Until recently, companies used to rely on investment from a limited selection of sources such as banks or, on a larger scale, shareholders. Over the last decade, alternative forms of financing, including crowdfunding, have grown to become a solid alternative to traditional finance, especially for start-ups and SMEs.
Crowdfunding involves raising funds, mostly through online platforms, through contributions from more or less numerous groups of investors who share a common interest or project, or wish to support an innovative idea. Although it is not a new concept, crowdfunding is gaining more and more space as an alternative method of financing to banks and is beginning to attract great interest for the possibilities of remuneration and return on investment it offers.
There are different types of crowdfunding:
- Equity crowdfunding. In return for your investment you receive a share of the company's stock.
- Loan-based crowdfunding. The loan is made in exchange for a set interest rate. It is also called peer-to-peer or peer-to-business lending (P2P or P2B).
- Donation-based crowdfunding. This is the case of a donation to a person or a charity (something can be promised in return, but not necessarily).
- Reward-based Crowdfunding. In return for the investment, a reward is promised that is linked to the project or cause being supported.
Donation-based crowdfunding or reward-based crowdfunding are not regulated by financial authorities. This article therefore focuses on investment-based or equity crowdfunding.
The equity crowdfunding model provides a method of raising capital that is quite similar to conventional systems, in which the company's financial securities (shares) are offered to potential investors in exchange for capital. As a result, each investor is entitled to a share in the company proportional to his or her investment. The crowdfunding process takes place on specialised online platforms that act as intermediaries and facilitate access to more lynchpin financing systems in an easier and more liberal way.
Unlike conventional methods of raising capital, which normally rely on a small number of professional players, equity crowdfunding targets a wider group of potential investors.
Advantages of Equity Crowdfunding
Equity crowdfunding introduces a new approach to the process of investing and raising capital, which can offer several advantages to both companies and investors.
1. Easier access to capital
Compared to traditional forms of raising capital, online crowdfunding platforms allow entrepreneurs and companies to present their projects to a larger number of potential investors,
2. Higher returns on investment
Start-ups and SMEs tend to be riskier businesses by nature. However, there is always the very attractive possibility that a company can become a 'unicorn' and provide very lucrative returns to investors.
3. Less pressure on management
Equity crowdfunding does not involve a dilution of power, unlike conventional forms of funding such as venture capital. Even if the number of shares is increased to attract more capital, the involvement of more investors means that power is not concentrated in a particular group of shareholders.
4. Diversification of investments
Equity crowdfunding allows the investor to create a well-balanced and diversified portfolio. In general, in order to mitigate the riskier nature of this type of investment, it is always advisable to diversify your cowdfunding portfolio.
5. Very low barriers to entry
Thanks to the numerous corwdfunding platforms operating online, the whole investment operation requires little time and effort. First of all, it is not necessary to have the right contacts or the right industry knowledge. All fundraising campaigns are available online and accessible in just a few clicks. Each company has a promotional page to promote its idea and capital needs.
Disadvantages of Equity Crowdfunding
Anyone wishing to invest using this type of instrument should be aware of the associated risks. Here are some of the most common ones to consider.
1. Dilution of one's share of shares
As equity crowdfunding is linked to the issuance of new shares, the share of existing shareholders is progressively diluted if new campaigns are launched. As mentioned above, however, share dilution does not usually have the same effect as it can have in more traditional funding scenarios (reduction of decision-making power).
2. Low liquidity
Securities purchased on equity crowdfunding platforms are characterised by lower liquidity than traditional ones and exit options are limited or realistically non-existent. Investors may have to wait years before seeing their investment paid back (but this is also true for venture capital, for example).
3. High risk of failure
The highest risk crowdfunding investors face is that the business they invest in might fail. Especially since these types of campaigns usually involve or are preferred by start-ups or small and medium-sized companies at the beginning of their business (but not always).
4. Risk of fraud
The risk of information asymmetries and fraud is higher in crowdfunding. Fortunately, all major online platforms, which in Italy are regulated by Consob, work very diligently to verify the information provided by companies and to minimise this risk.
Conclusion
Equity crowdfunding represents a very interesting opportunity for investors who are looking for a highly profitable and diversified portfolio. The crowdfunding market is increasingly regulated (now also at European level); digital platforms are working hard to adopt new measures and put in place increasingly sophisticated systems to protect investors.
Crowdfunding stems from the idea of sharing a common project: campaign creators provide the ideas, platforms attract potential investors and funders provide the capital. The underlying concept is to give visibility and space to innovative ideas and projects, through a streamlined and direct collaboration between different market players.