In 1997, fans of a British rock band – Marillion – underwrote their entire U.S. tour by raising $60,000 in donations through a fan centric internet campaign in a time when wearing baggy jeans or neon colours didn’t catch the eyes of the fashion police. This was the time when the term “crowd funding” truly gained popularity despite its inception in the 18th century in the form of war bonds. It was only in 1998 when proper reforms were put into place and the term “crowd-funding” was welcomed to conventional speech.

Crowd-funding is the practice of funding a venture by raising small amounts of money from a large number of people, generally through the internet. There are platforms on the internet – such as Kickstarter and Indiegogo – where people can set a target amount of funds to be raised – called the goal or target – and then all the people logged on their platform would have the option to pay some amount which would go directly into the account of the venture. In return, the website takes a small portion of the amount raised as its fee. It is a method of micro financing which is quite common in the modern world. In a nutshell, it may seem similar to stocks to an individual, but on delving deeper, one would realize that the differences are more pronounced than the neon signs at the Marillion concerts in 1997.

The most significant difference has to be the fulfilment of legal obligations which one has to comply with in order to invest in the stock market. As a result of this, until recently raising money through crowdfunding was a lot easier than raising funds through initial public offers in the stock market. The dynamics of transfer of ownership determines crowd-funding’s feasibility too, as it always takes place in case of issuing shares. For crowd-funding, on the other hand, only in the case of equity based crowdfunding would there be dilution of control, while in all other forms there is generally not any dilution of control or loss of equity. Moreover, when receiving money from issue of shares, the money has to be transferred to a seperate account, called ESCROW account, which the company cannot withdraw from for any purpose before it receives the amount of minimum subscription and commences it’s operations, while some forms of crowdfunding (like reward based crowdfunding) even allows the entrepreneurs to circumvent this hurdle.

There are four types of crowd-funding – debt based crowd-funding, equity crowd-funding, donation crowd-funding and reward based crowd-funding.

Debt based crowd-funding is fairly similar to any other debt source where people lend money for getting some interest on their returns (generally the rate is lower than bank’s rate). Similarly, equity crowd-funding is somewhat similar to issuing shares as it leads to transfer of ownership but has lesser complications and lesser cost of raising funds. For donation crowd-funding, people simply give their money for some cause or product they believe in without expecting anything in return, but generally the company gives them some token of appreciation such as some T-shirt, mug, etc. or display their name as contributors on their website. Finally, we introduce reward based crowd-funding. In this form of crowd-funding the people pay the money but not for getting monetary returns on their investment rather for some “gift” that is being offered. It may be anything ranging from some product such as a video game to some service such as a meal in a restaurant.

Reward based crowdfunding is particularly interesting as it doesn’t resemble any other previous form of investment vehicle or method of raising funds. The concept is relatively new as the industries using this method of financing are also relatively modern. This type of crowdfunding is popular mainly in the video game industry and some service industries such as the restaurant business. This is because these are industries where the customers’ opinions of the product are extremely essential. For example, let’s take a video game. Such a product requires a large amount of investment which can be seen in its price (ranges anywhere between Rs 500 to Rs 4000). Success of such a product (or any product for that matter) is heavily dependent upon the preference of the people. Because of the high prices and a large number of options any game deemed to be “boring “ would mean massive losses for the company producing that game as the cost of mass producing, distributing, programming are very high and generally unavoidable regardless of success of the product.

The major issue here is that all these expenditures have to be incurred before the product goes out to the market (i.e. before people could give their opinion about the game). This means that the risk associated would be too high. This is a situation where reward based crowdfunding is the perfect option. The people who find the concept of the game interesting could “pre-order” that game, for a certain amount which would act as finance for the company to actually make the game. On receiving the pre-ordered game, the customers act as beta testers and are able to give their opinion on the game, on receiving a positive reception the developers could go forward with the idea , on receiving a negative review they can “kill” the idea there and then, incurring no losses at all.

The above example perfectly demonstrates how crowdfunding helps in reducing risk. In cases of restaurants, it also helps in creating early demand and creating an early “club” of people who can be focused on to be made regular customers, effectively creating a “club” of customers that business could cater to. What this means is that even before officially commencing its operations the business would already have a customer base which acts as a source of revenue and feedback. On the flip side, even if the idea fails, there would be no legal obligation to return any amount to the customers, as in effect; they have consumed the product they had paid for beforehand.

