Welcome back to Fintech Fridays. In this edition, we look at the emergence of crowdfunding and its ability to replace traditional financial intermediaries. With the U.S. crowdfunding market exceeding more than $1 billion in value, it is more important than ever to understand this emerging trend.
Crowdfunding is the practice of raising a large amount of money from a large group of people each donating small amounts. The purpose of this is two-sided. Firstly, it enables firms to raise capital without facing the significant fees charged by investment banks or huge equity stakes demanded by angel investors. Secondly, it provides a way for retail investors to buy equity in emerging companies, which was previously never an option for them.
One success story was Oculus. The company intended to raise $250,000 and reached its target within 4 hours, ultimately raising as much as $2.4 million. The company went on to achieve huge success and was eventually bought out by Facebook for $2 billion!! Crowdfunding is also an important tool for charities. Recently, Celeste Barber managed to raise a whopping $51 million for firefighter relief after the Australian bushfires in 2020. These stories demonstrate the potential power which crowdfunding has.
Unfortunately there are many unsuccessful stories. One notable example was a man called Stephen Lauzon who claimed to have designed sophisticated bunker technology. His goal was to raise around $4 million USD, but he only raised a single dollar. In fact, as of 2018, it is reported that 63.5% of all kickstarter campaigns fail, so crowdfunding is certainly not a guarantee of the project being successful. In saying that, it is important to consider whether the failure rates would be even higher under traditional financing mechanisms.
The hype around crowdfunding also offers an opportunity for scammers. This has been particularly prevalent in recent years, with companies issuing their own cryptocurrencies to raise money, only to run away with their investors’ money. In this sense, it is crucial to understand the legal and financial risks before considering participating in crowdfunding.
After examining some specific examples, it is worth looking at the bigger picture. From a business side, does it offer an opportunity that they wouldn’t otherwise have? We argue that it depends. In some sense it may allow smaller businesses to get the leg up that they deserve, but as yet the amounts raised pale in comparison to the amount of money which is required for the bigger operating businesses. Therefore, it is unlikely that investment banks will be going away anytime soon.
From an investor side, is it a worthwhile investment? This is a nuanced question that we can’t really give an answer to, but it is important to be aware that there is a possibility to lose your entire investment, particularly as the risk of insolvency is quite high for young companies. There may also be liquidity issues, meaning you can’t sell out of your investment when you want to, and this makes the investment potentially less attractive. We would recommend consulting a financial advisor before entering into these types of investments.
Overall crowdfunding is an interesting and potentially useful way of raising money that wasn’t previously available to businesses or retail investors. Given the mix of successes and failures, we cannot say for sure whether the presence of crowdfunding will continue to grow at the rate it has over the past decade. Nevertheless, it is important to understand this opportunity and also to be aware of the risks involved before investing.
Stayed tuned for next Week’s article which will be on Central Bank Digital Currencies.
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References and Further Reading