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Debt Crowdfunding

Updated on May 6, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Debt Crowdfunding?

Debt Crowdfunding refers to a type of crowd-based system of lending where multiple small retail investors come together to lend to individuals or firms using a regulated platform. It offers an alternative mode to conventional bank loans with low-interest rates, a simple application process, and a faster approval process. 

Debt Crowdfunding

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Small and midsize enterprises (SMEs) and later-stage startups with two years of financial background use it. Compared to other crowdfunding avenues, it provides low-risk investment opportunities for investors. They differ a lot from the rewards-based crowd, creator, or project crowdfunding platforms, where repaying the loans is optional.

Key Takeaways

  • Debt crowdfunding refers to a crowd-related method of lending where a variety of small retail investors join collectively to lend to people or firms using a regulated platform.
  •  It provides an alternative process to standard financial institution loans with low-interest costs, a simple application, and quicker approval techniques.
  • It has the potential to become the alternative to SME funding, but it entails risk looming on investors over the default of loans by borrowers.
  • It has multiple types that can be used by all, like peer-to-peer lending (P2P), invoice financing, revenue-sharing loans, micro-lending, reward-based crowdfunding, equity crowdfunding, real estate crowdfunding, social impact crowdfunding, & debt crowdfunding platforms.

How Does Debt Crowdfunding Work?

Debt crowdfunding platforms for businesses comprise many different categories of crowd-based lending, like peer-to-peer lending (P2P lending), invoice financing, equity crowdfunding, and mini-bonds. Thus, retail investors now use lending platforms to lend to individuals or businesses directly, bypassing banks. Businesses and individuals seeking loans need to create a campaign on lending platforms. For this, they have to outline their project and loan terms, after which the businesses and individuals connect with potential investors.

However, the lending platform ensures that all parties—lenders and borrowers adhere to compliance standards while keeping the investment secure. Investors use debt crowdfunding for higher interest rates and the ability to fund preferred businesses. Thus, businesses or individuals can secure cost-effective loans at a favorable interest rate without sacrificing ownership or dealing with excessive paperwork. Nevertheless, it can also escalate risks to investors as the borrowers may default or fail to pay the loan.

Investors, individuals, and businesses easily select projects to lend funds or securities to borrowers. Consequently, it does have several effects on the financial world, like possible future disruptions in the traditional lending business. It can become a strong and stable option for SMEs to secure funding. Additionally, this can democratize funding by ensuring that only businesses supported by investors receive funding.

Types

It connects borrowers to lenders or investors directly using a platform of various types, like:

  • Peer-to-Peer Lending (P2P): It has lower interest rates on loans, gives good interest to investors, and enables direct lending between businesses or individuals.
  • Invoice Financing: It helps borrowers avoid due invoices, provides easy and fast access to capital, and removes cash flow issues.
  • Revenue-Sharing Loans: Risk-sharing benefits businesses with fluctuating incomes by sharing the borrower’s revenue with investors.
  • Micro Lending: Supports local communities and businesses by lending small amounts to underserved groups and non-profits.
  • Reward-Based Crowdfunding: No loan repayment; ideal for businesses seeking early adopters and pre-orders, with investors getting rewards like early access to services/products.
  • Equity Crowdfunding: Partial company ownership with high risks and returns is beneficial for organizations seeking growth capital.
  • Real-estate Crowdfunding: It gives higher returns at higher risks through a diversified investment portfolio that leads to investing in real estate projects.
  • Social Impact Crowdfunding: Funds projects that match personal values in the environment or social causes, prioritizing social impact over financial returns.
  • Debt Crowdfunding Platforms: Platforms connecting investors and borrowers use different platforms and loan types or investment opportunities.

Examples

Let us use a few examples to understand the topic.

Example #1

An article released on December 20, 2023, on Salaam Gateway delves into Lendo, a Saudi Arabian debt crowdfunding platform that complies with Shariah. Sanabil Investments, a division of the Public Investment Fund, spearheaded a Series B funding round in which it successfully raised $28 million (SAR 105 million). Important investors such as AB Ventures and Shorooq Partners also contributed to the funding round. Lendo functions as a network of borrowers and savvy investors, facilitating advance financing for business invoices in Saudi Arabia.

Authorized by the Saudi Central Bank, the platform aims to broaden its reach into markets, bolster existing customer relationships, and introduce Shariah-compliant financial products. With over 2,500 financing transactions processed to date, Lendo has provided more than SAR 1 billion ($300 million) in financing to SMEs while delivering SAR 140 million ($37 million) in returns to investors. The platform’s debt crowdfunding efforts are aligned with the goals of Vision 2030, which aims to increase SME lending from 4% in 2018 to 20% by the year 2030.

Example #2

Let us assume that NGO Muona partners with Old York Exchange and brings a debt crowdfunding initiative, allowing individuals an avenue to borrow up to $1000. It aims to contribute towards community development by helping individuals pay their urgent needs like bills, tuition fee payments, and rent payments at an affordable rate of 3.5 percent annually.

The platform has created a lot of hope for individuals suffering from immediate, urgent cash needs to meet their personal needs at affordable rates. Moreover, Muona’s debt crowdfunding platform succeeded in aligning its commitment to steering positive change while creating opportunities for community development.

Pros & Cons  

Although it has the potential to replace traditional lending, one has to keep the following in mind before using it:

ProsCons
It has the potential to become an alternative to SME funding.Risk looms for investors over defaults on loans by borrowers.
Investment portfolios can be easily diversified.Has interest rate risk.
It has a faster funding process.Offers high-risk laced higher returns.
Offers competitive rates and has lower overhead costs.Chances of overlooking the credit history of borrowers by investors.
It can provide higher returns on investment in contrast to conventional fixed-income schemes.The frameworks of central banks and financial authorities may not fully regulate it.

Frequently Asked Questions (FAQs)  

Which type of companies undertake debt crowdfunding?

Debt crowdfunding companies are early-stage companies in need of growth capital of between $50k and $250k. They’re often companies that have some level of sales and are looking for a source of financing that doesn’t cause them to dilute.

Is debt crowdfunding worth using for business use?

Sure, debt crowdfunding can be an option for businesses. It enables companies to raise funds without giving up ownership and offers a repayment plan for investors. This is especially advantageous for startups that are already making money.

When to initiate debt crowdfunding?

Businesses in their stages with revenue flow between $50k and $250k looking to secure funds for business expansion should consider debt crowdfunding. It’s a choice when a company aims to maintain control while securing capital.

This article has been a guide to what is debt crowdfunding. Here, we explain the concept in detail with its pros, cons, types, and examples. You may also find some useful articles here –

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