Will crowdfunding affect startup finance?

Banks, in theory, help put an economy’s excess capital to work where it can be most valuable. Increasingly, though, market actors have chafed at the poor job these risk-averse—post-2008—institutions are doing. Large companies are turning increasingly to bond markets. Smaller businesses and entrepreneurs can’t, but do face ongoing financial constraints from deleveraging banks.

Crowdfunding, with its ability to aggregate small investors and link them with projects or companies, has been booming as a result: In 2014, an estimated 2,700 crowdfunding platforms were in operation, more than double the number in 2013. The growth and diversity of models in the sector is reminiscent of the froth of the Internet bubble—the market has yet to decide which approach to reward.

By far the most common one is access to debt, with platforms like Crowdcube now big enough to create retail bonds worth millions of dollars. Another option, more applicable to entrepreneurs than to established companies, is the sale of an equity stake. Finally, start-ups with interesting ideas may offer funders a potential reward—like early access to their product—in return for money. Others platforms differentiate themselves with services: 1ClickFunding, for example, offers entrepreneurs crowdsourcing of mentors along with crowdfunding.

Given this effervescence, crowdfunding’s monetary contribution to companies is difficult to estimate. The International Organisation of Securities Commissions (IOSCO) put the global value of peer-to-peer loan and equity fund-raising in 2013 conservatively at $6.4bn. In absolute terms, this is not much. More striking is the phenomenon’s growth. It barely existed in 2009; IOSCO has found that lending is doubling annually. By 2025, crowdfunding could reach $96bn a year, according to the World Bank.

But will funding criteria for SMEs and entrepreneurs change dramatically? The little we know now of this emerging field suggests that much will remain the same:

The law will still matter: Securities authorities in both the US and UK are making efforts to regulate this field without throttling it. Although America’s Jumpstart Our Business Startups Act now permits the sale of equity shares through crowdsourcing sites, adequate disclosure to—possibly unsophisticated—investors will still be needed.

Preparation will still matter: Crowdfunders are not necessarily more generous than bank managers and are just as demanding of considered planning. In fact, most projects fail to find backers (60% on Kickstarter, 90% on Crowdcube). Just as with traditional sources of funding, the quality and clarity of the pitch are determinants in getting financed.

Stakeholders will still matter, sometimes in new ways: In 2012, Oculus Rift got more than $2.4m from 9,500 crowdfunders for rewards including a T-shirt or an early prototype of the virtual reality headset it was developing. When Facebook bought the company for $2bn last year, many of those initial supporters complained publicly—even though an equity stake was never part of the crowdfunding deal.

Crowdfunding has the potential to allocate capital more efficiently. That may mean more money going to deserving enterprises and ideas, but those looking for funding will still have to prove they are worth the risk.

This article is published in collaboration with GE Look Ahead. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Dr. Paul Kielstra is a freelance scenario builder, author, and editor.

Image: People cross a street in Mong Kok district in Hong Kong. REUTERS/Bobby Yip.