The concept of crowdfunding is derived from crowdsourcing and micro-finance. Crowdfunding is a financing process for individuals and enterprises to raise funds from the public via the internet. Crowdfunding platforms, project initiators, and investors are the participants in crowdfunding. Open online project exhibition, fund raising from non-specific objects and specific rewards are the three main characteristics of crowdfunding. There are four types of crowdfunding: equity-based crowdfunding, reward-based crowdfunding, debt-based crowdfunding (i.e. peer-to-peer lending) and donation-based crowdfunding. In China, reward-based crowdfunding and equity- based crowdfunding are the two main types of crowdfunding, in addition to peer-to- peer lending.
Similarities and Differences
Crowdfunding in China is still in its infancy compared to other relatively mature markets. In the United States, for example, 5600 projects raised $215 million USD from 2.8 million investors in the first half of 2014. In the Chinese crowdfunding market, 1400 projects raised $30 million USD from 0.11 million investors in the same period. The distinctive performance can be explained by the differences in the regulation and investment culture between the two countries. To take differences in regulation first; equity crowdfunding, which is a higher level of crowdfunding, has been protected and promoted by the introduction of the JOBS Act (2012) in the United States, which was a law intended to enable new capital formation for startups by easing securities regulations for equity-based crowdfunding. In China, there are no such national regulations or oversight body which screens and protects equity-based crowdfunding and issuing securities.
These regulatory differences reinforce differences in investment-culture or experience. The United States has many experienced individual investors within a wider investment-culture in which crowdfunding models can be easily accepted and spread. By comparison, China has a much younger recent history of individual investment with much lower levels of regulatory trust. Moreover new channels like equity crowdfunding promise an uncertain return on investment, and is perceived as high risk. Thus reward-based crowdfunding has been more readily accepted because it promises to deliver a tangible product, and Chinese practitioners have tended to promote crowdfunding as a way for customers to get early access to new products.
According to the 35th report of the CNNIC (China Internet Network Information Center), by December of 2014, China’s Internet users reached 649 million, and internet penetration rate was 47.9 percent of the population. Mobile internet usage was up to 85.8 percent of all internet users and 91.2 percent of Internet users used some form of instant messaging (CNNIC 2015). In addition, China’s total reported national savings was more than $4.59 trillion USD by the end of 2013, up to 51 percent of national GDP (IMF 2014). Although there is a huge amount of private capital in China, it currently lacks formal investment channels—and if crowdfunding is officially supported and regulated it could become a popular form of alternative investment for Chinese investors.
Crowdfunding platforms can be seen as innovative financing intermediaries. They offer efficient ways to combine four financial inputs–information, collateral, control and risk. Crowdfunding financing is based on the open use of the internet, which must provide transparent information on individual projects to be effective. Potential investors can invest in their preferred projects based on their risk tolerance levels on individual crowdfunding platforms. After investing, they can take seek to influence of their investment by participating in distinctive segments of the business they financed in direct or indirect ways–such as through providing feedback on product design or offering product delivering time suggestions. Thus the intellectual property of in-need-of-financing businesses can be seen as a form of collateral posted by fund-raisers to compensate investors for potential losses.
In China there is no lack of projects in need of capital. There are many innovative SMEs established every year. However because of the lack of capital, few of them are able to grow bigger and stronger. Although Venture Capital (VC) and Private Equity (PE) can partly mitigate the capital demand gap, there is still a very big capital demand gap for the new businesses seeking fundraising. In China, as elsewhere, some of this demand for capital is met by VC and PE, however because the VC and PC model is based on investing in already profitable high growth businesses with potential to scale and reap windfall profits, they have no interest in investing in SMEs in their infancy. However, there are potentially many more infant SMEs who need financing. Crowdfunding therefore offers a way for promising infant SMEs to be financed by grassroots investors. Reward and equity-based crowdfunding therefore provide a new channel for capital formation which is somewhere between founder and angel funds on the one hand, and VC and PE investment on the other.
The potential supply of capital for crowdfunding is likely to increase as more people in China are gradually shifting from a savings to an investment-orientation. As a result, more potential investors are willing to shoulder a higher risk to pursue returns from different sources. According to one study, about 30 per cent of peer-to-peer lending investors begin to seek higher risk-reward returns after one or two years of investing in peer-to-peer loans (Wei, 2014). Equity-crowdfunding is one way to meet their demand. By the end of 2014 Chinese peer-to-peer platforms had absorbed $40 billion USD in total investments. If the 30 percent of the low risk-averse P2P investors could have fully participant the equity-crowdfunding market, that market could have absorbed $12 billion USD in China by the end of 2014.
