— Att. Irem Sultan Gulden, LL.M

Oct 8, 2023

1. Introduction

As the financial world is getting digitalised perpetually, it is not surprising to see digital complementaries to traditional ways of raising capital. Although in modern finance we mostly see digital platforms facilitating crowdfunding, it is not a newcomer at all. Its roots reach back to the eighteenth century in Ireland (e.g. Irish Loan Fund and many similar ones after that), where small funds given by dispersed funders were lent out in small amounts. Numerous projects had been funded as well by small contributions of the surroundings, such as family members, friends, acquaintances, or some parts of the society. For example, The Statue of Liberty of America was completed with the funds provided by people upon the announcement of the call for donations. And Mozart, another well-known example in this regard, reached enough funds for his concerto tour with the contributions of his fans. History witnessed many examples of crowdfunding. With digital tools now integrated, the crowdfunding industry can flourish at its best.

In this blog series of which you are reading Part I, I aim to explore crowdfunding and the regulatory framework in Europe governing this area. In Part I, I am expanding on the concept of crowdfunding covering its definition, different models, and advantages to the economy.

2. What Does It Mean?

Crowdfunding is defined as:

“a collective effort by individuals who network and pool their money together, usually via the Internet, to invest in or support the efforts of others”.[1]

In this concept, a crowdfunding platform enables fundraisers and funders to meet. In other words, crowdfunding platforms are online marketplaces where the fundraisers launch their projects and potential funders find them.

3. Models of Crowdfunding

The concept of crowdfunding encompasses different models for the crowdfunding service. The classification of different models has been made based on several parameters so far, i.e. value propositions, practice patterns, funder motivations, risks and legal compliance needs of crowdfunding platforms.[2] Yet, a guiding distinction emerges from the expectation of the funder for a financial return in exchange for her contribution. In particular, while the following lending-based, investment-based and invoice trading models provide financial return, non-investment-based models do not.

(i) Lending-Based Crowdfunding

• Peer-to-Peer (P2P) Lending: Individuals or institutional funders provide a loan (secured or unsecured) to a business or consumer borrower.[3] This model is also referred to as marketplace lending. In this model, the platform serves as an intermediary between the funders and fundraisers. The borrower receives the loan by accepting an interest rate offered by the lender. This model resembles bank loans, yet differentiates by presenting decentralisation of lending by bringing it down to the individual level;
• Balance-Sheet Lending: The platform entity provides a loan (secured or unsecured) directly to a consumer or business borrower.[4] In this case, the platform functions as a fund giver, instead of being a mere intermediary.

(ii) Investment-Based Crowdfunding

• Debt-Based Securities: ‘Individuals or institutional funders purchase debt-based securities, typically a bond or debenture at a fixed interest rate’.[4]
• Equity-based Crowdfunding: An individual or institutional funders purchase equity issued by mostly an early-stage company.[4]
• Real estate crowdfunding: Investors finance a real estate project by directly investing in equity or subordinated debt securities of the property in return for receiving ownership of property assets.[2]

(iii) Invoice trading model allows small and medium-sized enterprises (SMEs) to sell their invoices or other receivables to individual or institutional investors at a discount.[2] It is a way of increasing financial liquidity for companies by selling out the invoices in hand at lower prices. It provides cash flow to SMEs.

(iv) Non-investment-based crowdfunding

• Reward-based crowdfunding enables backers to provide funding to individuals, projects or companies without monetary rewards or products.[2] Instead of financial return, backers receive products or services for their contribution. They may also be rewarded with getting their names published somewhere or receiving a letter of thanks.
• Donation-based crowdfunding allows donors to provide finance to ‘individuals, projects or companies based on philanthropic or civic motivations with no expectation of monetary or material benefit’.[2] In this model, donors do not receive any tangible reward in exchange for their contribution.
• Patronage crowdfunding enables donors to subscribe to individuals to make payments for an ongoing occupation or career.[2] ‘It is based on regular, typically monthly donations from patrons who continuously support creators (e.g., artists or journalists) or media enterprises’.[5] This model may be considered a subset of the donation-based model.

