Crowdfinance in Context of Corporate Finance

Table of Contents

Register of illustrations

1 Introduction
1.1 Problem Statement and Objective
1.2 Course of Analysis

2 Conceptual Delineation
2.1 From Crowdsourcing to Crowdfinance
2.2 The Crowd
2.3 Crowdfinance

3 Crowdfinance - A Corporate Finance Alternative?
3.1 Theory of Financial Intermediation
3.2 Monetary Recognition
3.2.1 Crowdinvesting (equity-based crowdfunding)
3.2.1.1 Definition
3.2.1.2 Crowdinvesting by using the Example of Seedmatch
3.2.1.3 Chances of Crowdinvesting for Founder and Investor
3.2.1.4 Risks of Crowdinvesting for Founder and Investor
3.2.2 Crowdlending (lending-based crowdfunding)
3.2.2.1 Definition
3.2.2.2 Crowdlending by using the Example of Auxmoney
3.2.2.3 Chances of Crowdlending for Founder and Investor
3.2.2.4 Risks of Crowdlending for Founder and Investor
3.3 Non-monetary Recognition
3.3.1 Crowdsupporting (reward-based crowdfunding)
3.3.1.1 Definiton
3.3.1.2 Crowdsupporting by using the Example of Startnext
3.3.1.3 Chances of Crowdsupporting for Founder and Investor
3.3.1.3 Risks of Crowdsupporting for Founder and Investor
3.3.2 Crowddonation (donation-based crowdfunding)
3.3.2.1 Definition
3.3.2.2 Crowddonation by using the Example of Betterplace.org
3.3.2.3 Chances of Crowddonation for Founder and Investor
3.3.2.4 Risks of Crowddonation for Founder and Investor
3.4 Factors Influencing the Use of Crowdfinance
3.5 Critical Examination

4 Summary and Conclusion

Bibliography

Register of illustrations

Illustration 1: Seedmatch in Numbers 2014

Illustration 2: Collected capital through crowdfunding per platform in 2014

Illustration 3: Betterplace.org - Donation and the factor of age

1 Introduction

Many companies transact their business processes online to enhance their effectiveness and productivity. The entire business concept of some enterprises is based on the worldwide data network. Also financial matters are more and more solved online. Bank customers are well informed by the Internet and willing to make use of different financial services of different providers simultaneously. This willingness is supported by the comparability of financial services in blogs, forums or social networks.

The services of traditional banks did not develop significantly during the last years. In contrast to this there are remarkable changes in macroeconomical, political and social surrounding conditions. Those affect the banks in a sustainable way and offer new com- petitors market access. Especially the availability of technology have an effect on the business activities of credit institutions, that transfer innovations only partial in turn. Simultaneously costumers show increasing experience and affinity with the handling of technology based financial services. Due to this they get a quick and easy access to in- formation that is not available in analogue environment in that extent.

Crowdfinance has a great importance in this development. It is an alternative form of financing online, mostly for small to medium scale capital sums. Generally there is a project or business funded by a plurality of persons. The roots of crowdfinance are found in the generic category of crowdsourcing, which focus is on working with crea- tive ideas and approaches of the crowd. Although the main features of crowdfinance go far back into the past, the subject matter moves closer into the public focus since only a few years. A reason for this popularity is amongst others the dispersion of social networks like Facebook, Twitter and innumerable blogs. By its ability to link the users among each other the Internet offers new and variegated possible applications to finance project ideas. In addition, the missing fulfilment of financing demand for small to medium scale capital sums¹ as well as increasing uncertainness in international capital markets play a major role.

1.1 Problem Statement and Objective

Many start-up entrepreneurs are confronted with the problem and demand of the ideal form of financing. The cause of this is primarily a lack of financial supporting on the part of informal and national investors, especially in the start-up business.² Projects are often too risky for credit institutions³, too large for family and friends and too small for venture capital companies. While there is professional support for large capital sums in terms of joint ventures, banks or markets, there are merely the own savings or the support of family and friends⁴. The idea of crowdfinance is to close this gap with the financial help from the general public instead of approaching investors like business angels or venture capital funds. The method of crowdfinance offers the opportunity to seek capital for project investments and start-up businesses. is the reason why crowdfi- nance cannot only be a possible addition but also an alternative for corporate finance.

