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Should we embrace crowdfunding?

  • Published at 10:36 pm September 12th, 2019
Start up
Should start-ups look to crowdfunding as a viable option? Bigstock

Typically this works via a crowdfunding platform such as Kickstarter, Funding Circle or Seedrs, which seek to bring entrepreneurs and investors together

The digital revolution has had a huge impact on the way new and small companies are financed -- and crowdfunding has been at the forefront. In little over a decade, it has emerged to become an important source of funding for entrepreneurs who are increasingly financing their ventures by attracting small amounts of money from large groups of individuals.

Typically this works via a crowdfunding platform such as Kickstarter, Funding Circle or Seedrs, which seek to bring entrepreneurs and investors together. But some businesses make a direct appeal to investors via their own fundraising platforms, such as their website.

Initially, crowdfunding brought great optimism that it would have a “democratizing effect” on finance. On the one hand, it would enable entrepreneurs excluded from traditional sources of finance to attract funding. And, on the other, it would provide new opportunities for people with even relatively modest amounts of money to invest. 

For example, private investors looking for higher returns than those available with high street banks have been attracted to various lending platforms -- also known as peer-to-peer (P2P) platforms. 

Our work has reviewed the available research on crowdfunding to examine whether this relatively recent method of financing new and small businesses lives up to the lofty claims of democratizing investment in the 21st century.

Donation-based crowdfunding platforms have certainly made it possible for lots of not-for-profit projects (such as charity-based ventures and social enterprises) to raise finance from philanthropic investors who are not seeking a financial return.

The types of businesses raising finance from P2P platforms (where lenders provide loans with interest), and equity-based crowdfunding platforms (where entrepreneurs sell a stake to investors), are certainly more diverse compared to those financed by banks, “business angels” and venture capital funds. 

But in other respects, we discovered this democratization idea can be challenged.

Bias, geography, skills, and risk

First, the “crowd” has its own preferences and biases. Some types of projects are less attractive than others. For example, consumer-oriented products and services work better than science and technology projects. The crowd also engages in herd behaviour -- if there is a lack of detailed information and track record for ventures seeking funds, investors will often look at the actions of other investors when making their own investment decisions.

Second, entrepreneurs differ in their ability to access the crowd. This happens in a variety of ways. Often they need to have raised initial finance to get their project off the ground before coming to a platform. 

Typically this comes from the entrepreneur’s own money and from family and friends. But not everybody has access to these sources. The entrepreneur’s personal networks are also vital, with funding success associated with those who have high levels of engagement on social media such as Facebook and Twitter.

As in the offline world, investors are attracted to entrepreneurs with high levels of “human capital” -- skills, experience, understanding of the market -- and who are able to signal their credibility, competence and trustworthiness. Entrepreneurs need strong communication skills to successfully raise finance.

Third, crowdfunding has not eliminated the issue of geography. Even though crowdfunding platforms overcome the distance problem by connecting entrepreneurs and investors regardless of where they are, “home bias” is a persistent feature of crowdfunding. Put simply, investors seem to prefer to fund ventures on their doorstep.

And fourth, an emerging concern is that it is no longer just the crowd who are participating on crowdfunding platforms. Both P2P and equity platforms -- including some of the UK’s established P2P lenders -- are increasingly raising finance from institutional investors, including banks, pension funds, mutual funds, and asset management companies. 

A final concern is the risk that investors are exposed to on crowdfunding platforms. Regulators in several countries are expressing increasing concern that some platforms give a misleading or unrealistically optimistic impression of expected returns, attracting retail investors with little experience or competence to adequately evaluate investment opportunities.

Because of the small amounts they are risking, investors have no economic incentive to undertake due diligence. In fact, most investors are reported to spend less than 20 minutes per week doing their homework. Crowdfunding platforms also lack governance mechanisms -- with entrepreneurial ventures raising finance from numerous individuals, each making small investments, there is little incentive for anyone to monitor the risks. 

Changing the market for good?

The industry is still relatively new, so it has not gone through a full economic cycle. When economic conditions deteriorate, this could trigger a rise in losses on loans and investments. Several established P2P platforms are already loss-making and returns for investors have fallen.

Lord Adair Turner, former chair of the Financial Services Authority in the UK, has predicted that the losses emerging from peer-to-peer lending over the next five to 10 years “will make the bankers look like lending geniuses.” 

Crowdfunding has undoubtedly changed the market for entrepreneurial finance. But, in contrast to the early optimism, it has not eliminated all of the inequalities encountered by entrepreneurs and investors in traditional financial markets. And what is becoming more apparent is that it has created new sources of inequality and new kinds of risks for investors.

Colin Mason is Professor of Entrepreneurship, Adam Smith Business School, University of Glasgow. This article was first published by The Conversation UK and has been reprinted by special arrangement.