What is crowdfunding and how is it helping small businesses in the UK?

Crowdfunding unlocks alternative financing for start-ups and small businesses by mobilising pools of small-scale investors via online platforms. The funding model spreads risk, enables innovative projects and democratises investment, allowing individuals to support causes that they care about.

Crowdfunding – a funding model that leverages online platforms to raise capital from a large pool of individuals – is currently valued at around $1.41 billion globally and is expected to reach $3.62 billion by 2030 (Statista, 2023). As of May 2023, Kickstarter, a leading crowdfunding platform, had launched more than 592,000 projects (Statista, 2023).

The emergence and growth of crowdfunding offers the potential to transform the structure and mechanisms by which small and medium-sized enterprises (SMEs) can raise capital. This is particularly valuable since the credit crunch that followed the global financial crisis of 2007-09 has made it more difficult for SMEs to secure capital injections, especially compared with their larger counterparts.

Within this challenging environment, new economic models have emerged, and crowdfunding is one such innovation. Traditional funding sources, such as banks, can be hesitant to fund small firms as such businesses may not have established assets to serve as collateral. This makes it riskier for banks to recover losses if the company defaults on a loan.

Rapid technological advancements have fuelled the growth of crowdfunding and the digital infrastructure to support it. In turn, with access to crowdfunded capital, companies can invest in research and development (R&D), hire skilled personnel and acquire the necessary resources to innovate.

This convergence is revolutionising the capital market landscape and exerting a significant impact on diverse industries, including education, business and medicine.

For example, Monzo – an early app-based bank – raised over £1 million on crowdfunding platform Crowdcube in 2016, disrupting the traditional banking landscape with its innovative, online-only approach. Notpla, a company developing sustainable packaging made from seaweed, raised £7 million on Seedrs in 2020. In each case, investors received shares in the company based on their contribution.

How does crowdfunding work?

By harnessing the power of the internet, crowdfunding enables individuals to connect with potential funders and raise capital for various projects, often in relatively small amounts. This democratisation of funding has created new avenues for economic development and empowered individuals to pursue their entrepreneurial ambitions (Chang, 2020).

Crowdfunding differs from traditional funding methods in that it involves simpler contracts, provides less information, engages a larger number of investors and requires a considerably shorter fundraising process.

It is a novel approach to financing that enables individual founders of for-profit, cultural or social projects to solicit funds from a broad range of individuals, typically in exchange for future products or equity (Belleflamme et al, 2014; Mollick, 2014).

Funds can also take the form of donations or an exchange for incentives and/or voting rights to support specific initiatives. For example, REPREZENT – a youth broadcasting platform – secured over £300,000 of donations on Crowdfunder in 2023, highlighting support for community projects.

In general, crowdfunding can be divided into four categories: equity-based, interest-based, donation-based and reward-based. Equity-based and interest-based crowdfunding fall under the commercial umbrella and are primarily characterised by investment. The other two types tend to favour sponsorship and support.

Reward-based crowdfunding

Reward-based crowdfunding can be employed to fund start-ups, expand existing businesses or finance individual creative projects.

In this scenario, the funder receives non-monetary returns, such as tangible products (for example, Kickstarter campaigns for new gadgets, board games or clothing lines) or services (including musicians offering demo recordings, chefs offering a private cooking class or filmmakers inviting backers to the set) in exchange for their investment.

The Oculus Rift, a virtual reality headset, raised over $2 million on Kickstarter in 2012. Funders received the headset early and at a discounted price. Exploding Kittens, a card game, raised over $8 million on Indiegogo in 2015 and, again, backers received the game when it was produced.

Reward-based crowdfunding platforms can also be used by businesses or individuals for market research during the initial stages of product development and design to gather feedback and facilitate modifications and improvements, progressively aligning with consumer and market demands (Chemla and Tinn, 2020).

This is made possible when projects allow individuals to participate in decision-making processes or choose project features (such as co-operative ventures allowing members to vote on product releases); offer public ‘thank yous’, mentions in credits or dedicated spaces on websites/products (such as film productions listing backers’ names in the credits); or there may be savings or special offers for future purchases (for example, a coffee shop offering backers lifetime discounts on drinks).

Equity-based crowdfunding

Equity-based crowdfunding models generally exhibit superior profitability and fundraising capabilities compared with reward-based crowdfunding models. Nevertheless, reward-based projects significantly outnumber equity-based endeavours.

Equity-based crowdfunding involves offering shares online at an accessible price, enabling investors to buy stakes in a company for a modest sum and secure claims on its future cash flows. For example, Hybrid Air Vehicles, the company behind the Airlander craft, raised £1.2 million on Crowdcube, surpassing its £500,000 target.

In 2015, the UK witnessed the fastest year-on-year growth in both the number of equity crowdfunding deals and the total amount of money raised through this method. In that year, around 21% of early-stage investments and 36% of seed-stage investments flowed through equity crowdfunding platforms.

Overall, the total value of equity-based crowdfunding in the UK increased steadily from 2013 to 2020 (see Figure 1). The total annual value grew from under £30 million in 2013 to almost £550 million in 2020.

