Much has been made about the ability of crowdfunding to transform new-business finance. Whether it is through a rewards based model, a peer-to-peer lending model or an equity finance model, the crowd has been theorised as the answer to a lack of appetite for risk amongst traditional finance institutions coupled with the always-present financial constraints placed on innovation.

Carrying crowdfunding through to its furthest potential conclusions, it has been theorised that it could take the place of banks for many functions – both for entrepreneurs and investors. It has also been put forward as a replacement to other forms of finance operating in the same sphere, such as angel investing and Venture Capital (VC).

But to achieve that potential, crowdfunding is going to have to prove it can answer a number of questions. For example: whether it can deal with dilution, whether it can produce successful exits and whether it can find solutions to secondary finance institutions being put off by too many stakeholders involved in crowdfunded businesses.

Banks are definitely undergoing significant backlash from a section of business and society in general, says Kevin Caley, managing director and founder of Thin Cats, a P2P lending site.”Some people have had such bad experiences with banks, they will never go to them again,” he adds. “Five to 10% of the people borrowing from us would never deal with a bank again.”

In fact the site’s name, Thin Cats, is a play on the reputation of bankers as ‘fat cats’ and how crowdfunding can provide an alternative. This can also be applied to investors and savers looking for a better rate of return. “Savers aren’t earning enough to cover inflation,” Caley says. “Every year their income is going down as they’re only earning a small rate of interest. P2P crowdfunding can offer a good savings opportunity that is not only a source of funds for business but also a better place to put your money.”

Funding Circle, another P2P lending site, sees crowdfunding and banks as taking more complimentary roles, according to James Meekings, the site’s co-founder. Although the addition of crowdfunding will increase competition for some business, it is more likely to lead to innovation amongst both sides than extinction of one, he says.

“There are some sectors that are definitely being under-served by banks. Investors should also get a better rate of return by lending directly to business,” he explains. “If you look at the finance market, I don’t see why P2P can’t take 10% and end up creating a whole new eco-system that compliments the banking model.”

“Banks work closely with marketplaces and have already built up a robust knowledge of credit analytics,” he adds. “Some sites are already working with a number of smaller banks to leverage knowledge. It can be a win-win for both sides.”

Meekings also sees crowdfunding and banks as acting in slightly different territory. “Nesta [an independent UK innovation charity] did a report and found that 30% of the businesses looking to borrow believe they couldn’t get a loan through a bank. Politicians believe that this is the perfect number,” he says. While crowdfunding sites and banks will compete for some of that 70% bank-loan share, crowdfunding can also do quite well out of catering for that remainder.

But that then leads to the question of whether the remainder businesses will enable crowdfunding sites – particularly those in equity crowdfunding – to make decent enough returns to keep investors coming back. And it is equity crowdfunders that seem to be the most bullish about the sector’s future – perhaps because equity is generally the newest, least established form of crowdfunding.

Seedrs, an equity crowdfunding site believes that equity crowdfunding has the traits necessary to replace most forms of current business-angel financing but that VC and institutional finance bring enough value to the table that they will remain.

“It has the tools to make it a simpler and more democratic process,” says Jeff Lynn, co-founder and chief executive officer of Seedrs.”Doing an angel deal the way we’re doing it today will look quaint and antiquated.”

VC and institutional finance operates in a slightly different area and generally will be working with larger amounts of money than crowdfunding, he adds. This means that VC and institutional finance will still play an important role in secondary financing but there is likely to be a culling.

“The good firms bring a lot to the table but the bad ones that base success on being the only ones with the information and the money will cease to exist,” he predicts. “Part of our platform is to make sure it all works together.”

Crowdcube another equity crowdfunding platform, sees the potential of crowdfunding as even greater than that. It could end up replacing VC in many ways, says Luke Lang, co-founder of Crowdcube.

“My vision for Crowdcube is to make it the Google of SME [Small and Medium Enterprise] financing in the UK,” he says. “It’s already becoming one of the main ways to raise funds when it used to be considered a last resort just three years ago.”

It’s a disruption that is being repeated right across the globe, he adds. “The internet has democratised the process. Look at where you’re most likely to get success. If you can get on Crowcube, you’ve got a very strong chance of raising the money you’re after. Escape the City [a job site], turned down offers for investment in favour of using Crowdcube.”

Gonçalo de Vasconcelos, co-founder and chief executive officer (CEO) of Syndicate Room agrees that equity crowdfunding could spell an end to VC. “They charge ridiculous amounts and are a huge burden on entrepreneurs. In fact they often end up kicking out the entrepreneur at some point after they invest and they dilute the investment of any angel investor that came in before,” he says.

“From an investor perspective, a VC means you have a manager who will come in and decide what to invest in and take 25% for the privilege. You go crowdfunding and you can say: ‘So now I can invest in 10 companies instead of eight and choose what to invest in. I like this idea and this company, not so much this one,’” adds Tom Britton, co-founder and chief Technology Officer (CTO) at Syndicate Room.

But despite the positives, there are still worrying signs in the sector, says Vasconcelos. Rampant growth in site number and the potential for unchecked unscrupulous sites could end up damaging the reputation of crowdfunding – potentially beyond repair. “You look at the number of deals going on across the UK alone, there is no way there are that many good companies and investments,” he explains. “It’s just a matter of statistics. Are they just churning out deals for the sake of it? It could be a numbers game – the more they get funded, the better for them.”

The trouble is that it is easy to find entrepreneurs that need money, it is much harder to find entrepreneurs worthy to take your money, he adds. If horror stories start emerging about investors losing significant amounts in deals gone bad, it could be extremely damaging to the sector, he says.

“You have to think that there are lots of people looking for money, but how many of them deserve it? And work from there,” agrees Britton.

And on the flip-side, there are concerns from entrepreneurs and later-stage investors about crowdfunded businesses. For one, there is not a single person that can be held accountable if it goes wrong, a business goes bankrupt and investors all lose their money, says Mark Payton, managing director of Mercia Fund Management.”There’s no one putting their name next to it and being able to claim the glory if it does well but be fingered if it doesn’t,” he adds.

Equally crowdfunded business can have too many stakeholders for secondary financiers. VCs and other forms of secondary finance like a nice simple share structure and decision route, he says. “Having multiple share-holders can make it difficult for an institutional investment fund to follow its money through,” Payton adds.

Although some sites, such as Seedrs, have put in place models to take care of this exact problem, many others will leave a business without a secondary funding option – putting it in jeopardy of not being able to expand. This could be a problem as the industry continues to look for successful exit stories.

For now, crowdfunding remains a new innovation with many questions facing it. First adopters are likely to continue to test it out but they should make sure they tread carefully, consider all scenarios fully and read the fine print.

 

This article was written by Freddie Dawson from Forbes and was legally licensed through the NewsCred publisher network.