Crowdfunding

What they are

Crowdfunding is when people who need funds for projects or personal reasons ask the general public for funding, usually on an online platform that makes it easy for those who need funds (typically individuals, firms or non-profit associations) to meet those willing to fund projects.

This is the definition according to the European Banking Authority (EBA) but put simply, what does it mean? Crowdfunding is a way to get a loan without having to apply to a bank, instead using specialized websites to look for people interested in lending money (often everyone involved lends a small sum).

All types of crowdfunding involve a project and many supporters who provide money to help realize it, but there are differences in what is offered in exchange for these contributions:

  • The reward-based model (such as that of the Kickstarter platform) offers an 'emotional' kind of reward (such as having your name on the credits of a self-financed film), or a prototype of a product once it's ready for the market.
  • The donation-based model (used by charities and generally by non-profit organizations) doesn't include any kind of economic reward at all.
  • The lending-based model (social lending or peer-to-peer lending) is where interest is paid on the money lent: the interest rate on the loan is normally higher than that offered by banks.
  • The equity-based model is the most popular with start-ups and in this one, those lending money become partners in the firm.

Interested parties

Anyone who needs a loan and anyone who wants to invest sums of money in specific projects. Just like in a market, these online platforms put together the demand for loans - people asking for financing for projects, but also for small expenses that they wouldn't be able to afford otherwise - and the supply of money from people willing to lend some small sums at an interest rate agreed and managed by the platforms.

Strengths and drawbacks

Crowdfunding platforms can be used to ask for a loan for all kinds of reasons: someone might need a small loan for special medical treatment, a small entrepreneur might want to launch a new product (in this case, those investing money might not be repaid with interest but with the first products made that would cost a lot more on the market), or companies may be looking for lots of investors for projects that need serious funding and promise to repay the loan at high interest. Because it is so versatile, it's one of the most interesting of the FinTech instruments, i.e. those that use financial technology.

Expenses

As we have seen, crowdfunding platforms can collect money for all kinds of reasons; this variety of purposes is often reflected in the intermediation costs. Since there are no rules or specific limits (for those asking for and those providing money) on these costs, you should always read the contract terms and conditions, which must be shown on the platform website and in the contract to be signed (even if it's only in digital form).

Underlying rules

The only type of crowdfunding in Italy that is regulated is the equity-based model. In this case, it is regulated by Consob, which is the Companies and Stock Exchange Commission that protects investors and, more generally speaking, the Italian securities market. Lending crowdfunding, i.e crowdfunding to get loans, must be compatible with the general rules of the banking system (Consolidated Law on Banking - TUB). In November 2016, the Bank of Italy published 'Disposizioni in materia di raccolta del risparmio da parte dei soggetti diversi dalle banche' (Provisions for fund collection by entities other than banks) in which it set the rules to safeguard those who provide money. Specifically, it strengthened the collateral requirements for cooperatives that receive social loans, and introduced transparency requirements to make savers more aware of the characteristics and risks of crowdfunding. You can find more information on crowdfunding on the websites of the Bank of Italy and of Consob.

Pitfalls

One important thing, which you shouldn't underestimate when you decide to lend money on crowdfunding platforms as a form of investment, is the creditworthiness of those asking for loans.

You should remember that in a non-binding opinion of 2015, the EBA underlines that the risks of investing on these platforms come from more than one source. On the site where the company operates, it needs to be made clear that you risk partially or totally losing the money you invested, that you might not make the profit you expect and that the lender may go bankrupt or have no liquidity.

Keywords

CROWDFUNDING

Crowdfunding is an innovative way of sourcing funding for new projects, businesses or ideas. People (typically individuals, firms or non-profit associations) who need funds for projects or personal reasons ask the general public for funding, usually on an online platform that makes it easy for those who need funds to meet those willing to fund projects. Crowdfunding is most often used by startup companies or growing businesses as a way of accessing alternative funds.