As the saying goes, necessity is the mother of invention. The economy of the world is expanding even though it has passed through some turbulent waters since the start of the new century. Business must make progress and innovative business minds will discover how to survive and grow even during times when credit is tight.
There are many projects and opportunities out there. Many are begging for the needed funds to enable them to see the light of day. The reality of the above gave birth to this child of necessity called crowdfunding.
The objective of this post is to explain the basics of crowdfunding. Is it a viable opportunity for investors? What are the merits as well as the shortcomings of the system?
Crowdfunding is the practice of raising money to fund a project through the collective efforts of many people whose resources are pulled together to fund the project. It derived its name from the many people that come together with their money to fund the project. It is a form of alternative investing.
The JOBS Act of 2012 has expanded the investment opportunities for small businesses to raise capital. Prior to this bill, only Accredited Investors had access to this type of investing. Following the JOBS Act of 2012, every American can now invest in new businesses or start-ups that were once only available to hedge funds or Venture Capital Firms.
In 2015, the total global sum invested in crowdfunding projects was put at $34 billion. That total also includes Peer-to-Peer Lending. That goes to show the strength and interest of this alternative method of raising capital. There are different categories of crowdfunding:
In a sense, this is entrepreneurship on open display. An entrepreneur has goals for their new venture, but limited funds. A brilliant new product or service is set to be launched, but to bring this idea to market, an entrepreneur needs funding. A wise businessman knows to avoid high-interest rates. Entrepreneurs do not want to incur debt, nor do they want to sell equities/shares at this early stage. In such a scenario, the soft landing is to pre-sell their product or services. The payments are sourced from people ahead of actual delivery and it is called rewards funding.
This method of operation is one by which the backer pledges an amount of money and in return receives equity shares of the company. This is basically investing in a privately held company. This usually happens in the early stages of the venture. It is a common form of funding for new real estate projects. There is a high potential for returns on investment in this system. However, like with most securities, there are not any guarantees in place to protect principle.
Just as its name implies, Donation Crowdfunding is a way to raise money for a cause. There is not a return on investment. The money is used to support a community project, pay for the medical expenses for someone who is in need, or support a cause. This type of crowdfunding attracts resources from sources that tend to have an emotional attachment to a cause.
Lending Based Crowdfunding
Lending Based Crowdfunding is also known and Peer-to-Peer Lending or P2P Lending. This is the practice of one individual lending money to another individual. The lender acts as a bank normally would. The individual who borrows money pays back the principle along with interest. These transactions occur on online platforms. Borrowers interest rates are based on their credit history.
Who Can Invest
Before you consider investing in a venture that is raising capital by way of crowdfunding, you first need to know some of the rules and qualifications:
- An investor can invest $2,000 per year if both their annual income and net worth are less than $100,000.
- An investor can invest up to 10% of their annual income or net worth per year if their net worth and annual income are equal to or greater than $100,000. An investor cannot exceed an annual investment of $100,000 per year.
How to Invest
There are many online crowdfunding platforms.
Below are some of the most popular:
- Kickstarter.com: is a funding platform for various creative projects including new technology, gaming, artistic design, and films.
- Gofundme.com: is a donation-based crowdfunding platform that allows people to raise money for various causes that include different life events.
- RocketHub.com: uses its online platform to raise capital for scientists, technology-based projects, philanthropists, various artist projects, and business ventures.
- Indiegogo.com: is an international crowdfunding platform that provides funding for films, start-ups, and charities.
WHY DO PEOPLE SUPPORT CROWDFUNDING?
You might be wondering what magic makes people support a cause with their financial resources even when they know next to nothing about a project. Four main reasons can be attributed to this behavior in people:
- The greater purpose of the campaign is a source of attraction. They feel an emotional connection. This campaign can make a positive difference.
- There is the physical aspect of the campaign. The people see the business wisdom in a campaign. People take a calculative look at the rewards and project an above average return on investment. They feel convinced based on the potential for financial gains.
- There is the aspect of the marketing campaign that is so compelling and convincing that people are attracted to the project or the idea.
- Above all, people are aware that they can sit at the remotest corner of the world and conduct their business through online means. The world is now a global village where even the smallest of business endeavors are transacted online.
THE ATTRIBUTES OF A GOOD CROWD FUNDING CAMPAIGN
For a successful crowdfunding campaign, there must be great preparation before results are achieved. The marketing must be well structured for a campaign to get off the ground and pull together the needed capital for the project. The preparations should include:
- Social media is a vital marketing tool. This is where the market is. You will get the crowd that you want and bring them together online. Maintaining a strong and aggressive campaign online is important to success.
- Before the project is launched, there is the need for the creation of an email distribution list. Members on the list are those that will form the mainstream of the needed crowd.
- The local media also has a role to play in the scheme of things. They can be helpful for promoting the publicity of the campaign. They can bring about local buy-in. This can help with the project going the distance.
- Potential for High Returns (above market averages)
- Adds diversification to an investors asset allocation (beyond equities & fixed income)
- Access to investments that were once only available to high net worth investors
- The satisfaction of being able to contribute to a cause, project, or start-up
- Loss of capital (riskier than micro-cap stocks)
- Liquidity (capital can be tied up for many years)
- Lack of transparency in financial records (who audited the books?)
- The project team is creative but has limited management skills
Based on the amount of capital that Crowdfunding has attracted, it appears that it has come to stay. While there are benefits for both the creator and investor, this is a highly risky type of investment. Equity crowdfunding is as speculative as investing in penny stocks. If an individual investor decided to invest in a venture that is being funded by way of equity crowdfunding, they should consider limiting their exposure to 3% or less of their asset allocation. That rule also applies to lending or rewards-based crowdfunding. Donation-based crowdfunding is not an investment. Limit the funds that you contribute to any crowdfunding cause to as much as you normally tithe or donate to charity. That is a prudent rule of thumb for investing in any type of alternative investment.
Please remember to check with a financial professional and to read the Disclaimer Page before you make any financial decisions.