Since the passage of the 2012 JOBS Act, the global crowdfunding industry has grown by leaps and bounds. Massolution’s Annual Crowdfunding Report estimates that the industry will be valued at $34 billion by the end of 2015, more than doubling in size over the previous year.
So what exactly is crowdfunding? In a nutshell, it means raising funds through a group effort but crowdfunding can take many forms. To shed some light on the subject, here’s an inside look at the four distinct crowdfunding categories.
Real Estate Investing
Once upon a time, the only way to invest in real estate was through real estate investment trusts (REITs) or buying investment properties directly. Thanks to the JOBS Act, crowdfunding has opened the door to a new era in real estate investing.
Investors have two distinct options with real estate crowdfunding. The first involves equity investments in specific residential and commercial properties. The investor acts as a shareholder in the property and receives a portion of its rental income, which is typically paid out quarterly.
The other option is debt investments. In this scenario, you’re investing in the mortgage loan that’s secured by the property (or in securities that are related to the performance of that loan). Returns are realized in the form of interest on the loan and they’re paid out monthly.
Between the two, equity investing is more popular, representing approximately 80% of real estate crowdfunding investments. Both require a relatively small investment to get started. RealtyShares, for example, features selected opportunities with a minimum investment of just $1,000.
Previously, real estate crowdfunding was only open to accredited investors. The U.S. Securities and Exchange Commission recently finalized Title III rules of the JOBS Act, making it possible for non-accredited investors to get in on the action. It remains to be seen, however, whether real estate crowdfunding platforms will adapt to welcome these investors in.
Entrepreneurs have long relied on venture capital funding to get their start-ups off the ground but thanks to crowdfunding, they’re now doing it in an entirely different way. Venture investing connects individual investors with entrepreneurs who need financial backing in the early stages of the start-up process through crowdfunding platforms.
In exchange for providing seed money, investors receive an equity share in the company. The premise is that once the business has had time to grow and begin generating a steady stream of revenue, investors can sell their shares for a profit. Because venture investing operates on a longer time frame it’s a highly illiquid investment choice.
In terms of risk, venture investors have a high potential for loss and individual returns can vary widely. If the company fails and ends up filing bankruptcy, the investor could walk away with nothing.
There is an upside to venture investing in that it doesn’t require a huge outlay of cash to get started. With sites like AngelList, investors can get in on the ground floor of start-up funding with as little as $1,000. The recently finalized Title III changes also extend to venture investing, making it possible for non-accredited investors to get involved.
Loan crowdfunding represents the largest share of the total crowdfunding market, with this segment projected to generate $25 billion in loans through the end of 2015. This type of crowdfunding is more commonly referred to as peer-to-peer lending.
Loan crowdfunding involves the lending and borrowing of money between individuals without going through financial institutions. SEC regulations allow both accredited and non-accredited investors to participate, however, because of the strict regulatory requirements involved only Prosper and LendingClub accept non-accredited investors at this time.
From a borrower perspective, peer-to-peer lending can be a more attractive alternative to a bank loan for a couple of reasons. For one thing, it can be easier for individuals with less than perfect credit to get funding through a peer-to-peer platform. That’s because peer-to-peer lenders often have their own internal credit rating systems that help investors identify risk.
The other advantage of loan crowdfunding is that it may be possible to qualify for more favorable loan terms. Prosper, for example, offers unsecured loans with an APR as low as 5.99% and borrowers can get up to $35,000 for just about any purpose. A bank may offer a rate that’s comparable or even better but the loan limit is likely to be lower unless the borrower is pledging some kind of collateral.
For investors, peer-to-peer lending is an opportunity to generate fixed returns. Loans granted through a P2P platform must be repaid with interest. Each investor who funds a loan receives a share of the interest as it’s repaid. Peer-to-peer lending carries a high risk level for investors compared to most public market fixed income investments, but the potential for return is also higher.
Donation and Reward-Based Crowdfunding
Collectively, it’s estimated that donation and reward-based crowdfunding will account for just over $6 billion in funding volume for 2015. This segment of the market goes back nearly a decade, predating both real estate and venture investing.
With this type of crowdfunding, individuals and businesses establish funding requests for a specific cause or project and anyone can contribute to the campaign. Kickstarter and Indiegogo are two of the most visible rewards-based crowdfunding platforms and they’re frequently used by entrepreneurs to raise funds. GoFundMe is geared more towards fundraising for personal causes.
There’s no minimum investment required and unlike peer-to-peer lending, there’s no expectation of repayment with donation and reward-based crowdfunding. Since the money isn’t a loan that can be defaulted on, there’s zero risk for people who contribute to a campaign. With reward-based options, there’s often some kind of incentive involved for donors but donation-based crowdfunding offers no tangible financial benefit.
Each of the four crowdfunding options outlined here offers distinct advantages and disadvantages. When comparing crowdfunding opportunities, investors need to weigh the risks against the projected returns carefully to determine which one is the best fit.