recently received attention from policymakers in the United States with direct mention in the Jobs Act – a hybrid legislation that allows for a wider pool of small investors with fewer restrictions. In Europe, the Directorate General for Internal Market and Services recently organised a workshop to explore opportunities related to crowd funding. This workshop argued the case for and against crowd funding and some of the conclusions reached showed how the biggest challenges for small businesses and entrepreneurs is to be able to plug all the holes in a business plan when seed capital has to be borrowed from external sources such as banks. The novel idea of crowd funding moves away from the risk / collateral approach taken by commercial banks in traditional assessment of project funding. By having a crowd funding campaign, the entrepreneur has the ability to engage the crowd and receive comments, feedback, and ideas, which is extremely valuable as it can help understand aspects of their business that were previously un-thought of. It could also potentially inspire some other ideas or modify existing ones to better match customer demand.
The process of organising a campaign not only allows an entrepreneur to present a business and a product / or service but it also gives them the ability to share the message and the purpose behind it. Ordinary investors who agree to the plan tend to own it and will closely follow it on the slippery path in the early stages of development. Successful merchandising ventures financed through crowd funding are blessed with investor loyalty throughout the entire gestation period of the project when branding is slowly but surely taking place. By comparison, small loans are not favoured by high street banks, which consider them risky and high cost, so they politely refuse applications or make impossible demands to nip them in the bud.
Let us compare the traditional path for an entrepreneur with a bright idea but no funds to kick-start the business and opts to secure such funds through a bank. Typically, you have to comb through one’s network to find appropriate investors you are connected to, or introduce yourself to a local bank, submit your business plan (mostly devoid of collateral), wait for a second interview where if interested the bank manager will request more details for a detailed project assessment, ask for due diligence, and finally, receive a sanction letter loaded with conditions/ charges. Now compare this lengthy ordeal with this simplified online process of crowd funding.
In normal circumstances, one has to submit online application to an appropriate platform, which then conducts vetting/due diligence work, and if accepted by platform, it creates your online profile, launches your online investment campaign, reviews all interested investors and chooses the best fit, and then, if successful, invites you to collect the funds.
What are the costs for such a process? On all or nothing platforms (meaning that you only get the funds raised if you reach 100 per cent or more of your funding target) there is no fee to participate. If an entrepreneur sets a target and doesn’t reach it, the funds are returned to each contributor, and no fee is charged by platform. On the other hand, if the fund-raising project is successful, the average commission for the platforms is around five per cent of total funds raised. This novel system speeds up the process for those business angels to register as an accredited investor with the crowd-funding platform. Once approved as an investor, one can directly go in and search through the different companies, doing fundamental analysis on the documentation and investor summaries thereby cutting out all the initial phone conversations and meetings. In fact, many investors can simply identify a company they are interested in and directly make an investment right then and there. What used to involve a series of meetings, phone calls, and lengthy wait periods, not to mention expensive legal advice, it can now prove to be a seamless transaction.
In the USA, where crowd funding is catching on, particularly in the shadow of risk-averse banks now closely monitored by Basel 111 strict rules, the application process for crowd funding is a welcome alternative. In order to get started on the path to funding and exposure, an entrepreneur first needs to contact the chosen crowd funding platform that best suits his/ her campaign theme and purpose, share the venture’s powerful message, create a marketing video, and list attractive aspects of the business. In essence, crowd funding is an excellent way for entrepreneurs to receive the financing and exposure they need in order to verify, execute, and help their ventures grow. What started out as a social experiment in the USA several years ago has proved to be a viable tool for thousands of people. Crowd funding has raised over $1.5 billion to give birth and growth to ventures at all stages that surprisingly survived the recession post 2008; yet as a young industry it is still evolving and is fast becoming more efficient. According to the media, seed capital raised in the US via the Small Business Administration has dropped as much as 20 per cent, while nearly 98 per cent of the business plans received by accredited investors and venture capital firms are rejected.
Having praised the fund-raising facility can one conclude that it is without faults? Certainly not – crowd funding is a relatively new phenomenon and it is a technique that has been successfully employed by non-profit and creative individuals/organizations yet it is not a solution for every business model and its detractors do not consider it as a sustainable source of revenue. Because it deals with the collection of money and soliciting investments, one has to be extra careful not to violate any existing banking laws or regulations. Investors expect returns and may not be patient if a company does not generate profits. Lawsuits arising from failed business ventures can occur and in such cases lenders may accuse the entrepreneur of fraud, breach of contract or mismanagement. Since only relatively small amounts of money are involved, it may be cost prohibitive for investors to pursue legal claims so instead entrepreneurs face endless harassment.
To conclude, if you are a fish in a small bowl and wish to migrate to a larger one make sure that you have enough strength to survive the ordeal... once successful congratulate yourself and swim in a sea full of opportunities.
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Mr Mangion is a partner at PKF, an audit and business advisory firm