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Finance briefing: Investors tap the wisdom of crowds

posted Jun 23, 2014, 10:10 PM by Siamak Ebarhimi

What is crowdfunding?

Crowdfunding entails the use of an online platform to present projects and collect funds from citizens and investors. Most projects financed through crowdfunding do not seek profits and do not promise financial returns to investors. These are donation-based campaigns where funders (the crowd) finance social or artistic ventures. Crowdfunding platforms are increasingly used to offer equities and debt securities to investors seeking financial returns.crowdfunding marketing

By channelling finance to projects that typically would not receive attention from more traditional funding sources, crowdfunding can help solve the structural gap in the financing of early-stage ventures. Some see it as the next pebble of popular capitalism, where small investors search for projects and diversify small amounts of their savings across several ventures. Currently, wealthy individuals and professional investors are the main funders of start-up equity.
Governments are seeking to stimulate investment-geared crowdfunding, as they struggle to find policies that could increase the financing for entrepreneurs and small and medium-sized enterprises. Italy, France, Spain, the UK and Belgium have moved first but many others will follow. However, investing in these projects is not without risks for investors.crowdfunding advertising

What is its potential?

Estimates from Iosco, the umbrella body for global market regulators, indicate that crowd-sourced loans exceeded $6.2bn worldwide in 2013. This is equivalent to just 0.01 per cent of the bank-originated credit to the real economy, but it is growing fast, up 145 per cent from 2012. In the UK (the most developed market), crowdfunding for financial returns accounted for more than £490m in 2013, including £28m in equity, according to the FSA, the former regulator. This is equivalent to approximately 1.8 per cent of unsecured personal loans and 1.1 per cent of assets under management.indiegogo marketing

The European Commission anticipates that, under current growth rates, crowdfunding could reach a size comparable to business angels and venture capital in Europe (around €7bn-€8bn). However, crowdfunding is still at an early stage of development. Most equity and debt-financed projects have not matured yet, so important uncertainties remain as to its future, which will ultimately depend on its ability to channel reasonable returns to investors.kickstarter marketing

What are its risks?

For loans, default rates appear to be moderate. Some platforms report rates of 1 per cent, although given the exponential growth in the industry, few loans have matured, meaning that more time is needed to get a clear picture of actual default rates. For equity invested in early-stage projects, the Financial Conduct Authority, the UK regulator, estimates that investors lose the entire principal in 50-70 per cent of ventures. Some argue that these figures are overstated.

Investing in early-stage ventures carries high project-specific risks, which inexperienced investors are poorly equipped to assess. Direct contact between potential investors and entrepreneurs, and public discussions through the networking functionalities embedded in crowdfunding platforms, may reduce the risk of fraud and increase the level of investor understanding of the project. But the risks specific to each project will remain high.kickstarter project

Equity or debt?

Investors also face risks specific to the instrument of choice, whether in the form of equity, debt securities or loans. Significant risks in equity-based campaigns arise from the illiquidity of the instruments, the lack of any secondary market and the potential for dilution of rights in the absence of governance protections. For loans, the main risk is the default or delay in the payment of interest and principal. Moreover, investors are exposed to fraud and operational failures within platforms.CrowdFunding advertizing

How important is regulation?

Regulation has an important role to play in allowing crowdfunding to develop and protect investors. Existing securities regulation does not reflect the specificities of crowdfunding. A specific framework is needed that ensures the integrity of platform operations, adequate due diligence to mitigate the potential for fraud, and a high level of transparency towards investors. Some jurisdictions require retail investors to review educational materials before being able to invest.CrowdFunding marketing

Without sufficient safeguards for investors, crowdfunding will not thrive. Platforms need to ensure that investors understand the risks and potential losses, while effectively protecting them from fraud. Otherwise investor detriment will quickly turn into lost trust, undermining an opportunity to invigorate entrepreneurship and innovation in Europe.Kickstarter Marketing

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 By David Khorram