The Risks and Rewards of Debt-Based Crowdfunding
Debt-based crowdfunding, often referred to as peer-to-peer lending (P2P), is a great way to raise money for small businesses that may find it more difficult to obtain loans from traditional lending institutions. Also, small business loans often take much longer to get funded than the average debt-based crowdfunding loan, which makes debt- based crowdfunding a suitable funding option for businesses that need funding relatively quickly. According to P2PMarketData, this crowdfunding model has proven to raise the largest amount of capital on various platforms. Businesses utilizing debt-based crowdfunding raise capital by taking micro-loans from hundreds of lenders who are also called investors.
These investor-lenders, like most lenders, expect full repayment of their mini-loan with interest over the life of the loan. These businesses must still adhere to securities laws when raising debt from micro-lenders. Oftentimes, they use the federal regulation crowdfunding exemption (Reg CF) to help them raise capital more economically and legally. This means that the business will need to draft certain legal documents, such as a term sheet, subscription agreement, promissory note to pay another party, and Form C, as well as adhere to the SEC requirement that the offer be hosted and advertised on a regulated crowdfunding platform.
Advantages to Debt-based Crowdfunding
Over the past decade, debt-based crowdfunding has increasingly gained popularity among both investors and companies. Debt-based crowdfunding is quick and easy because the entire process can be carried out online. The application process for a debt-based crowdfunding platform is more straightforward and convenient.
There are also some critical differences between traditional loans and crowdfunded loans. With the latter, the business’ borrowed funds are disbursed by a debt crowdfunding platform, not a bank or other financial institution. And while the crowdfunding platform sends the business the borrowed funds, the money comes directly from individual investors who pledge to provide only a portion of the borrower’s loan funds (with the total loan being financed by the entire crowd rather than one individual). Furthermore, when borrowers repay the crowdfunded loan with interest, the return on investment (ROI), which is a performance measure used to evaluate the efficiency of an investment, is distributed back to the individual investors in the form of interest payments .
Debt-based crowdfunding also often provides better interest rates to businesses - since it is the businesses that set the rate rather than the lenders- as compared to what they would receive from traditional lenders who quite often set the terms of the loans.. Likewise, debt-based crowdfunding is even attractive to those mini-lenders as they can expect to see their dollars invested in mission-aligned projects, and often these investors can expect a fixed return, making it easier for financial planning purposes.
Other advantages of debt-based crowdfunding campaigns include the fact that the business owner does not have to share equity in their company with investors. This means that business owners retain control of their day-to-day operations, a factor that is very important for cooperative organizations. For an example of a cooperative that successfully raised over $1MM in debt-based crowdfunding, check our client The Drivers Cooperative. This also means that nonprofit organizations may seek investors and provide returns without violating the prohibition against sharing profits with shareholders or private individuals. For an example of a nonprofit organization using debt-based crowdfunding to fund its efforts, check out Techsoup.
Debt-based crowdfunding also offers the business owner the advantage of short-term loans . Many debt-based crowdfunding loans mature ten (10) years or less. . Also, once the loan is repaid, all future earnings remain within the company rather than with the investors. Thus, the business owner has no further obligations to the investors, resulting in more profitability for the business in the future.
The debt-based crowdfunding model also offers minimal risks for investors. Since the loan is shared among several investors, the amount an investor places at risk is lowered. Moreover, in the event that the business undergoes liquidation or bankruptcy, debt is usually among the first items to be repaid from the company assets. So, debt-based crowdfund investors are more likely to be paid back than equity-based crowdfund investors. It is not uncommon for debt-based crowdfunding offers to generate interest payments to its investors every month. This creates better cash flow for these investors for as long as the loan repayment lasts.
Disadvantages to Debt-based Crowdfunding
Debt-based crowdfunding bears its risks for both businesses and investors. Here are some of the most important risk factors for both sides that one should be aware of before raising or investing capital through this model.
Loss of Investments for Investor
There is a possibility that an investor's money can be lost in one bad investment, even though the business owner is obligated to repay the loan. Circumstances can arise like forced liquidation or bankruptcy, where the business cannot repay the debt.
Repayment of loans
Business owners are required to repay loans with the agreed fixed interest within the agreed-upon time. Business owners must repay the loans regardless of how the business is performing. A company unable to repay the loan may be forced to liquidate all its assets.
Limited Access to Alternative Financial Institutions
Carrying existing debt may restrict a company from pursuing other financing options. Huge debts in terms of accrued interests also affect credit ratings and thus may scare away other potential investors that the business may seek out for another round of funding.
Debt-based Crowdfunding vs. Equity Crowdfunding
As an investor in equity or debt-based crowdfunding, an investor invests in a security of the company. However, unlike with debt-based crowdfunding, investors of an equity-based crowdfunding offer receive shares of the company in exchange for their investment with the expectation that the company will pay them monthly or annual dividends or distributions out of its profits or revenues. In other instances, investors of an equity-based crowdfunding offer may expect the company to grow to a point where they can resell their shares at a higher price than what was paid, and in all cases, equity investors may expect to receive profits or revenues at the time of company sale, merger or acquisition.
Debt-based crowdfunding is an excellent opportunity to raise capital for small businesses. It is also a great investment opportunity for investors. However, before pursuing it, a small business will need to ensure that it has met all the legal requirements of regulation crowdfunding. Let us help you create a legally compliant Reg CF offer. Schedule a consultation with us today.
*co-authored by Elizabeth L. Carter, Esq., Managing Attorney