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Crowdfunding is a finance technique that uses the internet to match investors and borrowers for projects of common interest. A social motivation is always present in this matching. Crowdfunding can be classified in non-financial (donations, rewards) and financial (peer to peer lending, or equity-related investments). In non-financial crowdfunding, investors are attracted by some characteristics of the project (e.g. their local engagement, possible job creation) and donate money without pro-quo, sometimes in exchange for a pre-order of a product, or a ticket to a show. In financial crowdfunding, there is also an expected monetary return.
Financial crowdfunding can be classified in peer-to-peer lending and crowdinvesting. The main benefit of crowdfunding is that it closes part of the finance gap that firms observe, in a shorter time span (usually in less than 60 days) than traditional bank lending. It also brings non-financial benefits, such as validation of R&D outputs, an estimation of the potential demand for a product, and brings in knowledge, network and expertise from founders. Crowdfunding also presents some risks, notably, risk of project failure, fraud, and lack of an exit option, as there is no secondary market to trade the investments.
Crowdfunding as a funding source for projects has been increasing rapidly since 2009 (first year with records of activity), although total amounts invested still remain small. Some Latin American countries (notably Mexico and Argentina) have active financial crowdfunding platforms. In the Dominican Republic, the existing crowdfunding platform (jompeame) is non-financial. In the international context, the European Venture Capital Association presents the amount invested in equity-related projects in Europe in 2013, and compares them to venture capital investments, showing that, although increasing at a rapid pace, volumes invested in this instrument are still minor. Gordon Mills and McCarthy provide a comparison of the amounts invested through peer to peer lending in the United States with the online SME loan market, again showing the (still) small relative importance of this instrument.
Crowdinvesting in Europe, 2013 (million EUR)
Source: EVCA (2014)
Online SME loan market in the United States, Total Debt Capital Outstanding as of 4Q2013
Source: Bank loans data taken from FDIC Call Reports, SBA data sourced from SBA publicly available information; Credit card data sourced from creditcards.com; remainder sourced from interviews with industry experts, and author's analysis.
Source: Gordon Mills and McCarthy (2014).
There are a number of specificities to crowdfunding, which may impact its ability to finance SMEs. First, crowdfunding finances projects, not firms. It therefore alleviates only part of SME finance needs, but it is not suitable as the main funding source for firms and entrepreneurs, because it cannot cover working capital or growth needs unrelated to new projects.
Second, crowdfunding depends on well-functioning bank instruments. Bank accounts, credit cards, an online payment system and credit records are all necessary for crowdfunding to work. Amounts traded through crowdfunding are relatively small and, so far do not present a systemic risk. Moreover, there is no leveraging of finance, as the amounts lent go directly to project financing.
It will be necessary to monitor the evolution of this instrument, in order to assess the appropriate regulatory environment for crowdfunding. To do so, more information on this phenomenon is needed. At present, there is no publicly available data on the previous use of crowdfunding of the borrowers, to further assess their characteristics, the evolution of the amounts needed, and the projects financed. This information would be useful in identifying potential measures to support the use of crowdfunding as a finance instrument.