Debt crowdfunding VS Equity Crowdfunding - Pros and Cons
The struggle to access funds is one thing nearly all businesses go through. Most banks remain, shall we say, ''extremely careful'' when offering loans for Small and Medium Enterprises (SMEs) and Startup businesses. Even when the company is already making a profit, banks will be protective. The issue often is not having sufficient collateral banking. But what can these SMEs and Startups do?
In this blog, we will be analyzing the difference between equity crowdfunding and debt crowdfunding. In addition, we will discuss some advantages and disadvantages of both crowdfunding types.
What is Crowdfunding?
For our new blog readers, a quick introduction to the nature of crowdfunding. Crowdfunding proves an optimum solution for people, businesses, and charities looking to increase capital for a specific project or business development. It's the opposite action then going to the bank for funding.
Crowdfunding brings together myriad individuals and organizations willing to micro-finance a project your business wants to execute. Crowdfunding investors are eager to support your business and partially invest in a sector they have always been interested in.
Why Are More and More People Using Crowdfunding?
Crowdfunding is transforming the way many people behave with their money. Not only that, but crowdfunding can potentially completely change the traditional financing sector. Crowdfunding disrupts the various financing models, such as venture capital and fund management, as well as the role of angel investors.
With crowdfunding, multiple investors can contribute to one project. However, senior lenders and banks are merely not prepared to finance as much as they used to. Crowdfunding was once only available for HNWI and institutional investors - those recognized and with already developed businesses. If you think about it on a broader scale, his form of alternative finance is beneficial for the current economy on a wider scale.
Crowdfunding has several enticing perks:
- Build your market and network: Whether you are launching a product or trying to develop an innovative project, crowdfunding campaigns help you tap into new markets and build a network with like-minded people and businesses.
- Accelerate your business: When you apply for a loan, you may only qualify for a certain amount of funding. When you crowdfund, you can set a goal, and if it goes well, you may exceed it.
- Campaigns are centralized: With one campaign page on a platform like Kickstarter or CrowdedHero, you can easily manage lead generation, outreach, and fundraising in a single location.
Crowdfunding has rapidly become a go-to strategy for many SMEs and Startups. However, all of these businesses have different maturity stages and thus different needs to access funds. Debt-based crowdfunding and equity-based crowdfunding, in particular, have been the most popular methods used to raise funds.
However, many business owners tend to confuse these two different crowdfunding methods. This can be a serious problem for basically any business, and you have to know where you are getting in.
The model you choose to use for your business funding most likely will have a long-term impact on your business's profitability and cash flow.
So, let's discuss the debt-based crowdfunding model and equity-based crowdfunding model.
Equity-based crowdfunding is the best-regulated and most popular model for business funding.
Using this crowdfunding model, the business can raise funds from a ''pool'' of investors. These investors can be found on a crowdfunding platform, such as CrowdedHero. Equity-based crowdfunding investors are willing to support your business by funding a project in exchange for partial ownership of your company (equity). The process is often very similar to traditional reward-based crowdfunding; however, the business gives up a percentage of the company's ownership instead of rewards.
In other words, money is an exchange for shares or a small stake in a business or project, meaning investors get their returns through profit or dividends.
The entire funding process takes place online through a regulated crowdfunding platform. The crowdfunding platform, such as Kickstarter or CrowdedHero, connects the investors with the business seeking funds. First, the business owner registers the company on the crowdfunding platform and provides detailed information about the business campaign. The detailed information includes explaining the need and use of funds and the expected profit results. Once the platform completes its due diligence on the business owner, management team, and the business as a whole, the campaign is made public to potential investors.
As the business owner, you must go through chosen platform's regulations to ensure the business campaign isn't rejected unexpectedly based on some issues. In most cases, there are some restrictions in place to protect investors. Severa platforms also impose regulations to ensure only legitimate campaigns are advertised.
Depending on the amount raised, the crowdfunding platform will also charge the business owner a monthly subscription fee or a commission fee. The percentage will vary across different equity crowdfunding platforms.
