Loan Basics. A primer on crowdfunding

Have a business idea and wondering how to raise capital to take it to the next level? Well, you no longer have to run from pillar to post seeking funding from banks or individuals; you can now borrow money at the click of a mouse.

The idea needn’t be a for-profit one. You can also raise money for social-impact initiatives or even creative pursuits such as books or movies. Welcome to the world of crowdfunding.

What is it?

Crowdfunding is soliciting funds from multiple individual investors through a web-based platform.

The funds can be raised for social/not-for-profit initiatives as well as commercial/for-profit ones. It is classified into four types, depending on the consideration, which can be financial or non-financial.

Crowdfunding for a financial consideration can be categorised into two — equity crowdfunding and peer-to-peer (P2P) lending. In equity crowdfunding, individuals lend money to business entities and get equity shares or a stake in the entity in return. Typically, this type of crowdfunding is common with start-ups trying to raise early-stage funding, where the company is yet to start generating revenue.

Equity crowdfunding is more common with idea/prototype-stage companies which may not find much favour with angel investors or other financial investors who may want to get some market validation and revenue traction before investing in start-ups. In India, angel investing platforms such as LetsVenture and 1crowd typically act as equity crowdfunding platforms.

These platforms validate the credentials of both investors and start-ups. They conduct due diligence on the start-ups that seek money, and the information is available to member investors to make informed decisions. There isn’t yet a regulatory framework governing equity crowdfunding.

P2P lending is when individuals lend to small businesses/individuals for either a social or a commercial initiative. P2P lending can also be for non-income-generating activities. The consideration here is the interest on the amount lent. The return varies with the risk associated with the business and the individuals running the business — higher the risk, higher the return. Some of the prominent P2P platforms include Milaap, Kiva, Faircent and Cashkumar.

P2P platforms insist on KYC fulfilment for both lenders and borrowers. Diligence exercise is done on borrowers to assess credit-worthiness, genuineness and repayment capability.

Crowdfunding for non-financial consideration is of two types — social lending/donation crowdfunding and reward crowdfunding. Here the return or consideration may or may not be commensurate with the money raised.

In the case of donation or social lending, there is no consideration; for example, it could be for serving a social cause, doing charity or supporting an artistic cause. In the US, platforms such Kickstarter and Indiegogo support donation crowdfunding. In India, P2P platforms such as Ketto, Milaap and Rang De support donation.

In reward crowdfunding, the consideration for investors is a tangible reward — immediate or in the near future. Reward crowdfunding is not as prevalent in India, unlike P2P or social-lending platforms.

Crowdfunding not only supports investors who want to earn more by investing/lending to early-stage ventures, but also enables them to support or donate for a cause they believe in.

For borrowers who may not be able to get bank loans due to stringent regulations, crowdfunding can be used to raise capital. They can choose the instrument that works well for them — equity or debt.

Challenges

As an investor, one needs to exercise caution and do her homework before committing capital to start-ups that seek money through crowdfunding platforms, given that these are unsecured borrowings and there is no guarantee that the lender will repay. Also, currently, there is no elaborate regulatory framework, except in the case of P2P lending (announced in October 2017).

While these platforms are a good source of funds for start-ups, entrepreneurs need to be judicious with money, and explore other sources such as scholarships and awards.

The author is co-founder, Rana Investment Advisors.

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