Crowd funding or crowdfunding (alternately investment crowdfunding, securities crowdfunding, crowdinvesting, crowd financing, debt crowdfunding, crowdlending or equity crowdfunding) describes the collective effort of individuals who network and pool their resources, usually via the Internet, to support efforts initiated by other people or organizations. Crowdfunding also includes Peer to Peer Lending but has recently been re-labled as “Marketplace Lending” as a growing number of direct lending platforms are using institutional money or their own balance sheet to finance loans. Crowdfunding is used in support of a wide variety of activities, including, businesses, disaster relief, citizen journalism, support of artists by fans, political campaigns, company funding, movies or software development, and scientific research.
Types of Investors
In the discussion of crowdfunding there are generally two types of investors: accredited investors and non-accredited investors. These two groups operate by differing rules when investing. In general, if you make less than $200,000 a year or are worth less than $1 million you are a non-accredited investor, although there are more complex rules that define these two groups.
The reason crowdfunding is an emerging topic in the United States is due to the JOBS act enabling non-accredited investors to invest in companies via crowdfunded offerings. This means average citizens can contribute capital to companies without those companies having to deal with the typical bureaucratic overhead of selling stock on typical stock exchanges.
Types of Crowdfunding
This is the most popular type of crowdfunding at this time. Donation crowdfunding has two types: rewards crowdfunding and charity crowdfunding.
Rewards-based crowdfunding is where contributions are exchanged for current or future of goods or services. Individuals or companies who launch campaigns may compensate contributors with something like a t-shirt, a copy of whatever they’re building or even just a thank you.
Rewards-based crowdfunding is perhaps the most prolific form of crowdfunding currently taking place in the US. Kickstarter and Indiegogo facilitate Anyone can go create a web page on these sites and pitch an idea. A famous example of this is the Pebble watch. Pebble used Kickstarter to pitch their idea: a relatively inexpensive e-paper watch that could be customized with apps to do things like display calendar notifications and emails. They outlined their idea on Kickstarter, made a video about the product and set a goal of $100,000 to complete R&D. A donation of $100 earned you a promise that you’d receive the watch when they are done. Different donation amounts had different rewards attached. You could even donate $10,000 for 100 watches!
Had the $100,000 goal not been met, the donors would get their money back and everyone goes on their merry way. Specific rules on funding vary by web site. In the case of Pebble the goal was met, so the money was transferred from Kickstarter to Pebble. Kickstarter charges a 5% comission. Pebble is now obligated to give everyone what they paid for. By the time the campaign was over Pebble had collected $10 million, or 100 times their initial goal. Pebble now has the capital they need to create the product and they’ve already tested the market. They’re off to the races.
Appropriate for: Projects in the arts (movies, art, music, etc.), companies looking to test markets, charitable groups and causes
Donation crowdfunding takes place when an individual, company or organization accepts charitable donations. Pretty simple, right? This has been taking place for a long time, albeit it may not have always been called “crowdfunding.” Wikipedia, the Red Cross, political parties, etc. all participate in donation-based crowdfunding.
Appropriate for: Nonprofits and causes.
Investment crowdfunding when the crowd exchanges money for securities. There are two types of investment crowdfunding: lending crowdfunding and equity crowdfunding.
Lending crowdfunding is when a crowd lends money to an individual or company with the understanding that the loan will be repaid with interest. This is the methodology behind peer to peer lending sites like SoFi, FundingCircle, Lending Club and Prosper. These sites facilitate crowdfunded loans to individuals for purposes like home improvement and debt refinancing. Debt-based crowdfunding has grown rapidly as institutional capital has capitalized on the superior risk adjusted returns generated by direct lenders. P2P lenders in some countries have re-labeled their platforms as “Marketplace Lenders” to reflect the shift from small investors to large ones. Some online direct lenders use their own balance sheet to finance individual loans.
In the UK there is a product called “Mini-Bonds”. Similar to traditional bonds, Mini-bonds allow issuing companies to crowdfund unsecured debt at competitive rates.
One risk of this type of crowdfunding is default. Every site will have their own policy on default and investors should understand these policies in order to protect themselves.
Appropriate for: Companies and individuals planning on multiple rounds of funding, companies who do not want to part with equity
Equity crowdfunding is crowdfunding where the exchange is company equity, or ownership, and not goods or services. The idea is very similar to how common stock is bought and sold on the stock market.
Equity crowdfunding cannot take place in the US at scale right now. That isn’t to say it can’t take place at all. It can and does. There are complex rules in current law that allow a company to sell stock to “accredited investors,” which is basically a fancy term for millionaires. This is deemed necessary because these types of investments are generally high risk.
The second problem for equity crowdfunding in the US relates to solicitation. In short, it is illegal to advertise the sale of stock.
Both of these problems are set to be alleviated soon thanks to the Jumpstart Our Business Startups Act, or JOBS act, which was signed into law on April 5th, 2012. The SEC is currently in the process of working with Congress and crowdfunding stakeholders to settle upon specific provisions for equity crowdfunding in the US. A few things from the bill are game changers here in the US:
- Certain small stock offerings (e.g. those taking place on future US crowdfunding sites) won’t be required to register with the SEC
- You won’t have to be an “accredited investor” to invest in these companies
- A company won’t trigger requirements to file with the SEC until they have 500 non-accredited investors OR 2,000 total investors
- The ban on general solicitation and advertising will be lifted for equity crowdfunding
Once this legislation is in effect US entrepreneurs can sell up to $1 million of common stock to as many as 1,999 people without having to go public.
To protect non-accredited investors from getting caught up and pledging their entire net worth to risky companies, the legislation caps annual contributions to these companies at “2% of someone’s yearly earnings OR net worth up to $40,000, up to a cap of $10,000 for people earning (or worth) $100,000 or more.”
Proposed Rules of Title III of the JOBS Act as published in the Federal Register.