Online funding platforms have transformed the ability of a start-up or growth-hungry business to attract finance. Yet for most entrepreneurs they are still far from being a mainstream choice and are poorly understood in terms of how their repayment and certification procedures actually work. SME Advisor looks at the plusses and minuses of crowdfunding…
Let’s start by dispelling some of the myths about online funding platforms –
- They are not just for ‘crowdfunding’, ie, attracting random sums of varying sizes from a broad and unfamiliar investment base. An online funding platform can equally well be used to attract two or three investors able to put up tens of millions of dollars.
- They are not just for attracting private investors: some of the world’s biggest companies use them to identify major institutional funding opportunities.
- The funding relationships generated are not ‘unmanaged’. While sometimes, the platform itself will use an algorithm to calculate investor repayments as your business grows, more frequently, the platform is simply a ‘front office’ for a company which will personally log, certify and manage the investment ratios.
Until recently, financing a business involved a complex research process that would mean ‘doing the rounds’ of banks, VCs (where available) and angel investors. It’s now possible to completely bypass this process: online funding platforms use the internet to help entrepreneurs talk to thousands of potential funders, and you can define the style and level of investment that you are looking to gain.
All of which means that small business owners who are being turned down by high street banks now have an opportunity to appeal directly to small investors. Equally, there are huge benefits from the investors’ side of things. Whereas investing in small businesses was previously a second-career option of the very rich, online funding means that anyone can reap the benefits of investing in promising start-ups – whether you want to risk USD500,000 or USD500.
The element of online funding that has really caught the public imagination is crowdfunding – where you attract a broad mix of investment values that give you the sums you are looking for by creating a patchwork of different commitments. The advantage here is pure flexibility, and the fact that you don’t need the complex raft of credentials that you would otherwise require to attract larger sums from targeted big-ticket investors. Anyone who fancies the idea of being an investor and who likes your concept can come into the mix. The disadvantage for the SME is that you can be left with an amazing array of commitments to people you don’t know – and whose long-term expectations are a mystery. It’s also unlikely that you will then enjoy the benefits of having an expert investor sitting on your Board, which while setting you free from the sometimes claustrophobic presence of a third party, also means you won’t enjoy the capable professional guidance of someone who really knows how to grow a business.
It remains true that companies requiring substantial amounts of start-up capital may continue to be funded in more traditional ways – angel investors, for example, are likely to carry on filling the funding gap. However, in the immediate term, funding platforms can impact the entrepreneurial ecosystem significantly, in the same way that the private equity model did previously. To be fair, online funding is a fairly new sector that is still developing. While it is an exciting prospect for many – and gives small businesses access to remarkable and fresh funding opportunities – it can be a confusing environment, simply because it is presented in such a wide diversity of ways.
The sector is not without its problems and concerns – which SMEs and their would-be investors need to take into account. While partial industry regulation has now been established in many GCC and MENA nations, discussions are ongoing between crowdfunding pioneers and regulators in an attempt to find a balance between protecting investors (given that many small businesses will fail in Year One), while allowing for the creativity and freedom needed to make ventures a success. In any environment where money is changing hands there is bound to some risk of fraud, and this is compounded through the anonymity of investor sourcing online.
There are several key generic types of online funding –
This is the ‘classic’ online funding model. Investors receive their money back with interest. Also called peer-to-peer lending, it allows for the lending of money without recourse to traditional finance houses or banks. Returns are financial, but investors also have the benefit of having contributed to the success of a potentially unique business concept. In the case of larger investments, this means that investors can therefore sometimes negotiate a share of intellectual property rights and brand value if the business is sold – even though they have technically not bought equity.
People invest in an opportunity in exchange for equity, ie, money is exchanged for a share in the business, project or venture. As with other types of shares if it is successful the value goes up. If not, the value goes down and potentially, you could lose your money completely.
Particularly with this kind of online platform, the process is not ‘one dimensional’ and purely online – it’s managed and manipulated at back office by the site provider, who then builds a verbal dialogue between company and equity investor. This is vital, because it is likely that the equity provider will command a seat on the Board of the funded business. As the company grows, a record is of course kept of how the ownership percentage translates into cash and what repayments are due and when.
Here; people invest purely because they believe in the cause that the business represents. Rewards can be offered, though, and these might be, eg, hospitality prizes, tickets to an event, an investor magazine, regular news updates or free premium gifts. The funding incentive is that donors have a social or personal motivation for putting their money in and expect nothing back, except to see the project grow to fruition and reap results in the community.
The risks roundabout
Online funding can be risky. One of the main reasons for this is that – especially for crowdfunding models – it breaks the accepted protocol of getting to know your investor and their track record. (Similarly, investors could say that they have no opportunity to get to know the business’ founder, its customers and its credit history).
Similarly, this heightens the risk that there is no guarantee investors will receive a return. What’s more, while you may receive a share of a business or project, dividends in the early stages of development are very rare indeed, forcing you to be a long-term player – but then again, your investment could be diluted if more investors are invited into the mix.
Just to further complicate matters, most crowdfunds have no liquidity at all. This means it can be difficult, or even impossible, to claim back money or have it converted back into cash – a major drawback if you are thinking of an equity solution. Plus, there’s no secondary market where you can sell your shares, which means that – for good or bad – you’re locked in. This tends to exert downward pressure on investment values throughout the online funding model.
On the other hand, for investors, lending money through debt crowdfunding gives the possibility of a regular income. There may also be the opportunity for dividend returns and some projects will pledge to return ongoing profits to investors.
Getting the strategy right
One of the secrets of using online funding platforms successfully is to see them as another weapon in your armoury, rather than as your one and only resource. The exception here is when you are a start-up or micro and want to attract a patchwork investment from scores of funders individually committing quite low investment values.
A prime strategic use of online funding is when you want to broaden the existing investor base and you have already worked the local pool of investors dry. Similarly, you might be a mature SME and ready for significant expansion, but don’t want to go down the route of relatively expensive secondary finance from a bank. With online funding, you can shop around indefinitely for an offer that is better value. By the same token, beware of the idea that, disappointed with local investors, you’re likely to attract investors from distant international locations – you may, but they will know very little about you, and vice versa, and this diminishes the chances of finance even more.
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Rushika Bhatia Editor
Rushika Bhatia is one of the region’s leading commentators on business and current affairs issues. She is the Editor of SME Advisor magazine - the flagship title of CPI Business. She is passionate about infographics – with special emphasis on data, research and statistics. Rushika has a Bachelor’s Degree from Indiana University, USA and is also CIMA qualified.