Crowdfunding is a novel method of raising capital through the power of family, friends and investors. This method of funding harnesses the power of a large pool of investors via the internet and/or social media. Crowdfunding is often able to harness investor funds
for different types of endeavors by leveraging the global nature of the internet.
Conventional Fundraising vs Crowdfunding
Crowdfunding centers around using an opposite approach to conventional fund raising. The conventional model of fundraising involves an entrepreneur creating a business plan, a prototype of a product or investment opportunity which they then pitch to interested parties, often investors. These usual funding sources include banks, angel investors, venture capital firms, or private investor groups. If they are able to garner interest from any of these potential avenues, they often obtain financing in the form of a convertible note, equity or debt. Crowdfunding, a new method of raising funds, bypasses the individual approach to raising funds in favor or utilizing the wide reach of the internet to pitch the concept or investment to a larger audience.
The last decade has seen the advent also of crowdfunding platforms which enable entrepreneurs to share their investment opportunity to a defined audience for a fee. This enables the individual to engage a wider audience than just their personal network and helps often in evaluating potential investors.
The most common type of crowdfunding fundraising is for products through destinations such as Kickstarter and Indiegogo where the inventor is seeking funding for a new product. There are opportunities for non-product concepts to be funded such as movies or services, although less common.
In the real estate investor market, Crowdfunding is typically focused on raising funds to fulfill a loan request or sell equity. As noted, conventionally, the ability to raise funds from single individuals was only possible with accredited investors which is defined as individuals with more than $1 million in net worth or more than $200,000 in annual income. This rule changed with the Jumpstart Our Business Startups Act of 2012 which opened the door to many of these restrictions and Crowdfunding is now available to a larger audience.
The Benefits of Crowdfunding
The key benefit to individuals or groups trying to raise funds is that crowdfunding allows the entrepreneur to access a wider investor group. The other benefits are that the platforms allow more non traditional financing and fundraising options. Lastly, the actual mechanics of fundraising via crowdfunding is typically more efficient as it is internet based. The crowdfunding model allows those seeking investment to to organize their fundraising efforts in one central location. The ability of the investors and the entrepreneurs to work from a common platform can makes the fundraising process much easier. A group looking for investment can keep track of all the interested investors along the many steps of the investment process instead of requiring the constant personal engagement. This can help limit the manpower and resources needed especially in terms of documentation, signatures, and information flow.
Types of Crowdfunding
There are several different types of crowdfunding models which usually depend on the type of offering. These primary types are generally termed equity-based, donation-based or rewards-based.
Real estate crowdfunded investing is usually centered around equity crowdfunding. The main difference between rewards and donation methods is that equity-based raises allow the investor to become a “part owner” of the company with capital as an exchange for equity. As an equity owner, the participant receives a cash return on the investment and at some point will usually receive dividends or distributions.
Real Estate Crowdfunding
The most common scenario in real estate crowdfunding is equity raises. This is primarily due to the commonly understand model and that it provides a higher return than traditional debt investments. In the crowdfunding scenario where interaction with potential investors is over the internet, the higher returns are often more appealing as a sales tactic. As such, the most ubiquitous crowdfunding real estate equity investments often provide the investor or investor group with a equity in the deal.
With this construct, the return provided to investors is based on rental income of the property minus crowdfunding fees. As the investor becomes an equity stakeholder, if/when the property is sold, the platform will also pay the investor’s share
There are several key enticing factors:
- Equity investments can have high returns : Certain crowdfunding real estate investments can offer up to 25 percent return with the possibility for higher overall returns
- Lower fees: Several platforms often provide an option to pay an annual fee to maintain shares in a property, instead of upfront fees and monthly fees.
- Tax Advantages: Given an equity investment, investors can participate in depreciation and repairs on a property and deduct expenses from annual income.
There are several risks that need to be considered:
- Risk: Investors in crowdfunded investments are often in the second lien position. If the property does not operate well and create a profit, there can be no return on investment.
- Hold Times: An investment in a property on a crowdfunding is not a liquid investment. The hold period can last upwards of ten years.
The other type of crowdfunding real estate investment utilizes debt. In this scenario, the investor serves as a lender to the property owner for which they receive a fixed return. The return on the investment is is often in the 5-10% range. The return on the investment is often paid monthly or quarterly. In this type of crowdfunded investor is in a first lien position and thus receives returns first.
The benefits of debt crowdfunding includes:
- More predictable returns: Given the return is based on pre-determined performance targets, investors can depend on a more predictable return.
- Risk: Debt crowd funded investments provide a better risk profile since the investor holds the primary lien. If the promoter fails to pay the returns on the loan, the property enters the foreclosure process.
- Hold times: Crowdfunded debt investments are usually utilized in ground up development projects and thus the hold period is shorter than equity type investments and are often between 6 months and 2 years.
- Fees: In these types of crowdfunded investments, the platform will take a percentage of the return .
- Predetermined returns: In a debt investment, the return is calculated based on the interest rate of the lien. As such, the return is limited to this percentage.