Too Risky for the Crowd? Assessing the Potential of Crowdfunding for Energy Access
Research by Energy 4 Impact shows crowdfunding raised $77 million for energy access between 2015 and the end of June 2019. If these growth rates continue, the energy access sector will have raised over $200 million from crowdsourced financing by 2020.
But despite this significant growth, crowdfunding doesn’t get much air time and remains poorly understood in the sector; it remains on the periphery of discussions on financing energy access.
The sector needs an estimated $33 billion in commercial capital to meet SDG7 (universal energy access) by 2030, and an additional $1 billion of softer early-stage support to generate a pipeline of companies that can absorb commercial investment. This funding will likely come from a diverse range of funders with different motivations, expectations and risk tolerance. But will the crowd be a part of the financing mix?
The sector seems to be divided on that question. There are entrepreneurs, platforms, co-investors and donors actively engaged with crowdfunding platforms. There are fence-sitters, waiting to see which way the wind will blow. And there are resolved critics, who believe the energy access sector is too risky for citizen capital.
So who’s right?
First, let’s be crystal clear about exactly what “crowdfunding” is, how it works, and how it is used by energy access businesses and nonprofits.
There are many types of crowdfunding, but it generally falls into two broad categories: non-investment crowdfunding and investment crowdfunding.
Non-investment crowdfunding refers to crowdfunding driven by donations and rewards, not by the promise of financial returns. In the energy access sector, donation crowdfunding tends to be used by nonprofits as an additional fundraising channel, while reward crowdfunding (think Kickstarter or Indiegogo) is used by startups.
Early-stage companies use reward crowdfunding to raise seed capital from their networks. Reward crowdfunding is a way to formalise a modest (say $10,000 to $50,000) “friends and family” round. Funders receive a small gift or reward in exchange for their contribution, but do not expect to get their money back.
Kiva is an exception to the rule. The platform provides microloans to entrepreneurs and direct loans to social enterprises which are intended to be “paid back” to the individuals who provide the funds. However, Kiva is not considered investment crowdfunding as lenders do not earn a return on their “investment,” but rather just get their money back as the borrowers repay their loans.
These approaches stand in contrast to investment crowdfunding, which involves both larger sums and a higher bar for participation.
The key difference between non-investment and investment crowdfunding is that investment crowdfunding is regulated – by the FCA in the U.K., the SEC in the U.S. and their counterparts across Europe and in Australia, Israel, Malaysia, Mexico, New Zealand and more. This means that where there are investment crowdfunding platforms, there are usually financial regulators governing activity.
In addition to investment crowdfunding regulations – which govern licensing, investment caps, fundraising limits, due diligence, promotion, and other activities – crowdfunding platforms are also subject to existing securities, lending, compliance and data laws. A bespoke legal framework, or at least a degree of regulatory certainty, is usually a precursor to crowdfunding sector growth, while regulatory ambiguity is an impediment.
Investment crowdfunding includes both debt and equity crowdfunding. Though both are regulated, these are “wildly different,” according to Julia Groves, Partner and Head of Crowdfunding at Downing LLP and long-time U.K. Crowdfunding Association Director. Let’s explore the differences between debt and equity crowdfunding.
Debt Crowdfunding – AKA P2P Lending or P2B Lending
Finance 101 tells us that investing equity in early-stage companies, which are pre-profit (and sometimes pre-revenue) is risky business, and many will fail. This is true across every sector worldwide, and isn’t unique to the energy access sector. Of course, money is also at risk when lending, but in this case borrowers must demonstrate an ability to pay back, which means they are likely to be post-revenue and in the growth phase (i.e. less risky).
Many energy access companies leverage debt crowdfunding via peer-to-peer (P2P) or peer-to-business (P2B) lending platforms to raise working capital. This type of crowdfunding accounts for over 90% of crowdfunding in the energy access sector. The average investor on a P2P lending platform lends less than $500 per campaign. The cost of capital for borrowers is usually 8% – 12% per annum and the expected return to crowd-investors is 4% – 8% per annum (for GBP and EUR denominated investments).