In this paper the main focus is put on the question if crowdfinance is proper as full fi- nancing alternative and not only as a possible addition. Crowdfinance will be presented in its entirety and the essential forms of characteristics will be disclosed and analysed. The differences of these forms are only shown by closer inspection. So there result sig- nificant contrasts in consideration of different projects. Thereby the motivations of investors as well as the chances and risks for the financing enterprise will be subsequently explained in detail.

1.2 Course of Analysis

To discuss the question if crowdfinance is proper as a corporate finance alternative a conceptual delineation is necessary first. This points out the concept of crowdfinance and functions as a theoretical introduction to the topic. Subsequently, different types and characteristics of crowdfinance are examined. Numerous examples of online crowd- finance platforms produce practical relevance of the topic. Due to the plurality of possi- ble platforms only the ones of greater importance are analysed. Because of the fast pace in terms of online structures, platforms and projects this analysis is understood as a snap-reading method. After the analysis of certain platforms the factors that influence the use of crowdfinance are discussed. In the end of this paper the substantial findings are summarised and a consequential conclusion about crowdfinance is drawn.

2 Conceptual Delineation

This chapter defines the scope of different concepts in reference to crowdfinance and builds a basic understanding for the following chapters.

2.1 From Crowdsourcing to Crowdfinance

The phenomena of crowdsourcing is defined as an activity that „takes place when a profit oriented firm outsources specific tasks essential for the making or sale of its product to the general public (the crowd) in the form of an open call over the internet, with the intention of animating individuals to make a contribution to the firm's pro- duction process for free or for significantly less than that contribution is worth to the firm”⁵. Crowdsourcing outsources activities that have been performed by the company itself so far. Put differently, companies create value by using the customers’ taskforce. It aims at the use of creative ideas and solutions of consuments that are integrated via internet into the value chain⁶. The crowd serves not only as a creative potential for companies but also as economic factor. The most famous examples are the online encyclopaedia Wikipedia and Google maps. While Wikipedia is the most often used online-reference in the world that can be corrected and added free by every user, Google provides with its map software Google maps information about the current state of traffic by an evaluation of dynamic user data (position and speed).

In reference to “crowd wisdom”⁷ by Surowiecki crowdsourcing can be classified into four sub-categories:

1) Crowd wisdom: A group generally comes up with a larger pool of collective knowledge than an individual. The shared knowledge can contribute to problem solving and estimate future developments.
2) Crowd creation: The creative performance of a crowd is used for the creation of further activities in the value chain. The collected ideas of the crowd will be applied in terms of texts, audio files or graphics.
3) Crowd voting: The opinion and discernment of the crowd is used to organise, filter and rate decisions concerning the mass of information.
4) Crowdfinance: The funding of project and business ideas by the crowd.

2.2 The Crowd

“The crowd consists of individuals connected to other individuals through the inter- net.”⁸ The human crowd is necessary to implement a project. Companies make use of the crowd mainly for cost- reduction reasons. Within the crowdfinance process individuals provide the capital needed to the particular company that will invest in a special project.

Alpheus Bingham, founder and member of the crowdsourcing specialised company InnoCentive, concretised in his interview “Using Crowd Power for R&D”⁹ the ideal size concerning the number of persons involved in a crowdsourcing project. Although the size of the crowd plays an essential role in crowdsourcing, Bingham defines a crucial limit of 5.000 persons at most. It depends strongly on the diversity of persons’ respective education and experience of life. It is a challenge to make the right choice of persons in order to support and implement a project.

Why do individuals take part in the crowd? A study indicates that many projects financed by the crowd do not offer a reward to the investors.¹⁰ Participants on crowd projects have motivations that can be intrinsic or extrinsic. Intrinsic motivation describes the pleasure of doing a particular task. Extrinsic motivation refers to an external reward, as money and goods, career benefits, learning or recognition.

2.3 Crowdfinance

Crowdfinance (or crowdfunding) is a special form of appearance of crowdsourcing and “involves an open call, mostly through the Internet, for the provision of financial resources either in form of donation or in exchange for the future product or some form of reward and/or voting rights”¹¹. Crowdfinance is the funding of a project or a venture by a group of individuals instead of professional parties such as banks, venture capitalists or business angels. It identifies an alternative form of financing and takes advantage of the crowd in order to finance a certain project. In the last years it has be- come more and more important as the media and social networks drew interest of the publicity. Lawton and Marom explore the potential of it: “Just how encompassing crowdfunding is, speaks to the enormity of its potential for economic and social impact. In the same way that social networking changed how we allocate time, crowdfunding will change how we allocate capital”. It is a great “potential to tap an almost unfathomable collective intelligence to pricess this collective complexity”.¹²

Crowdfinance is usually organised and processed on web based platforms. Several investors, who get involved by using social media platforms, fund the here presented projects. Especially the variety of projects affects crowdfinance to a great extent. Sporadically there are also offline projects that are communicated through other media.

