Crowdfunding for Returns
Published November 2016
Written by Shawn Yap CFP
Over the years, Crowdfunding has been on the rise and a go-to-model for a variety of businesses as internet penetration rises and the trend of digital migration continues. We try and explore the landscape and the pros and cons of this universe.
Crowdfunding is a way to raise funds for any cause often in small amounts of money from a group of people. The crowdfunding world has become so huge ranging from a donation-based project for charity to the development of a smart watch. The advancement of technology has accelerated the growth of crowdfunding disrupting almost every industry. In this article, we will look at the investment space. So, we will not be talking about the kind of crowdfunding that makes potato salad (Zack Brown raised more than fifty thousand dollars to do that!) Crowdfunding (equity or debt) has allowed consumers to invest in private companies. One example is the Peer-to-Peer (P2P) Lending where investors “loan” money to companies at an interest rate. This type of debt-based crowdfunding is more popular because of its simplicity compared to an equity-based crowdfunding which is more complicated with company shares involved. P2P lending has grown rapidly over the last couple of years evolving into its own broader category known as Marketplace Lending. If you think the terminologies are already mind-boggling, get ready for more when you dive into the crowdfunding universe.
Other than angel investors, banks and venture capitalists, P2P or Marketplace Lending has become an alternative source of funding for businesses. A business that gets rejected by the bank can get its financing through crowdfunding platforms. Most banks would usually require at least two to three years’ of audited financial statements because either they prefer more established businesses or simply want to avoid low quality credits. This creates a gap in financing which turns out to be a niche a crowdfunding becomes perhaps the only source of funding for unestablished companies typically those that has a short business history. With few regulations and disclosures, new businesses can raise funds relatively easy with no prospectus or little requirements. This has made crowdfunding an attractive option for Small and Medium Enterprises too.
Risks & Rewards
Before looking at the risks and rewards, there are two important factors we must consider for any investment: Liquidity and Time Horizon. Liquidity is non-existent unless you get someone else to take over. Unless there is a secondary market, you can forget about withdrawing your funds. The investment time frame varies widely from a couple of months in Invoice Financing to several years in Real Estate Crowdfunding.
The returns from crowdfunding can exceed 20% per annum for unsecured loans. Although lucrative, the high risks are often not highlighted. It is not uncommon for both retail and accredited investors to fall prey to investments that offer attractive gains with high risks including scams and Ponzi schemes. Another thing to note is that the promised return is not a guaranteed return. If the loan defaults, you get nothing back. Statistics have shown that most companies fail in the first few years of business. This is why it is a standard requirement for banks to require a minimum number of operating years.
Borrowers or platforms may provide some form of safety known as collaterals for asset-backed lending. While it sounds more secured, the level of protection varies. For example, precious metals like gold can easily be converted into cash at a standardized market price but a piece of real estate is not as liquid and the price is subject to valuation. Occasionally, the company directors may provide a personal guarantee which technically does not mean much as the fortunes of a businessman is usually tied with the company’s success.
Many platforms have been set up to connect borrowers and lenders especially online. Different platforms may focus on specialized areas of crowdfunding. The minimum investment amount ranges from as low as one hundred dollars to a hundred thousand dollars. Some platforms offer two or more types of crowdfunding opportunities available to anyone while others focus on accredited investors. In Singapore, an individual must have either a minimum net worth of two million Singapore dollars or an income of at least three hundred thousand in the preceding twelve months to qualify as an accredited investor.
Platforms do not endorse the borrowers and may not be responsible for the success or failure of a full repayment. A crowdfunding platform is merely a service provider that makes money through successful funding though some platforms collect fees that are tied to the repayments. Therefore, the underwriting process of the borrowers is a crucial part of the crowdfunding project for investors. Yet, platforms can finish assessing a borrower’s application in as little as a few days. A HDB Loan Eligibility (HLE) letter would take longer than that. Having said that, there might not be much information to verify unless you get a private investigator to tail the directors.
Similar to bonds, defaults are inevitable. The higher the risk of the loan, the higher the default rate so does the interest rate. Some platforms provide collateral and protection. One question to ask is whether the default rate can sustain without going under too. Try to avoid putting too much idle cash with the platforms unless they place your funds with an independent trustee. The disclosure of the default rate on the platform and late payment statistics can be very useful over the long term. Default rates can suddenly spike in any new platform where there are little or no regulation. However, the default rate should average lower as the industry matures.
Borrowers & Defaults
There are all sorts of companies that seek funding for their operations. It is challenging to differentiate the ones that genuinely require funds to improve and expand their businesses from those that are struggling to stay above water because of a weak foundation to begin with. There are no audit requirements for companies that meet at least 2 out of the 3 criteria for the immediate past two consecutive financial years: (i) total annual revenue ≤ $10million SGD (ii) total assets ≤ $10million SGD (iii) total employees ≤ 50. An audit by an independent party would definitely provide more reliability of the financial state the businesses are in. If you think creative accounting is bad, the financial information of the companies based on unaudited accounts is worse. Small companies are also not required to be rated by any independent agency. DP information group provides an independent credit rating on a voluntary basis. The DP Credit Rating (DP1 to DP8) grades companies into 3 different categories: Investment Grade, High Yield & High Risk. As with other rating agencies, being investment grade does not mean that it will not default and high risk does not deem it will default. If the financial statements are audited, investors must be familiar with a company’s financial ratios used in fundamental analysis to properly analyse the businesses they invest in.
Do check out the funding history of the companies. Some businesses seek funding in multiple platforms before repaying previous loans in full. This may be a red flag. Platforms also offer different ways of funding for the borrowers – first come first serve, multiple tranches and even auction style. I am appalled at the low interest rates investors are willing to accept just to bid for a piece of the pie while the risks maintain the same – High! Is this a case of low intelligence caused by high emotions?
In the event of a default when the borrower is unable to repay the loan, a recovery process will take time and money. Investors need to know whether to go after the platform if the platform is the loan issuer or the borrower directly. Fund recovery is a legal affair rather than a regulatory one. If extensions and negotiations fail, legal actions include Letter of Demand, Writ of Summon, Examination of Judgement Debtor, Writ of Seizure & Sale, Bankruptcy Notices, Winding-up proceedings, etc. Professional debt collectors may also be engaged. All these cost thousands of dollars making a total write-off more sensible if your investment is small. The platform is likely to lend a hand in most cases although they are not legally obligated. They too want to provide a good service for their reputation sake. When a borrower defaults in the absence of any collateral, the loss is very high. While the maximum loss of a private limited company due to a business failure is the paid up capital, you might be queuing up with other creditors for residual assets, if any. A professional debt collector once told me that this is the downside of a business friendly environment.
It is logical to put crowdfunding into the same category with Alternative Investments. As such, it should neither be the sole engine for growth nor occupy a large proportion of your overall investment portfolio. Other than looking at the various factors mentioned above, it is prudent to diversify across different borrowers and platforms to reduce the risks further. Assuming you allocate a total of $100,000 into crowdfunding and fund 20 projects of $5,000 each giving you 10% return over 1 year, you will lose money if two or more projects fail with zero recovery. Managing a crowdfunding portfolio is like being your own fund manager. You need to do research on the platforms and borrowers, allocate your funds and manage your portfolio risks. Unsecured crowdfunding tends to benefit the borrower more than the lender with the latter taking on all the financial risks. If the platform provides lenders with some form of collateral, the underwriting process should get more stringent giving investors more confidence since the interests are more aligned.
This article first appeared in the November 2016 issue of Financial Planning magazine published by the Financial Planning Association of Singapore (FPAS).