These are the “main models” that have taken place in the crowdfunding industry so far. The number of models presumably increase in the future, as crowdfunding is a very young and blooming area of finance.

The most known models by the general public are reward-based and donation-based models. These two are also older than investment-based models in the historical scene of modern crowdfunding. Yet, they were not so effective in igniting the European Commission to initiate a bespoke regulation for crowdfunding. A bespoke regulation came into play as late as when ‘loans (sometimes even if not remunerated) and/or investments are involved, not simple donations or pre-sales’.[6]

4. Advantages for The Economy

Crowdfunding is an excellent catalyst contributing to start-ups and SMEs, which are proven to play a crucial role in job creation. According to OECD’s findings, firms five years old or younger are responsible for 47% of job creation while accounting for only 21% of total employment.[7] This finding indicates that start-ups and SMEs are generating almost half of the new jobs in the total job market. This huge impact of SMEs on the job market was not overlooked by the European Commission either. Under the scope of Capital Markets Union(CMU) policy, supporting SMEs in seeking finance and alternative funding options — including crowdfunding, took part in the European Commission’s agenda for the purpose of strengthening Europe’s economy and stimulating investment to create jobs.[8]

Moreover, crowdfunding is very promising for the democratisation of finance by providing an alternative way for society to participate in the financial system.[9] It is also an important figure in the decentralisation of finance by removing the intervention of traditional subjects of finance (e.g. banks, credit rating agencies, etc.).[9]

5. Conclusion

Crowdfunding eliminates the complicated procedures and burdensome requirements of traditional methods of fundraising which may not seem appealing to start-ups and SMEs. Likewise, it eases the investment process for non-professional individuals. Different models of crowdfunding address different motivations of people and different needs of companies. As it meets the need in society for diversified finance and alternative investment channels, it is growing its proportion in the overall economy globally. With the help of ever-developing technology, crowdfunding recently started gaining importance more than ever.

References

[1] Ordanini, A., Miceli, L., Pizzetti, M., & Parasuraman, A. (2011). Crowdfunding: Transforming Customers into Investors Through Innovative Service Platforms, Journal of Service Management, 22(4), 443–470, as cited in Zhao, L. & Ryu, S., (2020) “Reward-Based Crowdfunding Research and Practice” Advances in Crowdfunding: Research and Practice, edited by Shneor, R., Zhao, L., & Flåten, B. T., 119, https://doi.org/10.1007/978-3-030-46309-0.

[2] Shneor, R. (2020), “Crowdfunding Models, Strategies, and Choices Between Them” Advances in Crowdfunding: Research and Practice, edited by Shneor, R., Zhao, L., & Flåten, B. T., 23–26, https://doi.org/10.1007/978-3-030-46309-0.

[3] Ziegler, T., Shneor, R., (2020), “Lending Crowdfunding: Principles and Market Development” Advances in Crowdfunding: Research and Practice, edited by Shneor, R., Zhao, L., & Flåten, B. T., 68–71, https://doi.org/10.1007/978-3-030-46309-0.

[4] Ziegler, T., Shneor, R., Garvey, K., Wenzlaff, K., Yerolemou, N., Rui, H., & Zhang, B. (2018), Expanding horizons: The 3rd European alternative finance industry report, 28, available SSRN 3106911.

[5] Galuszka, P., & Chmielewski, P. (2023). Digital Patronage: Toward a New Model of Building a Radio Station, International Journal of Communication, 17, 1862, available at https://ijoc.org/index.php/ijoc/article/view/20063/4082.

[6] Macchiavello, E., (2023) “Investment-Based Crowdfunding Platforms and Their Regulation” Forthcoming in ED Martino, H Nabilou, AM Pacces (eds), Research Handbook on Comparative Financial Regulation, Edward Elgar, available at https://ssrn.com/abstract=4474757, 1.

[7] OECD (2016), “No Country for Young Firms?”, Policy Note, Directorate for Science, Technology and Innovation Policy Note, June 2016, available at https://www.oecd.org/sti/ind/Policy-Note-No-Country-For-Young-Firms.pdf

[8] European Commission (2015), “Action Plan on Building a Capital Markets Union” COM(2015) 468 final.

[9] Supra [6], 2.