Crowdfunding is still a novel concept in China. Most Chinese grassroots investors are not familiar with crowdfunding, nor its advantages or operating rules. Moreover, crowdfunding related laws and regulatory oversight are not yet established, which is crucial for the success of equity-crowdfunding.
Policy and regulatory challenges
Yet despite the huge potential for crowdfunding in China, the policy and regulatory position of equity-crowdfunding in China remains uncertain. The China Securities Association, issued ‘tentative’ draft regulations on equity-based crowdfunding for discussion in December 2014 (SAC 2014). The draft regulatory management proposals lay out the elements of a clear regulatory framework under which equity-crowdfunding could further develop in China. The explanation for the draft provisions positions the provisions as steps to encourage the development of private finance for innovative small and micro enterprises, and the provisions draw clear lines for what equity-based crowdfunding platforms, investors and business can and can’t do.
Yet draft management proposals also raise the prospect of imposing a very high threshold on who could invest in equity-based crowdfunding based on the definition of ‘accredited investor’. Under the ‘tentative’ draft rules, the definition of ‘accredited investors’ for individuals limited to one of the following:
- investing at least RMB 1 million in a single project or
- possess net assets of RMB 10 million or
- possess financial assets of RMB 3 million and have an annual income of at least RMB 500,000 for the past 3 years
These restrictions are tight. While these rules are still under ‘discussion’, the limits they place under on ‘accredited investors’ would severely limit the potential of crowdfunding in China by reducing participation from potential investors to all but the extremely wealthy—and well over the $10,000 USD a year income benchmark used to estimate the potential $50 billion dollar market for crowdfunding investment suggested by the World Bank report (World Bank 2013).
Interestingly these limits on who qualifies as an accredited investor are almost identical to those under the current US Securities Act, 1933, which limits ‘accredited investors’ to the top one percent of the population, and which does not grant any exemption for smaller business or smaller scale securities investments by individuals.
It is for this reason that, under the impact of the crowdfunding ‘exemption’ movement in the United States, the SEC has proposed rules under Title III of the JOBs act (SEC 2013), which would ‘exempt’ equity based crowdfunding from the same rules governing investment in public companies and introduced lighter rules governing equity-based crowdfunding platforms, small business and investors.
While Title III has yet to be brought into law and plenty of debate and uncertainty remains over some of the proposed details, it proposes to lower the entry threshold for potential investors by introducing tiered rules for investment based on income and assets – for instance it expands the potential for investment to those earning less than $100,000 a year by allowing them to invest up to $2000 a year or 5 % of their income or net worth, which is greater if both are less than $100,000 USD. Similar tiered investment rules are needed to broaden the base of crowdfunding in China.
The World Bank’s (2013) report on The Potential for Crowdfunding in the Developing World has been widely cited as predicting that crowdfunding in China could be a US $50 billion market by 2025. This estimate was derived from calculations of the potential money available for investment by individuals (TK) in all forms of securities by those earning over $10,000 USD a year – or roughly 60,000 RMB.
In order to foster a market in its initial stages, most reward-based crowdfunding platforms in China do no currently charge a commission fee. Yet without a suitable business model and a profit point it is difficult to attract more platforms to develop crowdfunding in China. In order to make a profit and remain viable, some Chinese reward-based crowdfunding platforms have changed to become product pre-selling platforms and market testing mechanisms. For example, some Chinese crowdfunding platforms charge an extra fee for project initiators if they want more exposure of their projects on the website. Currently most platforms in China are now more like a mixture of a platform and an incubator, which deviates from the original conception of crowdfunding platforms. For a healthy crowdfunding market, charging commission fee should be the only way for platforms to make profits and remain viable. Crowdfunding platforms should become a more independent third party vehicle to connect potential investors and projects in need of funding.
