Crowdfunding and peer-to-peer lending are often regarded as one and the same, and it’s easy to see why: they both involve people coming together to provide financial support for something. In reality, however, they are very different beasts.
What is crowdfunding?
One of the reasons why people confuse crowdfunding with peer-to-peer lending is that the word ‘crowdfunding’ is often used as a catch-all term for many different financial activities. For the purposes of this article, we’ll be using crowdfunding to refer to two specific types of finance: equity crowdfunding and reward-based crowdfunding. We’ll then take a look at how these two compare to peer-to-peer lending.
You’ve probably heard of reward-based crowdfunding on websites like Kickstarter, where someone with a project, such as launching a niche recipe book, looks for like-minded individuals who can help fund that project (for example, to cover the printing costs). In return, they’ll usually get some form of reward: in this case it might be a signed copy of the book or an acknowledgement in the introduction.
The crucial point here is that it’s not really an investment in the conventional sense: an investor is funding a project, but not expecting a financial return. They’ll be rooting for the project to succeed, but they don’t stand to gain or lose money either way.
Equity crowdfunding is closer to an investment in shares – also known as equities, hence the name. Typically, people with either a young business, or maybe even just an idea, raise money in order to grow that business. The people and institutions who fund businesses through equity crowdfunding get a stake in the business: it might fail, in which case the investor could lose their investment, or it might prosper, in which case the investor could be in line for a tidy return.
From the point of view of the business seeking funds, there’s a clear advantage to this model: if the business does fail, its shares are simply worth nothing, and the business owners would not need to repay anything. Not so good for the investors, but then they have the prospect of substantial returns if the business comes good.
What are the risks of crowdfunding?
For investors, the primary risk of equity crowdfunding is that the business they’ve backed may fail, in which case it’s likely that they’ll lose all of their investment. There are other things to bear in mind too – while it’s relatively easy to sell a share in a listed company such as Apple, shares in smaller, early-stage companies are notoriously illiquid and subject to volatility. This means investors might find it difficult to access their money after it’s been invested.
What is peer-to-peer lending?
Peer-to-peer lending is a different model: rather than owning a stake in a business, investors’ money is matched, via an online platform, to a loan for a person or business. A loan is very different to equity: it’s a specific amount of money, repaid over a defined term, and investors earn a return via interest payable on the loan.
Generally, the risks and rewards are more modest with peer-to-peer lending. RateSetter, for example, has facilitated £1.4 billion of loans, but no investor has ever lost a penny – although this is not a guarantee for the future. On average, its investors have earned a return of 4.7%.
Peer-to-peer lending platforms may specialze in lending to certain types of borrower – individuals, businesses or property businesses – or may diversify across borrower types.
What are the risks of peer-to-peer lending?
The main risk when lending money is that the borrower doesn’t pay it back. To help investors deal with this risk, some peer-to-peer platforms offer features such as a Provision Fund, which take contributions from borrowers as part of their loan, and step in in the event of a missed payment. However, the bottom line is that this is still an investment, and peer-to-peer lenders cannot guarantee that investors’ money will always be safe.
Peer-to-peer lending vs. crowdfunding
Comparing the two models, equity crowdfunding is higher risk, but it could be argued that the rewards on offer reflect this. As a result, equity crowdfunding platforms tend to be aimed at sophisticated investors, i.e. people with a very high level of financial knowledge, as well as a good understanding of early-stage businesses and the risks involved. Peer-to-peer lending provides more predictable returns, and both the risks and returns are comparatively lower.
Obviously this guide is just an overview, and if you start to look at specific platforms, you’ll find that there are dozens of permutations of the models outlined above, each with its own strengths and weaknesses.
About the author
Paul Marston is head of commercial divisions at RateSetter, a peer-to-peer lending platform that matches investors with creditworthy businesses and consumers throughout the UK. Marston has a wealth of experience within SME finance, having previously held senior positions at RBS and Secure Trust Bank.