Feature Story

Crowdfunding: Finance in the Facebook Era

by Amy Cortese

How businesses can raise small sums of money from many individuals, often more quickly and on better terms than with conventional funding sources.

When Bubble & Baum, a British maker of fair trade natural body products, needed capital to expand, it didn't head to a bank or a well-heeled venture capitalist. Instead, the Warwickshire-based company turned to Crowdcube, a Web platform that lets small businesses raise funds from individuals. A total of 82 people invested between £10 and £7,500 a piece to buy £75,000 worth of Bubble & Baum shares, for a 15 percent stake in the company. "We now have the funds we need and a great team of supporters," says Bubble & Baum founder Sue Acton.

With credit still tight and venture capital out of reach for many small firms, "crowdfunding" sites such as Crowdcube offer an attractive alternative. By raising small sums from many individuals, businesses can access the capital they need to grow and thrive, often more quickly and on better terms than with conventional sources. And, their new investors often become their best customers and boosters. For investors, the crowdfunding sites offer a chance to make above-market returns and share in the success of a company they admire and support.

A Crowded Field

Crowdcube, founded in 2010 in Exeter, calls its crowdfunding model "the next generation of business investment." And sure enough, the competition is lining up. Seedrs.com, a London-based startup that will let investors buy shares in seed stage companies, plans to launch in early 2012.  Meanwhile, GrowVC, a company based in Hong Kong with global offices, bills itself as a "virtual Silicon Valley." Other sites, such as London-based Funding Circle, crowdfund small business loans, rather than equity. (Still others, such as Zopa.com in London and Prosper.com in San Francisco, focus on person-to-person lending).

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Fueled by the potent combination of social networking and finance, these sites—many of which are springing up in the United Kingdom, thanks to its accommodating securities laws—bypass traditional gatekeepers and allow any citizen to become a banker or VC. That could open up vast new pools of capital for cash-starved entrepreneurs and usher in a more democratic form of finance.

"The aim is to reinvent a large portion of the financial system in the UK," says Samir Desai, a cofounder and director of Funding Circle. "There are so many inefficiencies in small business lending." On Funding Circle, a company can get its loan funded in as little as 10 days, compared to the 15 to 20 weeks it can take to get a bank loan. Very often, the interest rates the company pays are lower, as well.  "It's a better model," Desai says.

In its first year, Funding Circle has attracted nearly 5,000 lenders—who earn an average return of 7.4 percent after fees—and more than 300 small business borrowers. Most lenders spread out their investment over multiple loans (which are unsecured) to mitigate risk, although so far only two borrowers have defaulted. The site has become popular with investors looking to support local businesses while earning a decent return. Funding Circle's members are funding loans at a rate of £2.3 million a month. The average loan is £40,000 and funded by 500 different lenders.

Social Media is Key

The process may look simple, but under the covers, crowdfunding sites rely on scalable networks and sophisticated financial technology. Funding Circle, for example, combines elements of a stock exchange for bidding on loans, and a loan servicing platform capable of spreading payments out over many individual lenders.

The crowdfunding sites also take advantage of the Internet to provide a high degree of transparency, allowing members and potential investors to see all of the investments made to date and their performance. Social networking is also a crucial piece of the equation. Funding Circle, for example, encourages members to form "circles" of interest. Groups have formed to lend money to small businesses in particular regions, such as East Midlands or London, as well as to types of firms, whether manufacturers or socially responsible companies. The sites also encourage active discussion forums for members.

"Networks are key and social media is the way to reach them," says Jeff Lynn, the CEO of Seedrs. He figures the first 20 percent to 40 percent of an investment might come from friends and family, which will then attract a broader group of investors. "We think there's a huge validation and trust factor when you see a business run by a friend of a friend," Lynn says.

Should banks and financial gatekeepers be worried? So far, crowdfunding is a niche business, but it is growing fast. And as the spreading Occupy Wall Street movement suggests, people are looking for alternatives. Says Desai: "We're just scratching the surface right now."

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