3 Crowdfinance - A Corporate Finance Alternative?

The chapter discusses crowdfinance as an alternative way of financing projects. In doing so there will not only be a holistic explanation but also a detailed treatment of special characteristics. At first a short definition of each manifestation is used as an introduction. This is followed by practical examples for each manifestation which are used as an illustration. In addition to the examples this short term paper will give an overview of the risks and chances of the founder and investor when using the specific manifestations.

There exist different characteristics in terms of crowdfinance. In order to clearly arrange the types of crowdfinance, which range over hundreds of online platforms worldwide, there will be two different categories. The service in return that results from successful financed projects varies from, firstly, monetary to, secondly, social recognition¹³. Those two categories will be again subdivided, so that there exist four types of crowdfinance altogether.

3.1 Theory of Financial Intermediation

Financial Intermediation contains all processes with the aim of bringing together capital supply and demand and matching them with one another. Thus, banks function as intermediary between economic subjects, that have a demand for the taking up of capital, and those that generate surpluses and want to invest capital. They are defined as corporations of distribution that assume a bundle of activities in order to balance monetary flows, and whose substantial elements are the exchange, the lodging, the transport and the provision of liquid funds.¹⁴ However, it is also possible that the ex- change of capital supply and demand take place without a bank as the intermediary. Web based platforms and other financial service provider can also take on the role of the intermediary, which will be assumed in the further course of this chapter.

3.2 Monetary Recognition

3.2.1 Crowdinvesting (equity-based crowdfunding)

3.2.1.1 Definition

Crowdinvesting, based on the definition of Moritz & Block, is the collection of financial contributions from several investors, who mostly buy smaller shares of a (start-up) company via the Internet. The investors receive a share of the company capital with profit sharing. This often happens by giving a silent participation, profit participation rights or equal credits.¹⁵

Especially in Germany crowdinvesting differs from the American model. Due to the subordination of the investors in the German contractual models it refers to investment capital with the character of equity, more precise, it is a form of mezzanine-finance. This can be noticed by looking at the contractual models that also imply typical characteristics of outside capital.

The first investment platforms that are connected with the term crowdinvesting were ProFounder, Fundable, Microventures (USA) and Crowdcube (GB) in 2009. Compa- nisto and Seedmatch represent the most important platforms in Germany. Especially in the US there is a regulation under the name of CROWDFUND Act in Title III of the Jumpstart our Business Act (JOBS Act). This act support small companies to enter the public capital market more easily. The CROWDFUND Act creates an except for the compulsory registration and regulates according to Section 302 §6 (B)¹⁶:

(i) The greater of $2.000 or 5 percent of the annual income or net worth of such in- vestor, as applicable, if either the annual income or the net worth of the investor is less than $100.000; and
(ii) 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100.000, if either the annual income or net worth of the investor is equal to or more than $100.000.

The background of this regulation is formed by the Securities Act from 1933.

3.2.1.2 Crowdinvesting by using the Example of Seedmatch

Seedmatch is one of the most influent online platforms for crowdinvesting in Germany. The company is located in Dresden. Seedmatch was founded in 2011 and it was the first online platform in Germany that offered private investors to invest in young, upcoming and trendsetting (start-up) companies.

By using the financial support of many small investors, large amounts of money can be collected easily to support the founders and their projects. Since the launch of Seed- match more than 75 successful investment rounds were realised and over 21 million euro could already be collected. Over 9000 investors already gained experiences in in- vesting on Seedmatch. Seedmatch is the largest crowdfunding platform in Germany.¹⁷

illustration not visible in this excerpt

Illustration 1: Seedmatch in Numbers 2014

Source: Seedmatch (2014)

But how does investing on Seedmatch work?

