Crowdfunding: Wise to bank on the wisdom of the crowd?
Flickr user: Ken Teegardin
Crowdfunding has gained increasing prominence in recent years. Just as how TripAdvisor uses reviews by tourists to garner data to compile rankings of hotels and places of interest, and how Uber depends on private car owners to provide a convenient, on-demand taxi service, crowdfunding boasts a similar concept.
Crowdfunding refers to raising funds from the public for specific purposes, such as fundraising for a charity, getting money to kickstart production of a new product by individual inventors, and so on.
In a business context, crowdfunding is a way to raise funds from the public for business needs. For investors, it is an alternative way to invest in private companies. In Peer-to-Peer (P2P) Lending, also known as Marketplace Lending, companies “borrow” money from investors and offer interest in return – this is the debt-based model and is more popular due to its simplicity.
Another type of P2P Lending is the equity-based model which is more complicated and involves issuing company shares.
Marketplace Lending has become an important source of funding for businesses, especially new companies or SMEs without established track records. This is due to its less restrictive lending criteria, regulations and disclosure requirements compared to traditional funding and loan sources such as banks.
Should I take the plunge?
One major attraction of investing in crowdfunded project is the prospect of high returns, which can exceed 20% per year. This assumes that the company uses the fresh funds prudently to improve and expand its operations and in turn, generate higher revenues and profits.
However, if the company is already not doing well and instead uses the funds to shore up its faltering operations or resolve cashflow issues, the outcome for the investor is a less happy one.
As such, the potential rewards are offset by the equally high risks of default, which means that you, the investor, may lose your entire investment. This is due to the inherently high-risk nature of such investments.
To illustrate, newly established companies usually seek crowdfunded capital as they are usually unable to obtain bank loans - for a good reason. Such companies, according to statistics, usually fail within their first few years of existence.
You would also need to do your homework on the companies and beware of multi-platform or multi-loan borrowers. These are borrowers who apply for multiple loans on more than one crowdfunding platform.
But doing research on such companies may be challenging. There are no audit requirements for smaller companies, nor are they required to be rated by an independent agency.
Lack of liquidity and the investment time frame are other factors to consider. If you change your mind about the investment, you are unable to withdraw any of it. Also take note of the time frame for such investments to pay off – it can vary from a few months to several years.
The role of crowdfunding platforms
A crowdfunding platform brings together companies (borrowers) and investors (lenders). Various crowdfunding platforms specialise in different areas and require different minimum investment sums – ranging from one hundred to a hundred thousand dollars. Platforms do not endorse the companies seeking funding and might not be responsible for full repayment of loans. Although platforms would evaluate borrowers’ applications, such checks are usually cursory. Some platforms or borrowers do provide a form of investment protection, for example, through collaterals such as precious metals or real estate.
If the borrower is unable to repay the loan, you can go through the recovery process to get back your investment, but it will take time and money. As a last resort, you might try legal action to recover the funds, but it is costly and legal expenses might exceed any amount you get in the end.
Proceed with caution
For those who are keen to explore the world of crowdfunding as an alternative – and, yes, exciting – investment opportunity, take note that handling a crowdfunding portfolio is hard work, akin to being your own fund manager.
You need to undertake intensive research on the companies and crowdfunding platforms, assess the risks, and gauge your risk appetite before deciding how much to put in it.
In short, crowdfunding can be a high-risk investment strategy which does hold out the promise of lucrative returns, but it should not be the sole or major component of your investment portfolio.