The story of financing innovations raining down on the slow adopters is becoming more common every day. Traditional investment banks are slowly tracking behind the crowded, but not overly-crowded fray of crowdfunding. It was certain to happen; as always, when markets begin to develop good reputation or a threatening size, the “big boy banks” tend to either build or buy their own version. The question is can they keep up?
What is crowdfunding?
Crowdfunding has become increasingly popular over the last few years as the ‘generation Y’ has increased its purchasing (and funding) power. This alternative type of funding appeals to individual investors that want to support the projects or individuals that provide interest and monetary satisfaction, as well as start-ups that obtain finance via online platforms, rather than the traditional route via a bank. Previously, bank loans have been the traditional source of capital for generating funds, but the new reality is that banks are not lending like they used to and available capital is not being made available by the people who have it, to the people who need it commonly enough.
Crowdfunding is about raising funds (in the form of donations, loans or participations) from businesses and individual investors in order to finance a product or a service. There are two main types of crowdfunding; rewards-based, which aims to attract individual investors and incentivise by introducing counterparties, and equity-based, where investors (whether professional or institutional) take some equity in the company in exchange to providing investment.
How is crowdfunding disrupting the market?
Crowdfunding seems to be temporarily serving small businesses that may have been considered to be too risky to attain financing through a traditional bank. Following the global credit crisis in 2008, banks can no longer afford to be liberal as regulators now require banks to give full assurance of a repayment before lending to a small business. This has allowed financing platforms such as Kickstarter, to capitalise in this market by focusing more on helping small businesses achieve their “company mission”, not just on the size of the profits. “Business and entrepreneurship” has easily become the most popular crowdfunding borrower category, raising $34 billion total crowdfunding volume in 2015 and is on course to account for more volume this year. This indicates the degree to which small businesses can overcome the obstacle banks pose to them when in search of capital.
For example, over the last eight years, Silicon Valley-based Indiegogo has helped entrepreneurs raise more than $1 billion across 690,000 successful reward-based campaigns. This is a reflection of equity-funding taking flight, where high net worth individuals, venture capital and private equity funds are being made available to innovative and profitable businesses / projects via online services.
Crowdfunding is also a growing trend in the UK, as British start-ups have raised about £4 billion through crowdfunding last year (and that equals 81% of the European market share). Following Brexit, crowdfunding investments have stagnated but experts foresee it not to be a long-term situation.
However, the safety of crowdfunding often comes into question as most platforms are not fully regulated. This requires investors to take the responsibility of performing due diligence in terms of viability of the investment and the business owners. Crowdfunding is growing in popularity by the day as seen by the volume funded in 2015, but the challenge is: can the momentum be maintained?
Will crowdfunding replace traditional banks?
In a nutshell, crowdfunding appears to be an efficient way of investing, providing the campaign is well run and successful. However, the great difference between crowdfunding and traditional banks means that crowdfunds are not a threat to traditional ways of financing but rather complementary to some products banks offer.
Nonetheless, they are grabbing many unsuccessful small businesses and start ups that may have been rejected by traditional banks. Therefore, it is unlikely that crowdfunding will be a direct replacement to traditional banking, but they will be more influential as it is a quick and transparent way to connect investors. This will continue to give traditional banks a lot to think about with regards to their financing approach to small businesses they may usually deem “risky”.