As the name suggests, Crowdfunding is raising small amounts of funds from multiple people to provide capital to a new business. Traditionally, funds are raised from relatives, friends and venture capitalists. However, recent developments in crowdfunding have allowed entrepreneurs to gain access beyond their circles and seek funding from the general public.
Crowdfunding has evolved in the modern world through the conceptualisation of microlending practices. Microlending was first established around the 1700s by Jonathan Swift in rural Ireland through the Irish Loan Fund, where low-income families were given short-term loans with no credit history. More recently, Dr. Muhammad Yunus who is often credited as a pioneer of micro-financing established a project in 1976 where low-income people of Bangladesh were given banking opportunities as an effort to drive social development in the region. This proved to be instrumental in how microcredit was implemented in other developing regions.
Over the past decade, Indiegogo and Kickstarter were some of the first crowdfunding platforms that gave people the choice to fund their own ventures.
How does Crowdfunding work?
Let’s assume you have a business idea that you would like to get funded for and you’ve decided to use crowdfunding. Here is how it works:
- You can raise a campaign on a Crowdfunding platform
- Enter all the details about the project (including costs) and the reason why people should invest in your idea. In simple words, a business plan.
- Share with thousands of people online, using social media platforms.
- People, who choose to be associated with the idea starts funding.
- Once the threshold amount is collected, the funds are disbursed.
Crowdfunding can be broadly categorized into the following three types:
- Rewards Crowdfunding – where investors receive some rewards/recognition for the contribution they made. For e.g. an author might offer a free copy of his book to all fund seekers contributing at least $20.
- Debt Crowdfunding – where the Crowdfunding investment is made to earn the money back with interest. Peer to Peer lending platforms is an example of this type of Crowdfunding.
- Equity Crowdfunding – the Crowdfunding investment is made in exchange for equity in the company.
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Let’s say that a company needs funds to purchase some additional machinery for their manufacturing unit. Traditionally, they would approach a bank for a loan or launch an IPO offering shares. With Crowdfunding, these companies can also look to fund their requirement using crowd-funders.
On the other hand, imagine an individual in need of a loan, to buy a house. For some reasons (other than a bad credit score), he is unable to get a loan from his bank. He can approach a Crowdfunding platform and offer to pay interest on the amount funded.
In both scenarios, investors can choose to fund the individual/company in exchange for a monetary gain. Or in simpler words, make a Crowdfunding investment.
It is important to note that Crowdfunding investment can be risky and due diligence is recommended to investors who are looking at these platforms, for investments. You can always start with a small amount of money and diversify it across multiple fund seekers to hedge yourself against the risk of a possible default.
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Here’s an example:
10 companies are seeking $200,000 for a new venture in exchange for equity. You like the business ideas of all these companies. Also, 10 individuals are seeking $25,000 for their wedding in exchange for interest on your funded amount. Being kind at heart you want to fund them all.
Now, let’s assume that you have $10,000 for investing. If you lend the total amount to any one of them, then you expose yourself to the risk of not getting returns on your investment. Worse still, the risk of losing your capital too! If you were to divide your funds into 20 packets of $500 each and funded all 20 of them, then your risk exposure gets divided by 20. Also, it is a Crowdfunding! As more people start funding, all these people will have the funds they require with minimal risk exposure for all investors. A win-win.
Some handy tips:
Being an investor in a Crowdfunding platform you will have benefits and risks. Here are some tips to help you get started:
- Clearly define your investment objectives, risk appetite and the time horizon of investment and create an investment strategy.
- Stick to the strategy at all costs. Don’t fall for the next ‘shiny thing’ in the market!
- Spend some time to understand the Crowdfunding landscape well, before you start investing.
- Don’t get excited by success stories. It is an investment, not a gamble!
- Read the fund seeker’s proposal carefully before deciding on investing. If you have any doubt, ask – don’t assume.
- Do your Math well. Include all costs before calculating returns.
- Diversify to reduce the capital exposure
- Choose the Crowdfunding platform meticulously. Find one, which screens the fund seeking applicants before uploading them to the website.