Figure 1: Annual volume of equity-based crowdfunding in the UK, 2013-20

Sources: Cambridge Judge Business School; CME Group Foundation

Crowdfunding for innovation

In the early stage of entrepreneurship, crowdfunding can be used to raise funds. Owing to its rapid nature, this mode of financing can provide enterprises with an early advantage and help to narrow the gap with competitors. For example, crowdfunding offers faster turnaround times, lower barriers to entry and potential exposure to large communities, making it an attractive alternative.

For many founders, crowdfunding serves primarily as a financial tool to secure the necessary funding to bring their projects to fruition. Some businesses also use crowdfunding to gain public recognition, enhance their visibility and promote themselves.

Further, by presenting an idea or product to the public through a crowdfunding campaign, companies can gather feedback on products and services, and gauge interest and demand before committing significant resources.

This can be a form of market research, helping companies to improve innovative ideas. As founders often lack comprehensive control or understanding of consumer and market dynamics, this is a crucial development.

The collaboration that this enables can help to foster consumer involvement in product development, allowing for the pooling and adoption of diverse ideas and perspectives. With the funds and feedback obtained from crowdfunding, companies can test their products and services more effectively. This can lead to a more refined and innovative final offer.

Indeed, when backers actively participate in product creation, they can inadvertently become unpaid advocates, promoting the project through word-of-mouth or social media. In this way, successful crowdfunding campaigns can build a community of supporters who are invested in the product’s success, which can reduce marketing costs.

Potential backers are more likely to support projects when they perceive the product as innovative and have favourable views of the product’s quality and the founders’ capabilities. (Cumming et al 2021). Engagement with supporters through web design or promotional videos can increase the likelihood of sponsorship too.

In this way, positive feedback can encourage more potential customers to support the project, but conversely, negative feedback can have the opposite effect. This further influences the quantity of products or services sold, ultimately affecting final revenue.

How have recent developments affected crowdfunding?

SMEs have sought to compete with larger companies through new product and service developments, particularly in light of technological advancements and increased competition.

Identifying a suitable operational process and technology that can help a company to grow is important for smaller businesses. In many cases, start-ups and SMEs are at the forefront of digital technology adoption, with new processes more efficiently and eagerly integrated.

For example, Not on the High Street is a UK-based online marketplace that supports small independent businesses by selling their products online. Gousto, a recipe box delivery service, uses cloud computing to store customer data, manage its supply chain and power its website and mobile app.

Automation and digital tools can streamline various business operations – from inventory management to accounting, enhancing efficiency and productivity. Technologies can also help start-ups to reduce transport costs, enhance their scope to trade services and optimise integration into global markets (OECD, 2021).

Crowdfunding platforms have also simplified the process for SMEs to access international markets. By selling goods and services online, SMEs can bypass physical borders and reach a wider audience without hefty transport costs. Platforms like Shopify and Etsy enable them to set up online stores quickly and efficiently. Crowdfunding platforms also give access to international investors.

Indeed, e-commerce, digital marketing and online communication tools can extend a company’s reach far beyond local borders, opening up new avenues for growth and innovation. For example, SMEs in the UK food service industry have increased their sales by embracing digital technologies and partnering with delivery services to expand their reach and customer base. Joining platforms like Deliveroo, Just Eat and Uber Eats has extended reach beyond their physical location to access online customers who prefer convenience.

The efficiency brought by the integration of technology and better processes can free up resources and time that can be redirected towards innovative projects and growth strategies. Technologies such as 3D printing and virtual reality have allowed for quick and cost-effective prototyping, testing and iteration of new products and services. This can significantly speed up the innovation process and reduce development costs.

Digital technologies facilitate collaboration both within the company and with external partners. For example, cloud computing enables team members to work together in real time, regardless of their locations. Crowdfunding platforms have connected SMEs with potential partners, mentors and investors.

Conclusion

Crowdfunding offers an alternative to traditional financing sources, especially for businesses that struggle to meet stringent lending requirements. This can foster innovation and entrepreneurship.

By mobilising a large pool of contributors who invest smaller amounts, crowdfunding effectively distributes the financial risk. This risk-sharing approach makes it more viable to pursue innovative projects that might be considered too risky for individual investors or lenders.

Additionally, crowdfunding can empower individuals to invest in projects in which they believe, potentially leading to more diverse funding sources and fairer access to capital. Crowdfunding can also support the development of innovative solutions to social and environmental challenges.

For example, the Save the River Wye campaign attracted over £120,000 on Crowdfunder in 2023, showcasing the collective power of individuals fighting for causes they care about. Similarly, Whiteheath Infant and Nursery School raised over £30,000 on the same platform in 2023, demonstrating the use of crowdfunding for local needs and improvement projects. And the Just in Time, North Tower Clock Campaign successfully raised over £11,000 on Crowdfunder in 2023, displaying the community’s commitment to preserving historical landmarks.

Nevertheless, the lack of robust regulations can expose investors to risks such as fraud, misinformation and project failure. Investors, especially unsophisticated ones, may then need additional protection from misleading information and unfair practices.

Likewise, if large-scale crowdfunding platforms fail, it could have negative consequences for the financial system. Overly generous support for crowdfunding may also discourage businesses from seeking traditional financing, potentially leading to inefficiencies.

As a result, policy-makers will need to implement regulations that protect investors without stifling innovation. They can also educate potential investors about the risks and rewards of crowdfunding. There is a further potential need to offer incentives or assistance to promote crowdfunding for social impact, innovation or specific sectors.