The terms “crowdfunding” and “peer-to-peer lending” often get confused as one and the same—and there’s a good reason for that. Both involve groups of people providing financial assistance in support of entrepreneurship, usually small business ownership. But peer-to-peer lending is actually a subset of crowdfunding, and the terms shouldn’t be used interchangeably. Why? Because these two business loan alternatives offer different advantages and disadvantages, depending on your business type and goals.
What is crowdfunding?
Crowdfunding and peer-to-peer lending are very often used as an umbrella term to encompass all sorts of group funding methods. In reality, however, crowdfunding refers specifically to when multiple businesses, organizations, and/or individuals provide funding for a project or venture, resulting in many smaller donations spread across multiple entities.
By sourcing from a “crowd”, these businesses are able to secure the boost in cash flow needed to get their project off the ground. The majority of these startup funding campaigns are run through internet platforms, with set time frames and monetary goals.
What are the different types of crowdfunding?
There are four types of crowdfunding: donation-, rewards-, equity-, and debt-based.
- Donation-based: This type of crowdfunding refers to receiving financial support, in the form of donations, in which the person or company donating receives nothing in return. One of the most popular donation-based crowdfunding platforms is GoFundMe.
- Rewards-based: Unlike donation-based crowdfunding, participants in rewards-based crowdfunding receive a “reward” for their support. Generally, the reward varies based on the size of the contribution in order to incentivize larger amounts. Most campaigns of this type will offer a product—usually at a discounted price—or branded merchandise. Notable rewards-based crowdfunding platforms include Kickstarter and Indiegogo.
- Equity-based: As its name suggests, this type of crowdfunding offers contributors a portion of ownership in the business in exchange for financial support; participants receive a number of shares depending on how much they contribute. A prominent example of equity-based crowdfunding is Wefunder.
- Debt-based: Debt-based crowdfunding refers to peer-to-peer lending, in which contributions are loans that need to be repaid with interest within a certain timeframe.
How does peer-to-peer lending work?
Peer-to-peer lending, or debt-based crowdfunding, brings together a group of like-minded entrepreneurs who want to make contributions to businesses by loaning them small(er) amounts of money. Rather than owning a stake in the business, like in equity crowdfunding, investors loan the business a specific amount of money via an online platform like Upstart, Funding Circle, or Fundable. This amount is then repaid over a set repayment term, in which investors receive a return through interest payable on the loan. Some peer-to-peer lending platforms specificalize in certain types of businesses or even types of borrowers—such as iFundWomen—whereas others apply to more broad demographics.
Which business loan alternative is right for my business?
Generally speaking, equity crowdfunding tends to come with higher risk, because it doesn’t guarantee a return on investment. The most notable risk when it comes to peer-to-peer lending, on the other hand, is that the borrower doesn’t pay the loan back. In order to help mitigate this risk, some platforms offer a provision fund, in which contributions taken from borrowers are part of their loan—which can then be used to compensate the investor in the event of a missed payment.
Because equity crowdfunding is inherently riskier, it tends to attract more sophisticated investors with a high-level knowledge of finance, startup funding and early-stage businesses. Since peer-to-peer lending offers more predictable returns, the barrier to entry is lower, and both the risks and consequent returns are comparatively lower.