Given the difficulty in getting bank funding over the past few years, crowdfunding has become an increasingly popular method for businesses to raise finance from individuals and organisations, typically through an internet based platform.
How does it work?
Crowdfunding generally involves three parties:
- the business seeking the investment;
- an intermediary providing the internet crowdfunding platform; and
- the investor.
The intermediary connects the investor with the investee business thereby facilitating the investment. The intermediary charges the investee business a fee for the service.
Crowdfunding can be divided into two models: (1) peer-to-peer lending and (2) equity crowd-funding.
This facilitates lending by individuals and organisations to a business in return for a rate of interest. The terms of a loan agreement stipulate the interest rate and the period of the loan. Generally seen as the less risky of the two models, the returns can also be more modest.
In this model an investor subscribes for shares in the business. The investment is usually realised when the business is sold by means of a share sale. Typically, the investor is passive i.e. the investor will have no say in the running of the company. The investor will seek to guard against dilution of his investment by seeking rights to participate in future fundraisings in accordance with the percentage shareholding he or she has in the company. As the shareholder is the last to receive payment (after lenders and other creditors and preferential shareholders) the risks attached to equity crowdfunding are far greater than in peer-to-peer lending, however the returns are potentially much greater. There may be tax relief on making an equity investment, such as the Employment and Investment Incentive Scheme. Note however that the opportunity for an Irish company to raise funds this way are limited as there are company law restrictions on offering shares to the public.
Risk to Investors
There are many risks associated with crowdfunding, for example: the risk of default and the high failure of start-up businesses, platform failure, fraud and money laundering issues, dilution of investments and instances where an investor is misinformed about the business that is seeking funding. Measures that could mitigate such risks include:
- requiring crowdfunding platforms to register and be licensed by the Central Bank (currently there is no regulation governing crowdfunding in Ireland);
- setting disclosure requirements for business seeking funding and crowdfunding platforms;
- limiting the services that may be provided by crowdfunding platforms;
- investor education and/or statements signed by investors acknowledging their understanding of risks;
- limiting the size of the investments made by an individual in each offering and in a given timeframe; and
- requiring the appointment of a third party custodian to hold investor assets.
Crowdfunding can be a quick way for businesses to raise working capital needed to establish and expand. As crowdfunding platforms are internet based, the investment market is huge and it enables individual and smaller investors to connect with and invest in businesses in a convenient and cost effective manner.