Crowdfunding changes the face of small business financing

Crowdfunding is threatening to supplant the banking industry’s status as the go-to source of finance for small businesses, writes Matt Timms

An attendee tries out the Oculus Rift at the Electronic Entertainment Expo. Crowdfunding is forecast to create a further 270,000 jobs in 2014 and boost the global economy by some $65bn

It’s been over half a decade since the financial crisis and still more than half of all small businesses are turned away from banks empty handed, their request for a loan rejected and their prospects short of what they were on entering the building. Without the necessary quality of earnings, cash flow or collateral requirements, those grinding the gears in the world economy’s engine room are more often than not starved of the financing they so desperately need.

Statistics show 21 million of the US’s 27 million businesses have zero employees, and 4.6 million of the remaining 5.9 million have fewer than 10. Here we begin to gain an understanding of just how big a part small businesses and entrepreneurs play in job creation, and an insight into what repercussions a lack of funding could have on the wider economy. Credit approval ratings still linger at desperately low levels, and new regulatory requirements ask that banks be near enough guaranteed a repayment before they invest in small businesses.

Unwillingness on the part of lenders to back small businesses has, however, given rise to alternative lending solutions, not least in the crowdfunding market. “Crowdfunding can be an attractive alternative because it is faster, more cost-effective and in many cases connects businesses with their consumers, who are then more inclined to stay as customers when they have a financial interest in the business’s success,” says Julia Groves, Chair of the UK Crowdfunding Association.

Crowdfunding is forecast to create a further 270,000 jobs in 2014 and boost the global economy by some $65bn

The rise of crowdfunding
Five years on from the establishment of Kickstarter, crowdfunding has cemented its status as a proven investment alternative for all manner of popular initiatives and enterprises. “More than money, Kickstarter helps people build a community of support around an idea,” said one company spokesperson. “Creators get to develop closer connections with their audiences, and backers enjoy a behind the scenes look at the creative process along the way.”

Built on the so-called wisdom of crowds, crowdfunding platforms have emerged as a surprisingly sophisticated means of democratising access to capital and partnering causes with appropriate backers. Beginning as a means of funding social projects, crowdfunding has become a destination for small businesses and entrepreneurs seeking financial support.

One recent success story of note is the Oculus Rift project, which started out with a target of $250,000 but quickly attracted over 9,000 backers and $2.4m in funding. Less than two years on from the campaign’s success, the virtual reality start-up was acquired in full by Facebook for $2bn; proof, if ever it were needed, that crowdfunding can sometimes determine a sound investment ahead of its more conventional banking counterparts.

With an expected annual growth rate of 92 percent in 2014, the crowdfunding industry is on track to rack up impressive gains far ahead of traditional banking – although the fact remains that the industry is largely undeveloped. Crowdfunding is split into four categories (donation, reward, equity and debt) and each represents an alternative avenue of financing, with its own advantages and complications. Of the four, equity-based crowdfunding is the standout sector, and also the one bound by the most stringent regulatory ties as backers and businesses struggle to arrive upon a framework whereby both sides of the bargain are upheld.

Regardless of the complications, crowdfunding is forecast by Fundable to create a further 270,000 jobs in 2014 and boost the global economy by some $65bn. While the $5.1bn raised through crowdfunding platforms last year pales in comparison to the amount loaned by banks, the industry’s expansion (over 1,000 percent in the last five years) is certainly enough to rattle the cages of traditional lenders.

A threat to banking
Having heard the stories of crowdfunding’s rise and the effect it has had on so many small businesses, commentators have been quick to pre-empt its potentially disruptive influence on the banking sector. “Crowdfunding is not just about raising funds,” says Jessica Ratty, Brand Communications Manager at Crowdfunder. “The whole process teaches entrepreneurial behaviour alongside marketing, PR and social media skills. By reaching out to your community to raise funds, you heighten awareness, gather supporters and future customers, and create a fan-base of people who really want your idea to be a success.” Crucially, crowdfunding platforms are exempt from many of the regulatory restraints that have inhibited lenders when it comes to backing small businesses.

27m

Businesses in the US

21m

have zero employees

If not an alternative to traditional banking, crowdfunding platforms at the very least act as an intermediary between unsuccessful start-ups and investors that may otherwise be priced out of the market. Many platforms allow backers to participate in campaigns for as little as $5 apiece; a far cry from the financial exclusivity of more traditional investment platforms. This difference has given rise to many more philanthropic enterprises.

“Crowdfunding is based on the principle of ‘democratic finance’, which means that it offers relatively low minimum investment amounts when compared to conventional investments,” says Bruce Davis, co-founder and joint MD of Abundance Generation and former co-founder of Zopa. “This means that individuals have access to a greater range of choices in how to invest their money and can avoid the problem of concentrating their eggs in a single ‘asset basket’.”

“People can lend or invest as little as £20 and actually see where their money is going and what difference it is making. This transparency is what we think has been lacking in financial services to date,” says Groves. “Crowdfunding is simple and direct and has the potential to re-engage people with their money, because they can choose for themselves where it goes and make more of the return than if they invested through funds and other intermediaries.”

Arguably the most important lesson for traditional lenders is that transparency and community have been the two most influential facets in breeding success in the crowdfunding industry. Without either, the platform would be unable to attract the investment and create the network of trust it has done so far. The question shouldn’t be whether crowdfunding will replace traditional lending, but whether banks will incorporate similar facilities into their operations and expand the loan opportunities available to small businesses.