The global crowdfunding ecosystem is still quite young. When you compare traditional forms of capital formation to emerging online models crowdfunding is very much in its infancy and will take many years to fully mature. Prognosticators abound as to the success, or failure of, alternative finance in providing a more efficient and equitiable method for matching investors to businesses in need of growth capital.
Several weeks back, there was an article that described crowdfunding in rather harsh terms. The industry was described as a “monster”. Too much risk. Too many failures. Investors backing companies with little chance of success fueled by hype and a lack of transparency. So is this really the case? Should anyone be backing small and emerging companies? Or is this simply throwing out the baby with the bathwater?
Granted, early stage investing is a risky endeavor. Many, perhaps most, of the earliest stage companies will fail. Perhaps a few may become quite successful and some will stumble along. Crowdfunding in many ways is similar to venture capital.
Early research on crowdfunding based on empirical evidence has been encouraging. But if you step back and review the process of launching, and then establishing, a business, investment crowdfunding is not for the impatient. It may take many years to see a return from an early stage equity investment. We live and operate in a market based economy. Risk and failure are part of the game. Apple, the largest company in the world, was not built in a fortnight (and in fact Apple almost failed multiple times in its history).
Crowdfund Insider recently spoke with Raghavendra Rau to better understand his perspective on the crowdfunding market. Rau is the Sir Evelyn de Rothschild Professor of Finance at Cambridge Judge Business School. He is also a founder and Director at the Cambridge Centre for Alternative Finance (CCAF). At the most recent CCAF annual conference in Cambridge, Rau shared some insightful research he had recently completed on the global crowdfunding market.
First, to clarify, in the UK crowdfunding encompasses both debt and equity so peer to peer lending (IE Marketplace Lending) is included in aggregate terms. It is more about many people (and perhaps some institutions) funding a single project. Rau, in his research, emphasizes that in the UK the debt crowdfunding market is far larger than the equity side. This makes sense and mirrors the public markets. Yet access to capital at a very early stage may require equity capital. But globally, over 90% of the crowdfunding market is debt, not equity. It is a debt financed world, at least for SMEs, said Rau.
So are new forms of finance effective? Does crowdfunding work? Can crowdfunding provide a more robust funding system? Rau explained;
“Yes, there is definitely potential here. Usually you have two types of firms. Most small enterprises do not require equity. They require debt. Debt means you have to have approximately stable cash flows. Equity means you have to convince the investors that you have an amazing idea that is going to pay off in several years and I am going to let you (the investor) share in this. This is more risky for the investor and so all SMEs are not suitable candidates to raise equity.”
Traditional channels of providing the funding necessary for growth to occur have fallen short said Rau. This is the crux of the need for alternative finance;
“Access to capital is crucial. If you are a small firm, then most likely your access to capital is through your bank. Then you have a problem. The bank depends on formal financial statements. They require hard financials. But this is the only source you have. You have few other sources that can support a small firm, apart maybe from friends and family, who can only provide limited support. The financial crisis did not help us as banks pulled back lending because of many reasons. Interest rates dropped dramatically, cutting bank profitability and lending requirements became more stringent simultaneously.”
Rau said there are two different paths. Banks or crowdfunding. With crowdfunding there is less paperwork. It is easier to process and in some instances less risk averse. Banks are pulling back from lending across the spectrum. SMEs, the engine of economic growth, are not getting the necessary capital via the traditional route.
So has the UK crowdfunding system been effective?
“Yes, I think it has done a reasonably good job,” stated Rau. “But equity has been a small portion of funding. The majority of funding has been largely through debt.”
In the broader scope of things, China is the largest alternative finance market in the world. The US comes in a distant second. The UK is a strong third. But given the relative size of the UK economy, Rau calls the UK performance “extremely impressive.”
“The number of funding models is also impressive,” added Rau. “This makes the UK a very interesting place for crowdfunding. The UK punches above its weight. In terms of alternative finance per capita, all these three countries dominate the rest of the world. In the UK, part of the regulatory environment is more permissive than the US. In the UK, the FCA has a set of rules that are a lot easier to comply with.”
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Rau gives credit to the UK regulatory environment. The UK government has been notably supportive of crowdfunding and Fintech in general. The UK is recognized as the top Fintech hub in the world but this required policymakers to be more creative and to take some chances. So far, it has paid off.
“The rules in the UK are more conducive to the growth of crowdfunding. The US treats it as more of variants of traditional financing models. In a way, the US rules and regulations are holding back growth in the US. But the traditional financial markets are a lot deeper there.”
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Of course, everything can be improved upon and the UK has fortunately not let perfect get in the way of good enough. But we asked Rau where he thought improvements could be made. Speaking directly about equity crowdfunding, Rau explained;
“As a firm, how do I persuade a potential investor that I am trustworthy? Anything that can strengthen signals of value will encourage investor confidence. SyndicateRoom tries to do this by allowing you to invest alongside someone who is an expert in the business. You have other types of these models that improve your confidence in these models that they can pay back what they are promising. Basically, the investor needs to see proof that the firm manager is not lying to [them]. There are a lot of signals they can send to [a person]. In addition, the platform can itself check the firm data and be willing to guarantee these firms are not lying. Skin in the game is an another way for entrepreneurs to increase the confidence of investors.”
We asked Rau if the lead investor model, where a professional Angel or VC is joined by crowd investors, will become dominant and he was uncertain. The variable is the due diligence. Someone must to do this and if the platform does the diligence “then the platform becomes more credible.” But every model has trade offs and the industry is still evolving rapidly.
Returning to the topic of early stage funding and equity capital Rau noted that companies seeking equity financing cannot go to a bank;
“The types of companies involved in equity crowdfunding should not be the same type of firms that seek bank financing. I would expect them to be young, very early stage. Looking more like a VC type offering. A bank will never fund a VC type of idea. Perhaps only angels or VCs will finance these firms.”
In his opinion, there is not enough data yet to have a good sense as to the failure rate of these early stage firms. But just like venture capital, many firms will go bust.
“Equity crowdfunding is much more about new ideas … equity crowdfunding is a good idea. I do see evidence that investors are not stupid to invest in these types of firms. Full disclosure: I have invested in some of these myself, so perhaps it is a bit self-serving to say that investors are not stupid.”
From a societal perspective, equity crowdfunding is more conducive to innovation. If you want an innovation driven economy early stage companies need access to funds. But in the long run, debt is a more important tool for companies that eventually employ people. But first, you have to get them to the stage where they are big enough to borrow.