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Crowdfunding Model: Banking on an Alternative Finance

Crowdfunding Model: Banking on an alternative finance

Crowdfunding is unleashing new capabilities, and entrepreneurs and the internet are transforming and democratising the access to finance for all kinds of enterprises and good causes. Professor (Dr.) Alan Barrell, Entrepreneur-in-Residence at University of Cambridge Judge Business School sheds light on alternative finance; types of crowdfunding models, and how the concept works. Adapted from Cambridge Business Magazine.

Of all my “Heroes of Communication” none surpasses Tim Berners-Lee, who took the early concept of the internet and transformed it into the world wide web, without which most of us in the developed world would find existence of the kind that suits us unimaginable.

In some senses, a New Renaissance began in 1991 when WWW came to mean so much more than three simple letters. Not since 1485 – when Johannes Gutenberg gave the world the Renaissance Moving Type Press and books flooded across the borders of Europe – has there been such a revolution in communication, learning and behaviour change. And some say it has only just begun. But what does this have to do with Alternative Finance?

The innovative forms of finance now supporting more and more companies and other types of enterprises only operate at all because of the connectivity the world wide web enables. Some refer to Alternative Finance as Internet Finance. And today we speak of Crowdfunding model, Peer to Peer Lending, Invoice Trading and hybrids of these forms – which we are about to explore in more detail. And yet the first great crowdfunding events of which we have a clear record took place long before we had the internet or email or connected international telephone systems.

Crowdfunding model: Banking on Alternative FinanceIn 1885 the people of France commissioned and built a wonderful gift for the people of the USA to commemorate the Union Victory in the American Civil War and the end of slavery. A colossal neoclassical sculpture designed by Frederic Auguste Bartholdi and built by Gustav Eiffel in copper was to be commissioned by 1886. It was to be housed on what would become Liberty Island in New York Harbour – the robed figure of Libertas, the Roman goddess holding aloft a torch and holding a tabula ansata (a tablet espousing aspects of law) with an inscription showing “July 4th 1776 – the date of the American Declaration of Independence.” Truly an icon of freedom – and seen by all sailing past in the harbour.

By summer 1885 the pieces of this great work were in New York awaiting assembly and to be mounted on a plinth – which had yet to be built. And there things stuck. The $250,000 to build the plinth had not been raised. The Governor of New York refused to allow city funds to be used. Other cities bid to have Liberty in their back yards. At the eleventh hour, the inspiration of a great publisher, Joseph Pulitzer, rescued the project – with a crowdfunding campaign.

Using his newspaper, The New York World, and mounting a crowdfunding platform in the printed word – in much the same way that crowdfunding platforms such as Indiegogo, Kickstarter and others do with videos and internet messages today – he engaged no less than 160,000 people to contribute to a fund that did the trick and raised the money, even having some left over which was presented as a gift to the sculptor. The newspaper kept records of the development of the fund – and kept the messages flowing, just like crowdfunding platforms do today.

Astonishingly, donors gave in many in stances less than $1. A quote from The New York World during the campaign recorded that “the family of Philip Benderin Jersey City donated $2.65, including his children Philip and Eliza 50 cents each, Anna 25 cents, Leonard 10 cents and Carries 25 cents”. The campaign had all the hallmarks we find in modern crowdfunding campaigns – managed from one central point and evoking passion for a cause or the development of a collective spirit to contribute to something special.

We will discuss “Rewards Crowdfunding model” soon – and indeed there were rewards for the largest donors in the Liberty campaign – commemorative gold coins.

If we look back in history we can find other examples of collective fundraising efforts – some for book printing and a little later for films. And for a significant number of years now, inspired by the work of Mohammed Younus, founder of Grameen Bank, microfinance through that bank, and other web-based organisations such as Kiva, funded by Jessica Jackley and Matt Flannery in the US, have enabled literally millions of small loans to be extended to some of the poorest communities in the world.“Lending to the poor online”, with contributions often just a few £s or $s from individuals, has made big differences to many lives, and lenders using these channels often also tell us how fulfilling it has been to engage in projects in remote areas of emerging nations and see how much impact small contributions can make.

