Crowdfunding is a type of alternative finance. Alternative finance is an umbrella term that refers to a new financing mechanism that has emerged outside of the traditional financial system and helps connect fundraisers directly with funders often via online platforms or websites. Alternative finance differs to traditional banking or capital market finance through technology-enabled ‘disintermediation’, which means utilising third party capital by connecting fundraisers directly with funders, in turn, reducing transactional costs and improving market efficiency.
Hence, crowdfunding is one of the more common alternative financing methods. Small amounts of money are raised from numerous investors, meaning a solid business plan and confident pitch are required to convince potential lenders. Money can be borrowed or exchanged for equity in the business, depending on whether equity crowdfunding or loan-based crowdfunding are used (the latter is also known as Peer-to-Peer (P2P) lending).
The boom of crowdfunding and alternative finance can be attributed to the following reasons:
- Banks refusing to provide financing of smaller loans as it means smaller profits
Providing low volume loans to small companies is not as profitable as providing loans to big companies for large volumes.
- Increased regulation for banks
After the global financial crisis, regulation increased making compliance more expensive and time consuming. Therefore, the low profits and resource heavy requirements do not make a strong business case to service SMEs with loans.
- Lack of collateral
SMEs tend to be higher risk as they are generally not established and have lower turnovers than larger companies. To address this risk, secured loans tend to be preferred by banks where collateral is furnished to service the loan if there is default. However, many SMEs do not have many assets that can cover the size of the loans.
- Weak cash flows
SMEs tend to have weak cash flows. Some SMEs are very seasonal businesses, and therefore pose significant risk. This is a warning sign for banks that the SME may not be in a position during the year to make good the loan.
- Poor credit histories
Credit histories and credit scores are an indication of the creditworthiness of businesses – a high score indicates that the business is more likely to repay its debts. However, if a business lacks credit history or has a low credit score, it is likely to be rejected for financing by banks.
Crowdfunding models can be divided into investment crowdfunding and non-investment crowdfunding. This distinction highlights a fundamental difference between crowdfunding where funders act as investors aiming to achieve an economic return and crowdfunding where funders are either aiming to support a charitable project or receive a non-monetary reward.
Debt-based crowdfunding is characterised by investors providing funds in exchange for the right to have their money paid back with interest according to the repayment terms specified in a loan contract or debt security.
Equity-based crowdfunding is also known as crowd-investing and is characterised by individuals or institutional investors providing funds in exchange for unlisted shares in a company or project. Since this gives partial ownership of the company or project, the reward for investors is a possible future cash flow stream and increase of stock price. Thus, investors will generally profit if the company or project performs well and lose the full investment if it fails. However, as equity crowdfunding becomes more common the marketability on secondary markets also increases, which means that the probability of losing the full investment decreases (if one is willing to sell at the offered price).
Real estate crowdfunding is a way for property developers and landlords to raise money. This is done by offering equity in a property to a large pool of investors where each investor contributes a small amount of money. The key difference between traditional real estate financing and real estate equity crowdfunding is that crowdfunding is done online with the platform used to facilitate the process.
In reward-based crowdfunding, funders in exchange for a non-monetary reward, usually place a pre-order for a new product or service which is still under production. This enables businesses to secure cash flows and launch their product with committed customers and orders already in the books. To attract funders of a product or service which is not yet available, a discount on the expected future market price will often be provided.
In donation-based crowdfunding, donors provide funds for philanthropic or sponsorship reasons with no expectation or right of remuneration. This is usually for altruistic and charitable intents. At times, the donors are rewarded with either a non-tangible asset, such as a token, recognition or brand promotion (reward donation) or a tangible asset of much lower value than the donation, e.g. a t-shirt or a pen.
In Islam, a loan (qarḍ) is considered a gratuitous contract, and it is commendable for a lender to provide a loan to a borrower who is in need of money. Both the Qur’an and Sunnah promise reward to a lender who provides a loan to a person in need. The fact that the Shariah prohibits the lender to derive any conditional benefit from the loan further emphasises its gratuitous nature.
Real estate crowdfunding is similar to equity crowdfunding. If it is a residential property, there is very low Shariah non-compliance risk. If it is commercial property, there is a greater risk of non-compliance as it is an AAOIFI Standard’s requirement that the commercial tenant’s business is Shariah compliant
Donation based crowdfunding is made of donations to the crowd funder with nothing usually stipulated in return. For social projects, charitable projects and not-for-profit ventures, this structure is permissible and is rewarding for funders.
The Shariah compliance of any crowdfunding depends on the following elements:
- The business of the company
- The financials of the company
- The purpose of the crowdfund
- The structure of the crowdfund
Before a company can be admitted on a Shariah compliant crowdfund, its core business activity should be reviewed to ensure it does not violate any Shariah principles. The objective of raising funds must be Shariah compliant. If a company or start-up is raising funds to develop a product or fund which is not compliant to principles of Shariah or to expand its business to incorporate something non-compliant, it will not be admitted on a Shariah compliant crowdfunding platform.