The question of how to develop a higher level of trust from potential investors is a major challenge for the development of crowdfunding in China. China can be said to have low levels of public trust in certain spheres, especially when it comes to money and individual investing. Chinese society is still organised by strong ties of kinship and close personal relationships and most Chinese people tend to belong to strong and cohesive in-groups such as extended families from birth onwards. Thus there tends to be higher levels of trust and co-operation for in-group people who conform, while there is often a stated distrust towards out-group people. As with any country, developing or otherwise, where certain public institutions are lacking, informal private networks and informal institutions often stand in their place. These informal networks, such as informal financing networks, tend to be dense social networks with high information levels about the participants, such as close family, friends and business associates in which participants can rely on in-group member trust for interest protection and risk avoidance.
By contrast for online crowdfunding projects information levels and social trust are generally low, and crowdfunding specific regulations are still opaque or incomplete in China. There is little regulatory mediation by authorities if disputes arise. For crowdfunding, it is difficult to persuade the investors to trust the unfamiliar project initiators on the Internet and then support their novel ideas in an environment that lacks both social sense of trust and regulative protection.
Project visualisation and campaign promotion are of great importance in overcoming information asymmetries and obtaining financing. Many Chinese project initiators lack innovative original ideas, which leads to a scarcity of high-quality projects on Chinese platforms. Projects are often based on the same core concept and differ only in appearance. On the other hand, high-quality ideas have trouble getting successfully funded. Poor project visualisation together with poor campaign promotion skills makes it difficult for Chinese initiators to attract potential investors.
There is a legal “forbidden zone” and institutional barriers which hinder the development of reward and equity crowdfunding platforms. Under the existing Chinese Securities Law, it is illegal to offer shares to non-specific individuals or to more than 200 specific individuals in public without regulatory approval. Most crowdfunding platforms are also not equipped with third-party independent payment functions. Therefore, it is illegal for the platforms to keep the money raised from the public and then transfer the funds to the successful projects. Such functions can only be performed by certified independent transaction support platforms, i.e. by third- party payment permit platforms. If the crowdfunding platform collects money from the public, rather than via an independent third party, the crowdfunding platforms can be seen as conducting illegal fundraising or to be engaging in fund-raising fraud. Thus the platforms have no ability to guarantee the reward of the projects. In the emerging Chinese crowdfunding market it is therefore possible that ‘irrational’ grassroots investors may blame platforms for any investment failure. In addition, some wealthy investors may contact the project initiators offline to invest in their projects via personal connections. These risks undermine the potential growth of reward and equity-based crowdfunding.
Project evaluation is a key role for leading investors in reward and especially in equity-based crowdfunding. Because crowdfunding is in its infancy in China, due to relative investor inexperience and the lack of regulation on investment in crowdfunding, investors can end up playing a less than constructive role in project evaluation. Many individual investors are motivated by seeking to gain short-term profits rather than by seeking to learn about potential long-term investments, which manifests itself in unrealistic expectations from investors who lack the skills or interest in evaluating individual projects. Investor-herding and a lack of diversification is therefore a common problem in China. Investors also face high risk from reward-based crowdfunding where initiators may over-promise or make fraudulent claims about their projects in order to get funded successfully in a regulatory void environment.
Regulatory protection for intellectual property is not well established in China. Projects in an open crowdfunding platform can be easily copied by others. Therefore, creators face a dilemma when posting their projects online. If initiators describe their core concept in an opaque way to mitigate plagiarism, they may not get fully funded. Yet if they offer detailed information about their projects to attract potential investors, they expose their ideas to a high-plagiarism environment.
Crowdfunding is an open online financing tool. There could be thousands of people who view your project page (idea) once it has been posted online. In other words, once you have posted your project online, you get a far higher exposure rate than that via the traditional offline financing channel. If you failed in the traditional offline financing channel, it is possible for a second round offline financing. For the outsiders [new investors], your idea is still new. On the contrary, if you post it on the Internet, once you have failed. You cannot get the second chance for financing with the same idea. Not only because most of the Internet users know about your idea but also other creators may copy your idea and make it into a better project faster than your second try.
Supporting the growth and stability of reward-based crowdfunding will build awareness and confidence in the idea of crowdfunding throughout the market in China. In the short run, the relative simplicity of reward-based crowdfunding makes it easier to promote in the Chinese market where online crowdfunding mechanisms are not well known in public. The public can learn the basics of how online crowdfunding transactions work by seeing reward-based crowdfunding in operation. As a result, increased confidence and familiarity in this lower level type of crowdfunding can generate momentum for developing equity-based crowdfunding. In long-run, developing the crowdfunding market as a whole can open new channels for financing businesses at different stages of the start-up development cycle. For example, business projects at the initial stage can first raise money from a reward-based platform, and if successful later they can seek to attain growth financing from equity-based platforms.