Our little historical diversion does establish some of the principles present in successful crowdfunding, but Alternative Finance today, having developed largely in the past three to four years, is much more varied and diverse, and innovative new models are appearing all the time. Some of these we will discuss, but first it will help to draw on some of the excellent work done in defining and researching Alternative Finance done by organisations such as NESTA and the Cambridge Centre for Alternative Finance in setting out for us a common language to use in describing the main types of alternative finance.

Thanks to the authors of the excellent report Understanding Alternative Finance published in late 2014 by NESTA and Cambridge University we can reproduce here the clear definitions they gave us:

  1. Peer-to-peer business lending: debt-based transactions between individuals and existing businesses that are mostly SMEs(small to mid-sized enterprises) with many individual lenders contributing to any one loan.
  2. Peer-to-peer consumer lending: individuals using an online platform to borrow from a number of individual lenders, each lending a small amount; most are unsecured loans.
  3. Donation-based crowdfunding: individuals donate small amounts to meet the larger funding aim of a specific charitable project while receiving no financial or material return in exchange.
  4. Reward-based crowdfunding: individuals donate to a specific project with the expectation of receiving a tangible (but non-financial) reward or product at a later date in exchange for their contribution.
  5. Equity-based crowdfunding: sale of a stake in a business to a number of investors in return for investment (equity). Predominantly used in early stage firms.
  6. Invoice trading: Firms sell their invoices at a discount to a pool of individuals or institutional investors in order to receive funds immediately rather than waiting for invoices to be paid in full.
  7. Pension-led funding: mainly allows SME owners/directors to use their accumulated pension funds in order to invest in their own businesses. Intellectual property is often used as collateral.
  8. Community shares: this term refers to withdrawal of capital that can only be issued by co-operative societies, community benefit societies and charitable community benefit societies.
  9. Debt-based securities: lenders receive a non-collateralised debt obligation typically paid back over an extended period of time. Similar in structure to purchasing a bond, but with different rights and obligations Nine categories of alternative finance are thus identified, all becoming more widely used and showing significant growth.

But how does Crowdfunding Model & Alternative Finance work?

A good question for those new to the subject. And the first part of the answer is a clear statement that it should not be seen as easier finance. Those thinking this is a way to raise money with less effort and less of a case for showing the need for funding – think again. Alternative finance does not replace developing a good business model, planning or preparation, nor does it offer short cuts avoiding understanding key business parameters such as cash flow.

We hear and read mostly about alternative finance in terms of platforms. The platforms permit the fund seeker to “show and tell online”. Most often a company will put up a video and other information online – with the help of professional platform managers who advise on best ways to promote and display. Financial data is provided and those interested can dig deeper through enquiry.

Some platforms – mainly donation-based and reward-based – are open to all to put up the story without much checking. I recommend using platforms where the platform team look closely at anything proposed and in the best cases, do due diligence and give prospective investors confidence that the investment opportunity has been carefully vetted.

This is especially important for equity-based crowdfunding model, where investors receive shares in exchange for their cash with the expectation of a financial return. In the peer-to-peer lending area, the professional platforms insist that fund seekers follow rules and guidelines concerning financial disclosure. Indeed, with online finance there is greater transparency than with bank lending.

Who among investors knows exactly what the bank does when you invest in an account? In peer-to-peer lending the lender can see exactly how the company accepting the loan uses money and manages its accounts. Transparency and Trust – two words not always credited as watchwords and standards which banks have all been noted for in recent times!

“What will it cost me?”the borrower or crowdfunder asks. Preparation and making a video for crowdfunding carry costs. In most cases, the peer-to-peer lenders will look for at least a 6 per cent interest rate and crowdfunding platforms will take about the same percentage out of monies raised, and in many cases do not charge fees nor take a cut unless and until the money is raised.

It is all relatively uncomplicated, professional, well controlled and well managed. There will always be risk involved with investment. Obviously, equity crowdfunding investments carry a fairly high risk. Peer-to-peer lending of working capital to an established company or an individual who wants to buy a car or van – less so.

In some cases, as in one of the case studies outlined in the final part of this piece, crowdfunding model serves the purpose of establishing whether there is a market for a proposed new product or service – rather than just raising cash. The number of respondents to a call for investment which carries the reward of preferential or exclusive supply of a product will indicate demand levels and market size.

 

Professor (Dr.) Alan Barrell is Entrepreneur-in-Residence at Judge Business School, University of Cambridge. He is a serial entrepreneur, and angel investor and author of “Show Me The Money”  now available on Amazon.

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