The way people invest in emerging businesses is undergoing a quiet revolution. In the past, an entrepreneur with a bright idea but without the resources beat a path to a sympathetic friend or relative with some spare cash. Failing that, they might have turned to their local bank manager in the hope of getting a loan.
These sources of funding tended to work on the whole – but they have some specific failings. Those who were well-connected and had rich family and friends found it easy to raise funds from people they knew. Those who had tried and tested – and often fairly conservative - business propositions, found it relatively easy to raise money from banks. However, entrepreneurs whose business ideas were more radical and did not have stellar connections found themselves up against apparently insurmountable odds.
Investors looking for riskier and more radical ventures only had access to a fairly small pool of potential ventures they could invest in. Some were willing to put in the time and effort required to expand that pool of potential investments by actively looking around for the latest new micro-businesses. In recent years, match-making services have appeared which link angel investors with start-ups. This approach can be rewarding, but it is also risky and can prove to be hard work. It also requires a reasonable chunk of money. If an investor is serious about this approach, they need to invest in multiple businesses with the knowledge that only about one in 10 will create a serious return – but that return could be very substantial.
Given the limitations of the angel investing model, people have been experimenting with new ways of harnessing technology to help connect investors and start-ups. One of the most well-known models to emerge from these experiments has been crowdfunding. This is a system whereby an entrepreneur raises start-up funds through soliciting small investments from a large number of funders. Often they do this through an online platform such as Kickstarter.
There are two major forms of crowdfunding. The first is rewards-based, where funders simply pledge to buy a product or service before it has actually been created. This is very attractive for entrepreneurs because it can help to build an order book, or, more generally, show there is interest in a product or service before it is actually produced. Rewards-based crowdfunding can be a great way to test whether there is actually interest in the products or services of a new venture before it is even pursued.
The second major type of crowdfunding is equity-based. This approach involves the entrepreneur selling shares in a fledgling venture to a range of backers. This is often a useful way for entrepreneurs to test investor appetite, but also, crucially, to raise capital. In recent years, some new forms of crowdfunding have begun to appear. These include debt-based crowdfunding, where individuals lend money to ventures, and litigation-based crowdfunding where people pledge money to fight a court case (and may gain some of the proceeds back if there is a win).
Despite being fairly new, crowdfunding has become increasingly big business. Last year, a report by Nesta – an independent charity that encourages innovative businesses – found that the UK crowdfunding market was worth about £112m, and growing quickly. Equity-based crowdfunding was growing by 410 per cent and rewards-based crowd fund was growing by 206 per cent each year. While many well-known crowdfunding platforms are based in the US, the UK has been a pioneer in the sector. Zopa, one of the oldest and largest peer-to-peer lending services in the world, is based in the UK. It has been operating since 2005.
There are already some well-known examples of crowdfunded projects. In 2012, Pebble raised £6.6m on Kickstarter from about 70,000 people to develop one of the world’s first smart watches. Musicians have turned to crowdfunding as a way of supporting the recording and promotion of new albums. Authors have also got in on the game, crowdfunding the writing of new books. Even real-estate entrepreneurs are beginning to turn to crowdfunding as a way to fund their ventures.
While there is much hype around crowdfunding, there is less evidence about what investors need to expect. Fortunately, there is now a small but steady stream of studies emerging from around the world that give a slightly more realistic picture on crowdfunding. A recent study by Ajay Agrawal and his colleagues who specialise in the economics of innovation and entrepreneurship at the University of Toronto, have identified seven broad patterns in how crowdfunding works:
1. Crowdfunding is not constrained by locality. People do not tend to only invest in ventures that are next-door, or even in the same country. In fact, the average distance between investor and venture is 3,000 miles. What this means is that investors typically put their money in ventures throughout the world.
2. Crowdfunding is highly concentrated. The majority of crowdfunding goes to a small minority of projects – 63 per cent of projects are not funded at all, while 1 per cent of projects receive 36 per cent of all funds.
3. Investors tend to follow the crowd. One way in which investors judge if something is a good bet is whether other people have invested in it already. As a venture gains more commitments, this attracts potential investors’ attention, leading them to be more likely to invest. What this means is that ventures that get investors on board early are more likely to build up momentum.
4. Friends and family are crucial early investors. Just like many traditional ventures, often the first people to invest in a venture are those who already know the entrepreneur. When the first few people have already jumped on board because they know the entrepreneur, it makes others more likely to follow.
5. People are more likely to invest in a place they know. Ventures that are based in places well-known for entrepreneurship, such as Silicon Valley, Brooklyn or Shoreditch, tend to find it easier to raise money than those based in places that are less well-known as entrepreneurial hotspots.
6. Entrepreneurs tend to be overly optimistic. Generally, people tend to think they can raise too much on crowdfunding sites and set their targets too high. They also tend to think they can deliver their product more quickly than is realistic. They usually do get there, but it takes longer than expected.
7. Crowdfunding is used as an alternative to other sources of finance. Entrepreneurs tend to use a portfolio of different forms of finance. When other sources are blocked off, they will often turn to crowdfunding.
The world of crowdfunding certainly offers access to a wide range of new businesses that investors would otherwise never hear about. It also offers the opportunity to make small pledges to companies that we might find interesting or because we simply believe in what they are doing. But to get the most out of crowdfunding, it is necessary to put the hype aside. Many of the basic rules of investing in start-ups do not seem to have changed. Just like other start-up funding, it is risky, faddish, reliant on friends and family – but also potentially rewarding.
André Spicer is Professor at Cass Business School, City University, London
Key points
Crowdfunding is a system where an entrepreneur raises start-up funds through soliciting small investments from a large number of funders.
Crowdfunding has become increasingly big business.
It offers the opportunity to make small pledges to companies that we might find interesting or because we simply believe in what they are doing