In China, there is a perceived lack of high-quality businesses which are worth for funding from investors. Entrepreneurs must know the advantages of crowdfunding financing first and then enhance their ability to express their funding needs effectively via online crowdfunding platforms. The quality of online campaigns can be improved by offline activities offered by platforms such as entrepreneurial innovation education, campaign promotion workshops and business skill training. The American platform Indiegogo, for example, hosts such workshops every month in order to help initiators make more attractive projects. The CIFC (China Internet Finance Confederation) and CEA (Chinese Entrepreneur Association) can help to provide technology skills training, social media marketing strategies, support and legal advisory for initial entrepreneurs to take advantage of the emerging crowdfunding market more effectively.
Chinese crowdfunding platforms should promote attractive types of businesses for investors in order to close the gap between funding demand and supply. Businesses should be automatically matched with investors without any interference. Platforms roles should be limited to connecting investors and projects. An optimal operating model for crowdfunding in China needs to be developed and based on existing regulatory standards. Effective fraud prevention measures and high degrees of information disclosure should incorporated into such a model. Crowdfunding platforms can use crowdsourcing in practice to secure high information transparency for projects. For example, platforms can offer some incentives for participants to deliver a high level of information about their projects. Then information disclosure can be done by the platform after selecting and summarising the collected information. A higher level of information disclosure can reduce the risk of fraud. For instance, one successfully funded project cannot send the promised reward to the investors in the promised time for some insoluble problems. It is worse if they have already spent part of the investors’ money. In this case, the spent money may be covered by a risk prevention fund in order to protect the investors’ benefit.
The core idea of crowdfunding is empowering people to be participants. In other words, encouraging broad-based participation can be seen as priority for crowdfunding development. Greater awareness of crowdfunding can be achieved by engaging more trusted Chinese business brands in this emerging market. If better known Chinese companies adopt the crowdfunding model it will help to raise public awareness and confidence of crowdfunding. Telling success stories in crowdfunding market can also raise public confidence for the emerging market. Public media should also promote crowdfunding related news, events, and best practices through various communications channels, including in rural areas.
Crowdfunding in China needs a specific regulatory framework which is flexible, offers incentives and which will increases investor confidence in Chinese crowdfunding markets, without being too prescriptive. The voice of all the crowdfunding-related participants should be taken into consideration to meet a politically viable regulatory solution. Legislation established without consensus will not be effective to implement. Chinese regulators need to design effective mechanisms to prevent online fraud in order to increase the trust level for crowdfunding investors. Official trust certificates and safe payment tools should be built in established crowdfunding websites. Regulators should create a public database to alert users of crowdfunding fraud. Well-established legislation for intellectual property protection would encourage more Chinese entrepreneurs to fund their own projects through crowdfunding platforms by reducing the risks of IP theft.
After years of crowdfunding market cultivation, the business model of crowdfunding will become more familiar with the public. It will generate more participants in this emerging market. The market size of crowdfunding in China will be expanded. More crowdfunding platforms and crowdfunding navigation websites will also be established.
With the establishment of regulations and monitoring laws for crowdfunding, the market entry threshold will be raised. It is possible to see a healthy and dynamic crowdfunding environment in the future. More vertical crowdfunding platforms (crowdfunding platforms focus on certain areas such as music, game etc.) will appear in the future as the crowdfunding market segments. Big data derived from the Chinese crowdfunding market will allow more in- depth research of the market characteristics. More valuable principles about crowdfunding will be discovered through the analysis of big data.
With the gradual implementation of the financial reform in China, P2P loan and equity-crowdfunding will be integrated together with regulations that strengthen the advantages and mitigate risk of alternative financing. Crowdfunding platforms will evolve into the core players of crowdfunding ecosystem. It will provide a full range of services to support business initiators, and not be limited to the financing.
Zhao Liang, is a PhD candidate at Amsterdam Business School, University of Amsterdam. Liang’s research is on crowdfunding in mainland China, with a focus questions on the roles of platforms, investors, and entrepreneurs. His multi-dimensional study looks at questions trust and e-trust, institutional support, community formation and cultural characteristics in the development of Chinese crowdfunding industry and its impact on entrepreneurship. Liang’s four-year PhD project is fully sponsored by China Scholarship Council (CSC).