The business owner has a lot of control over the terms, making the equity-based crowdfunding model appealing. Of course, it depends on the platform you choose, but in most cases, the business owner can decide how much money to raise, the minimum investment amount, and how much equity to give up. The more explicit and concise the business terms, the more likely your campaign will succeed. Therefore, the business owner should be prepared to submit regular reports to investors about the progress of the project's execution. In addition, you must inform your investors about how the money is spent and how the company is doing.
Recent developments in the crowdfunding industry now allow more and more people to be connected through equity-based crowdfunding. As a result, not only businesses in various maturity stages can apply for funds, but also investors with diverse portfolios can fund new projects. This means that with the equity crowdfunding method, you have the potential to raise constantly higher lumps of money much quicker.
For instance, equity-based crowdfunding is quite popular in the real estate world. Many landlords and real estate developers use this method to raise funds from many investors instead of just one. It's a time-saving, convenient and fast way to increase capital for any innovative business.
Advantages of Equity-based Crowdfunding
- Debt-free fundraising model
With equity-based crowdfunding, the business owner doesn't owe a thing to the investors if the venture doesn't work out. Instead, the investors bear all the risk and receive profit from dividends.
- New opportunities for your business
We know it's not that easy to find like-minded investors. However, your business can be connected to potential projects and brands with the right investors. Such opportunities are crucial to expanding the business's growth. Moreover, well-connected investors can also offer free brand recognization, marketing and improve your business visibility in the market.
- Fast and easy access to capital
Equity-based crowdfunding platforms give your business access to a large crowd of investors, both accredited and non-accredited. This opportunity will increase the odds of hitting your target amount of investment. The equity crowdfunding process also takes less time than the conventional banking process.
Looking from the investor side, equity crowdfunding will also benefit investors. This is because equity crowdfunding is generally considered a high-yield investment. Which means that this type of online investment can offer a significantly higher level of returns. In fact, the average annual return for Equity Crowdfunding can typically range from 15% to 25%. However, an individual can expect only a 0.5% to 3% return when leaving money in the bank.
Disadvantages of Equity-based Crowdfunding
- The business is giving up a part of the ownership
Even though this financing model can make it much easier to raise capital, the business owner is giving up a percentage of the business ownership to its investors. This means the business is obligated to share its profits with all investors who have supported it through equity funding.
- You lose the decision-making power
Giving up equity in your business means that your investors have a partial saying in the decisions you make for the company. In some cases, few investors might stand out as not necessarily good business leaders, so giving them the power to influence decisions can shake things up.
- Filed campaigns are public
The results of your campaign will remain public. So, once you try to raise capital and fail to reach your target, these results will remain available to the public. This can have a negative impact, for instance, on potential investors who liked your development project idea. In addition, you will be sharing many details and plans for your business with investors and with the public. So before publishing a campaign, make sure that everything is on the right track and that you are prepared to accept the consequences if the campaign fails.
Looking from the investor side, equity crowdfunding can also present higher risks for investors. This is because the returns on investment with equity-based crowdfunding are guaranteed to be significantly smaller than with debt funding. It is also worth remembering that if you invest in a startup project, there is always a possibility that the company could fail the assignment. These failing projects usually occur because of a lack of knowledge and expertise. So before investing, please do your due diligence research and collect detailed information about the business, its team, and its owner. Then, feel free to support the business with funding if you feel familiar with the company and its past actions.
Most of the processes involved with debt-based crowdfunding are similar to equity funding.
In this model, a business takes a loan from many different investors through a crowdfunding platform. The loan is taken in exchange for interest and payback after an agreed period of time. It's like taking a loan from a bank and repaying with interest.