The investment contract refers to the, so called, equal subordinated loans. It was developed over several months in a coordination process involving different types of groups like start-ups, lawyers, venture capital-companies, business angels and investors. Before making any investment decision this defined contract can be inspected in a pdf- file on Seedmatch.¹⁸

The first step to become an investor on seedmatch is to register on the Seedmatch homepage. The registration is for free but according to the rules of Seedmatch you have to be 18 years of age and a German bank account is required to participate. After com- pleting your profile potential investors can search through all the different start-ups and projects to get an idea what fits their interests. Once the investor finishes the selection the investment process starts with a personal start-up analysis. The investor needs to check if there is a kind of identification with the team and products and most important raise the question whether there is a potential market for the product. In case of any further questions the investor can quickly get into contact with the founders by using a contact form.¹⁹

When an investor is convinced of the concept there is a level between 250€ and 10.000€ that can be invested. This decision is made according to the investor’s financial status and what chances the investor sees in the investment. After taking the investment the money is managed by the Secupay AG that transfers the amount collected to an escrow account. Now the investor needs to wait until the deadline that was set up for the project is reached. In case the funding barrier is reached the investment takes place, otherwise the investor will get their invested money back.

What rights do the investors have after a successful investment?

Due to the contract with the equal subordinated loans the investors are not given the right to a say. They get the possibility to log-in to an internal investor-relation platform that is also located on Seedmatch. The investors can communicate with the founders and participate actively. The rights of information are clearly structured. The start-up needs to communicate its quarterly reports to the end of the months January, April, July and October and in addition to that, the yearly report through the investor-relation chan- nel on Seedmatch.²⁰

There is a yearly, final maturity fixed interest rate of about 1% and a profit-based yearly bonus interest-rate. There are three possible scenarios afterwards. One is the cancellation. In this case the investor is able to cancel the contract after the minimum runtime and they receive a one-time bonus interest rate.

Second scenario is the exit. If more than 50% shares of the founders are sold, the investor is participates on the exit profits - in the height of their individual investment quote.

Last scenario is the insolvency. This could always happen. In this case the investor loses all the invested money.²¹

3.2.1.3 Chances of Crowdinvesting for Founder and Investor

The main reason for a founder to use crowdinvesting is the current situation on the financial markets. It is hard, especially in the founding phase, to receive credits the “old-fashioned” way, by asking your bank.²² The other most important reason for using crowdinvesting is the fact that you can get many interesting new ideas and the knowledge from all your investors to push your start-up into the right direction.

Other important aspects that need to be mentioned are the mobilisation of the masses and the multiplier effect. The higher the activity in social media and the higher the awareness level of the platform, the higher is the potential to find investors for the individual start-up. It is not just that the masses will be lenders of capital, they can also form a potential new target market. A study of McKinsey showed that the per capita sales of companies that are more active in social networks or platforms like Seedmatch is higher than the per capita of those companies who do not actively participate in social media.²³

Main reasons for investors to use crowdinvesting are the wide distribution of risks and the low transaction costs. They can invest way smaller amounts of money in different start-up companies that raise their interest. Another reason is that there are less market limitations than in the traditional way.

[...]

¹ Cp. Colombo, M. G., Grilli, L. (2007), p. 26

² Cp. Schwienbacher, A., Larralde, B. (2010), p. 3

³ Cp. Söderblom, A. (2012), p. 20

⁴ Cp. Lahm, R. J., Little, H. T. (2005), p. 15

⁵ Kleemann et al. (2008), p. 6

⁶ Leimeister, J. (2012), p. 388

⁷ Surowiecki, J. (2005), p. 280

⁸ Fink, A. C. (2012), p. 5

⁹ qtd. in Dorner, K. (2012), p. 5

¹⁰ Lambert, T., Schwienbacher, A. (2010), p. 9

¹¹ Belleflamme et al. (2012), p. 7

¹² Lawton, K., Marom, D. (2010), p.1

¹³ Cp. Ordanini, A. et al. (2011), p. 445

¹⁴ Cp. Süchting, J, (1992), p. 7

¹⁵ Cp. Moritz, A., Block, J. (2014), p. 57-90

¹⁶ The CROWDFUND Act Section 302 §6 (B) (2015)

¹⁷ Cp. Seedmatch Facts (2015)

¹⁸ Seedmatch (2015): Risk notifications

¹⁹ Seedmatch FAQ (2015): Registration

²⁰ Cp. E-Book: Seedmatch Crowdfunding Manual (2015)

²¹ Cp. Seedmatch FAQ (2015): Scenarios

²² Cp. Handelsblatt, Littmann, S. (2012)

²³ Cp. McKinsey (2010