By Daniel Ling CrowdFundBeat contributing guest editor firstname.lastname@example.org
Crowdfunding is becoming increasingly regarded as the ideal future for startups and small-scale ventures. Across all debt-based and equity-based crowdfunding projects lies a sense of freedom and democratization. Anyone can start a campaign, and furthermore, anyone can support one, which broadens the landscape of investors and donors available to your project. The regulations for debt and equity-based crowdfunding that are in place provide more options for entrepreneurs seeking funding.
Defining Debt and Equity-based Crowdfunding
The emergence of the JOBS Act (hyperlink to our article on this topic) has drawn a lot of attention on the crowdfunding industry, especially in the nascent equity-based realm. Equity-based crowdfunding occurs when companies raise money through investors who receive shares of equity in the company in exchange. Traditionally, equity financing started and stopped with angels and venture capitalists; however, the equity investment eco system is forever changed thanks to crowdfunding. A combination of early stage ventures who are unable to raise capital through debt, due to a lack of belief in their business model, and a number of companies who seek to raise equity in situations out of desperation also fit into this category of equity crowdfunding. This financing mechanism has allowed ordinary investors to take stakes in companies that were previously only accessible through niche investment syndicates and well-connected, wealthy individuals.
Debt-based crowdfunding is more suitable for situations where revenue growth is inadequate and the asset to liabilities ratio is crumbling. “Lenders” is a more appropriate term for the players in the debt-based crowdfunding sphere rather than “investors.” Lenders provide much needed debt financing, receiving interest on their loan as opposed to an equity stake. Debt financing should be considered by a company only when the capital is raised for a single purpose over a defined period of time. Equity-based crowdfunding is on the horizon as the definitive next step for investors hoping to invest in both early-stage ventures and more established companies. Many describe debt crowdfunding or crowdlending as a form of peer-to-peer (P2P) lending. Under the debt structure for crowdfunding, investors are lenders on, rather than owners of, securities.
Real Estate Market as an Exemplar
The real estate market is one exemplar medium of how debt and equity transactions fit into crowdfunding. The level of risk aversion is different between the two types of crowdfunding. Traditionally, real estate has generated solid returns tied to a hard, durable asset. In the past, it was difficult for smaller investors to take advantage of these opportunities, as institutions and wealthy families mainly dominated real estate investing. The disruptive nature of crowdfunding is allowing an entirely new population of investors to participate in a realm that was previously and uniquely exclusive.
Debt Financing vs Equity Financing
Debt is best for companies that have both assets to borrow against and the cash flow to service the loans. Asset backed debt will help control the interest rate while ensuring that the late payments and the associated fees are avoided. On the other hand, debt is not ideal for companies that have tight cash flows and the regular dividends that are repayed may place too much pressure on the balance sheet.
Equity is more suitable for companies that already have raised a large amount of debt, as raising equity does not require additional repayment to the lender after maturation of the loan. The disadvantage of equity is that while the company is being financed, the entrepreneur or existing executive board gives up a certain amount of ownership to the outside investors. Young companies are often worried about giving up too much equity particularly at an early stage when the value of the business may not be high, and they would prefer to retain their founding principles.
Another differentiating factor of crowdfunded debt versus equity is the typical hold period for each type of investment. Hold periods tend to be shorter with debt, ranging from 6 to 18 months. There is more variation with equity on the other hand, with hold periods varying from 6 months to up to 10 years in some cases.
Regardless of the debt or equity foundation of a venture, arguably the most important characteristic of a company is the way the entrepreneur describes and presents the project, which in turn influences how willing others are to support it. Successful campaigns often include the story behind the project, and go beyond the simple “what.” The “why” is usually more important, and the most compelling stories are ones about people behind the idea. The passion of the people behind the project drives the passion of the investors.
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