But, don’t judge the pretty picture by its dynamic colours. Since the medium has to be the internet, the idea would be put out there without any patents; this would probably lead to the idea being plagiarised, not to mention that it is not generally possible to raise large amounts of funds through this method owing to their unsecure nature. Despite the exceptions, most of the Kickstarter campaigns could take months to hit their goal in which time many other similar campaigns would pop up. Moreover, unlike some other forms of crowd-funding, in some cases, if the venture is not able to achieve it’s goal, it may have to return the entire amount back and it cannot start using the amount received until the amount set as goal has been achieved (except, as previously mentioned, in the case of reward based crowd-funding); Meaning there’s no scope for any sort of underwriters to ensure that the venture raises the required funds.

Let us now introduce the different facets of the premise of crowd funding and how the masses perceive it as a practical go-to. “Star Citizen” is a video game set to be released in 2020 and boasts to be the most expensive video game in the gaming history. As of 30th June 2019, the game developers claimed to have raised a whooping $250 million and had blown through most their funds. It’s claimed to be one of the most ambitious projects ever. However, there are still few reasons to be cautious. According to precedents, there have been games which were crowd-funded and hyped to be the “next-big-thing”, but couldn’t live up to the hype. As a result, they failed to meet deadlines and deliver in terms of features leading to widespread protest against the developers, to the extent of death threats from angry users.

This drastically changed people’s perception of crowdfunding, where instead of seeing it as an investment people just saw it as a pre order cost and donated the amount they saw fit rather than being generous. The argument which people give is that if they have a small amount of excess savings left, say $50, then investing such a small amount may not be of much help to their portfolio so they prefer to spend this amount on something which they find “fun”. This works out for the economy as it still technically is a form of investment and would contribute to the stimulating growth of the country as opposed to being saved by individuals as petty cash.

Incidents like these could affect people’s perception of crowdfunding. Sentiments are not just exclusive to the stock market. Let’s take India, for instance. In 2016, SEBI (Security Exchange Board of India) had put a hold on the growth of crowd-funding in India. In a country blessed with genius cons in the stock market – despite the strict regulations – something so unregulated as crowdfunding could have caused chaos among the public. Thus, SEBI had imposed severe restrictions and sent show cause notices to these platforms for raising money. But, over the last few months SEBI has allowed many crowdfunding firms to register under it as “alternative investment platforms “or AIFs. Some prominent examples are Angel List One Crowd and One Venture. Moreover, it’s not completely regulations-free. For example, these AIFs could only pool money from people whose net liquid worth is more than Rs. 2 crores and the minimum investment must be Rs. 1 crore. Additionally, the company seeking the investment must be categorized as a start-up by the Department of Industrial Policy and Promotion (DIPP) and only investors with prior experience could invest money on these platforms.

On the first glance, these restrictions may seem too harsh, especially when compared to acts regulating crowdfunding/micro financing in other countries such as the JOBS (JumpStart Our Business Start-up), 2012 of the U.S. by President Obama’s cabinet. This Act was specifically brought into existence to legalize and remove all restrictions and complications regarding crowdfunding in the country to promote the entrepreneurial spirit among the public. With the danger of irregularities always looming over the country, it is only natural for our country to be cautious rather than liberal in this matter.

With the slowdown looming over and ominous signs like the yield curve inverting, SEBI should consider being a bit liberal with its restrictions in this sector. India has been called the “sleeping giant” in terms of potential, but has not yet been able to tap into this potential. While the propensity of irregularities and frauds has persisted over the years, India has not slowed down in terms of growth up until recently. Thus people now are demanding for certain stimulating decisions from the government and this could definitely be a step towards this. While there have been cases of dissatisfaction and animosity among the people in the past in cases of failed crowdfunding campaigns, it still remains one of the most convenient and cheapest micro financing vehicles. As far as risk is concerned, it’s a part of every investment vehicle and at a time when there is “bear” in the market and there are hardly any new IPOs (initial public offers); crowd-funding could “kick-start” the economic engine.

By Harsh Singh