Debt-based crowdfunding takes place online through a crowdfunding platform that regulates the process. Like equity crowdfunding, as the business is looking to raise capital, the business owner has to register the company on a crowdfunding platform and submit detailed information about the business campaign. When such actions are made, potential investors can consider their participation in supporting the business. Then, the platform conducts the necessary due diligence, including credit checks. When due diligence is done, the platform publishes the campaign to the availability of the investors; thus, the investors can place their bids. The interest rate is already set with some platforms, but sometimes investors can sort of ''bid'' on different interest options.
The business owner may be required to place some security based on the amount the person is interested in raising. The security provided can be a personal guarantee or a business asset. The business owner will have to meet higher qualifications as the larger loans are targeted. The debt-based crowdfunding provides a similar process to that in banks.
As a business owner have enough investors to meet the loan target, the crowdfunding platform irons out all the details of the loan and interest payments. For small businesses that have been in the industry for a while and have defined their innovation plan, this model of raising capital can be very attractive. However, most investors tend to disregard startups for this investment model, as they hold the most risk. Regardless, some startups successfully have increased their capital with debt funding.
Advantages of Debt-based Crowdfunding
- The business owner retains ownership of the company
Unlike equity funding, with debt-based crowdfunding, the business owner controls 100% of the company's ownership. The only obligation for a business owner using debt funding is to pay interest and repay the principal amount to its investors.
- Low-interest rates
The administrative costs are significantly reduced since the whole landing process takes place online. This also means that the interest rate on loans can be lower than in banks.
- No profit-sharing
The relationship with investors is cut off once the business owner has completed repayment of the principal amount and interest. Therefore, all the profits that the company gains belong to the business.
- Faster loan approval
The loan application and approval take much less time with debt-based crowdfunding than with the banking system.
From the investors' point of view, debt-based crowdfunding is a desirable option, especially for those investors who want to receive a fixed return. If we compare it with equity crowdfunding, debt funding is also a relatively low-risk investment. This is because loans have fixed terms and interest rates. Further to this, the investor's capital will most likely be secured by a charge on the project asset. For example, suppose the business project is not going as planned, and there are issues with capital repayment. In that case, the P2P lending platform can fore a sale of the asset to recoup any outstanding capital and interest. Another significant advantage of investing through debt-based crowdfunding is that investors can invest using their ISA allowance via an IFISA (Innovative Finance ISA) and take advantage of tax breaks.
Disadvantages of Debt-based Crowdfunding
- Loans have to paid
Once the business has received the loans, the investors expect to receive a payback of their principal amount and interest. A business owner is obligated to make a payback regardless of how good or bad the business performs in the industry. If the business owner can't repay the loan, the company may be forced to liquidate assets or shut down all operations.
- The business owner might be responsible
The business owner might be held responsible for the debt with debt-based crowdfunding. This might happen when the business cannot repay the loan and interest. For example, if the business owner issued a personal guarantee for repayment. This means that business owners and the whole company's reputation are on the line when choosing debt-based crowdfunding.
- ''Too much'' transparency
When running a debt-based crowdfunding campaign, the business owner reveals the business plans, structure, goals, and other vital information. Therefore, all this information is available to the public, and other companies can copy your business model. It is a risk that any business owner has to consider.
There are some disadvantages for investors as well when involved in debt-based crowdfunding. For instance, P2P funding corresponds with lower returns on investment. This is because, with such a crowdfunding model, investors have significantly lower risks. As a result, returns on debt funding range between 5% to 9% per annum. It should be noted that even though debt-based investments have lower risks, the investment platforms still will require to do the same level of due diligence as the venue would ask for equity-based investment.
Both the debt-based and equity-based crowdfunding models are great ways to raise funding for business development. However, the decision to which model chose solely depends on the nature of the business, its operations, and the related funds needed. Therefore, the business owner needs to know the maturity of the company. Knowing the exact maturity stage will ease the decision process, as it's easier to see which funding option is more appropriate for business growth.
For investors, any investment comes with rewards and some risks. The key to deciding how and where to invest is balancing the risks and the rewards. For instance, if the investor is willing to take slightly higher stakes, it will receive a somewhat higher return; thus, the best choice would be to go with equity-based investments.
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