What is... | September 2, 2014

What is crowdfunding?

You want to start a project but need extra money to set it up. You could use a traditional form of finance, such as a bank loan. Or you may ask others, friends or strangers, to financially back you.


Often conducted via online social networks, this second option is known as crowdfunding – and it is a close relative of peer-to-peer lending and microfinance.
Instead of raising large amounts from a small number of sources, crowdfunding typically seeks small contributions from a large number of backers.
Projects include the high-profile Veronica Mars movie, which CNBC reports raised more than USD5 million, through to cottage industry and charity initiatives.
Crowdfunding is an increasingly popular way for individuals and small companies to raise money and – on the other side – presents an opportunity to invest. But, beware, crowdfunding carries risks as well as opportunities.

It’s getting crowded
United Kingdom fundraising charity Nesta points to the citizen donations that paid for the Statue of Liberty plinth in the 1880s as an early example of crowdfunding.
In recent years, crowdfunding has seen a rapid rise, with technological advances in the “information age” and lending constraints in the aftermath of the global financial crisis both said to play a role. Figures from the European Commission estimate almost half a million projects were financed through crowdfunding across Europe in 2012. It says the projects raised EUR735 million, a 65% rise on 2011.
Researchers in France question if crowdfunding is “a new revolution” in a 2014 working paper detailing how founders of for-profit, cultural, or social projects use crowdfunding to request backing from many individuals via the internet. It says more than half of the EUR40 million invested in crowdfunding in France between 2007 and 2012 was invested in 2012, demonstrating the rapid growth.
In addition, crowdfunding is credited with creating 7,500 of “crowdjobs” in Spain, in the EC document, and is said to have created opportunities for those otherwise unable to access finance and increased competition between lenders.

How well do you know the risks?
Like all investing, crowdfunding will carry financial risks for those putting money in to projects.
A National Bureau of Economic Research publication argues crowdfunding “offers little opportunity for careful due diligence and involves not only friends and family but also many strangers from near and far”.
A 2014 study of more than 48,500 projects found “the vast majority of founders seem to fulfil their obligations to funders” but “over 75% of them delivered later than expected”.
A 2011 BBC report outlines how fair trade soap maker Bubble & Balm went bust after raising GBP75,000 from 82 investors on crowdfunding platform Crowdcube and, reports say, ceased trading in 2013.

Wisdom of the crowd?
There is a tendency for people to pick investments that are familiar – or and even underestimate financial risks associated with subject areas they think they know well.
Known as familiarity bias, investors who choose crowdfunding projects that involve a favourite pastime or passion could be at particular risk of succumbing to this thinking trap.
Even if a project’s founder is known personally, is located close to where you live or involves a hobby that you enjoy, it can pay to take a step back and apply more objective criteria to see if the investment suits an individual’s goals.
Moreover, it is likely crowdfunding projects will not be unregulated and not offer the same protections as authorised firms.
Crowdfunding is a fascinating new opportunity for some – providing funding for many new projects and investment opportunities. But like many crowded situations, beware of getting carried away with the throng.

InvestingEuropeRisk

eZonomics team
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