The lending platform earns fees from the interest rate spread, along with upfront fees (e.g. arranger fees), which sustain operating expenses. Loans are often unsecured, but to reduce risk, platforms often pay the loan proceeds directly to the product manufacturer (e.g. solar home system manufacturer). The platform’s fee model can be a helpful proxy to determine the quality of investments offered on a platform. If the majority of platform revenue is from upfront fees, there may be an incentive for the platform to originate deal volume, rather than deal quality. Ideally the platform should have skin in the game across the loan duration (i.e. revenue derived from the interest rate spread, not just from initial fees).
Platforms may also operate their own fund and co-invest alongside the crowd, which can align platform and investor interests. Some platforms have a provision fund, which is a “buffer fund” roughly equal to the anticipated default rate. (But this fund is only as good as the anticipated default estimate!) Sweden-based debt platform TRINE is the first platform to publish their default rate, which is currently 1.4% of their €28 million portfolio. However, this rate does not include loans which were covered by guarantees or investor protection.
Equity crowdfunding accounts for just 6% of crowdfunding in the energy access sector based on data from 2015 to 2018 (in contrast, equity funding accounts for almost half of publicly disclosed deals in the energy access sector, excluding crowdfunding, over the same period). Most equity crowdfunding platforms are located in the U.K. and Europe, and campaigns usually must be conducted by companies registered in the same jurisdiction as the platform.
Equity crowdfunding platforms often work with lead investors, such as VCs and impact funds, to increase deal flow and deal quality. In fact, some platforms (such as Syndicate Room) only offer investments to the crowd if they have secured a lead investor first. Either the platform or lead investor will complete due diligence.
Equity platforms typically take an upfront fee of around 5% of capital raised, although some platforms operate a co-investment fund, which is an on-balance sheet fund that invests alongside the crowd, to ensure that they have skin in the game. The average investment varies across platforms and markets, but (based on limited data) we estimate it to be typically a few thousand dollars.
Equity crowdfunding is often criticised for the low number of exits and the upfront fee model, which can misalign platform and investor interests.
Energy Access: Too Risky for Crowdfunding?
So, now that we’ve outlined these various approaches, let’s return to our original question: Is the energy access sector too risky for the crowd?
The answer is: It depends.
First, it’s important to keep in mind that non-investment crowdfunding is entirely different from investment crowdfunding. Funders of most non-investment campaigns don’t expect to get their money back. They are motivated by altruism or a connection to the campaign-maker. Even if the platform doesn’t have a rigorous due diligence process, there is a high level of social due diligence, as campaign-backers are usually affiliated with the campaign-maker in some way.
Second, investment crowdfunding models and platforms differ wildly. Making a sweeping judgement on the suitability of energy access companies for the crowd ignores the spectrum of companies across the sector – and the nuances of capital types, financial instruments, pricing, platform fee models, co-investment funds, provision funds, syndication and due diligence.
Finally, to assume investment crowdfunding is too risky for the crowd ignores investor motivations, portfolio strategy, risk-return profiles and diversification strategy. We know from our research that investors on P2P lending platforms invest because it aligns with their personal values, has a positive environmental impact and generates a financial return (based on our e-survey of over 900 participants in energy access crowdfunding, which asked individuals for their top three motivations, out of 12 motivation options). As an investor in an Azuri Technologies crowdfunding campaign said, “Investment [crowdfunding] is an underutilised mechanism to effect change that people often don’t think or know about.”
The results of our research suggest that this sentiment is shared by a growing number of investors. We found that over half of all survey respondents who had donated or invested in energy access campaigns had also engaged in other forms of crowdfunding – which demonstrates investors’ increasing acceptance of this approach. In fact, we found that donors’ or investors’ contributions to energy access campaigns represented less than 25% of their total contributions to crowdfunding, across most platforms.
This finding also suggests that energy access crowdfunders are not a niche group, and that most of these funders are actually sector agnostic, distinguished by their common embrace of crowdfunding as an effective approach. This is good news for energy companies considering crowdfunding campaigns in this space, as the energy access “crowd” might be much larger than we think.
Photo courtesy of Megapixl.