Reward Based crowdfunding- An alternative to standard private equity and venture capital financing

Raising capital through IPO is really tough and pretty large business especially for start-ups that are not anywhere near to reach IPO status any time soon. To help these start-ups who have just an idea but don’t have access to capital to kick off their dream, many new type of fintech innovations have surfaced recently which aims to drastically expand access to capital, particularly for smaller start-up companies. In this article, we will discuss reward based crowd funding, which is quickly becoming a viable alternative to standard private equity or venture capital financing. 

        For most of the crowd funded ventures, the common starting point is a very small start-up with a highly uncertain project. For example, say you come up with an idea that's a bit ahead of its time i.e it doesn’t exist yet, and because it's so new, venture capitalists and private equity financiers may not get on board with your idea and will not be interested to invest. Now, here a way to get finance for your dream and that is online crowd funding -a new vehicle that potentially allows you to get financing. The way is that instead of going to the banks or venture capitalists, entrepreneurs appeal directly to the crowd. An Entrepreneur tries to get small capital contributions from individual backers online. And if enough people see value in his ahead-of-its-time idea, then maybe he will have enough initial capital to get going, moving from the idea to a blueprint and maybe to a prototype. To do that, to appeal to the crowd, an entrepreneur needs a venue and that's where crowd funding portals come in. Again, the technology itself is very simple. Similar to platform lending like banks, crowd funding portals are platforms or an online marketplace that directly connects the entrepreneurs on one side and individual investors on the other side. These portals are for-profit portals, where the entrepreneur takes small capital contributions from backers and in return, promises to return something to the backers. And this something is what distinguishes the different types of crowd funding platforms? 

      In reward based crowd funding, the entrepreneur takes the money and promises to send the backers the finished products or services or access to these products. It’s an online venue for entrepreneurs to appeal to the crowd with their projects or ideas. And they do so by starting a funding quote-unquote campaign on the portal where they'll devote a considerable amount of time to put out a good description of the project. In designing the campaign the entrepreneur will also set some funding targets and funding limits. In fact, because the entrepreneur has complete discretion in setting their funding limits and goals, they often use these crowd funding campaigns to gauge interest on their products before potentially going to venture capitalists. In this the entrepreneurs do not promise any form of claim on cash flows or any form of corporate control to the backers. Instead, they promise purely to deliver a finished product to the backers. For example, backers contributing higher amounts are getting progressively higher discounts on the finished products. Typically in the reward-based crowd funding, the entrepreneur can be seen as simply pre-selling their products. It's important to note that participants are not really seeking to speculate, they merely want the product. It's the utility of the product that attracts them to provide the capital instead of speculative motives. If at any stage entrepreneur faces difficulty in developing the product and isn't able to develop a successful prototype, the contributed capital is lost. For the entrepreneur, the platform levies no additional punishment except possible reputation loss, with the investors less likely to back the same entrepreneur again in the future. On the other hand, if the development is successful, the project further transitions into the scaling and fulfilment stage. Both the technology and the operations of a reward-based crowd funding portals are quite straightforward. But there are also some important risk factors that you should be aware of. Specifically these platforms usually are not regulated; they don't need to register because they're not offering securities. Therefore, anyone can launch a portal and anyone can participate on either side of a portal. Researchers at the University of Pennsylvania conducted an analysis of their projects in 2015 and found that over 75% of the projects have experienced delays in fulfilment while about 10% of the projects had their funding goals met, but nothing was delivered at all. So when analysing these platforms, one should take into account the inherent high degree of information asymmetry on these platforms and their associated risks. 

        In fact, many entrepreneurs simply use reward-based crowd funding like a viral marketing campaign, hoping to either attract attention from the media or private venture capitalists.

01-04-2024