Could you use crowdfunding to grow your business?16 September, 2014
Recent times have seen SME’s in the technology sector struggle to access bank loans and overdrafts. Crowdfunding, also known as peer-to-peer or peer-to-business lending, provides a potential alternative source of finance, and is becoming increasingly popular. In an aim to provide enhanced protection for consumers without discouraging the growth of this emerging market, the FCA has recently introduced new regulations.
Crowdfunding works through platforms (essentially websites), set up by providers such as Zopa and Funding Circle, through which individuals or firms can invest in particular businesses or activities.
There are a number of different forms of crowdfunding, and the best model will depend on the nature of business seeking funding.
If you are a start-up, early-stage entrepreneur or an SME seeking publicity for a new product, a pre-payment or rewards-based scheme may be suitable. This would involve people giving you money in return for a reward, service or product (for example a copy of your new software product). Potential advantages to this are:
- you aren’t required to give up equity in your business or accumulate debt;
- it allows some market validation of your product without you having to initiate an expensive marketing campaign or market research (because you will only get the funding if people think your idea or product is good and can get useful feedback from potential investors);
- it can be a cheap but efficient way of marketing your business with many platforms incorporating social media mechanisms (with a potential for this to lead to viral marketing);
- it might make getting later funding from angels or institutional investors easier if you can demonstrate an effective crowdfunding campaign.
Rewards-based schemes are considered low risk so are not FCA regulated, but you will of course need to ensure you properly protect your business idea or the intellectual property in your product before releasing it to the public and apply the usual caution in relation to the use of social media to promote your business (bearing in mind the damage that bad publicity can do).
If you are a more established business looking for a serious alternative to bank finance however, you will be looking at either a loan-based or investment-based platform.
Investment (or equity) based schemes
Investment based crowdfunding (IBC), involves people investing directly in your business through shares or debt securities or through units in an unregulated collective investment scheme. IBC has always been subject to FCA regulation, but recent regulatory changes designed to protect investors have limited the promotion of this type of investment to sophisticated and high net worth individuals. This has raised concerns that the market for IBC will shrink. From a practical perspective, the process of getting IBC is not dissimilar to getting any other equity based investment in your company – requiring a suite of legal documentation including a subscription and shareholders agreement – and you should give detailed and thorough consideration of the financial and legal terms being offered to you for this investment, and the costs associated with it.
Loan-based crowdfunding (LBC), which accounts for about 90% of the crowdfunding market, means you will pay interest on the amount loaned to you and be expected to repay the capital, just like a traditional loan. The potential advantages to borrowers of using LBC are:
- lower interest rates due to the lower costs for platform operators;
- more transparent fees because of the lack of tag-on products like insurance;
- a faster timeframe within which to access the money.
Now subject to FCA regulation, there are stricter requirements on LBC platforms, but these are largely aimed at protecting investors. Borrowers may benefit either indirectly (if tighter regulation encourages more investment and more reputable providers) or, if the borrower is an individual, small partnership or unincorporated association, they may benefit directly from regulation of their credit agreements. However, it may be that the increased costs associated with tighter regulation will be passed on to borrowers through higher fees.