Crowdfunding is the latest catchphrase in capital formation, and these days it seems as if everyone is jumping on the bandwagon. With a profit-sharing model in close alignment to Shariah principles and a structure enabling unparalleled access to funding for entry-level players, LAUREN MCAUGHTRY looks at the astonishing growth trajectory of the sector — and asks whether this latest fashion could truly translate into the Next Big Thing for Islamic finance…
A Cinderella story
The growth in popularity of the crowdfunding model has been nothing short of extraordinary. Between 2010-13 the amount of capital raised by crowdfunding sites grew at an average annual rate of 179%, with US$5 billion raised in 2013 alone. Over US$10 billion has been raised worldwide through crowdfunding platforms in the last five years, with the number of players currently topping 500 — following a 91% increase in platforms in 2012. The US is now home to over 350 sites, along with almost 100 in the UK, over 50 in France and a growing number of launches across the developing world.
Although based on similar principles of profit-sharing, crowdfunding campaigns can be structured along a variety of different lines. The most common so far have been reward or donation-based campaigns, popularized by success stories such as US platform Kickstarter, the world’s largest funding platform for creative projects, which in the space of just five years has attracted over five million contributors and raised almost US$1 billion for over 55,000 projects. Lending platforms, such as UK-based Funding Circle or ethical platform Abundance Generation, in comparison offer debentures in return for investment, which are repaid over a period of time.
But one of the most exciting opportunities around, especially for Islamic investors, is the rise of the equity-based funding model, in which participants receive a security in the venture in return for their contribution. While one of the most complex structures in terms of regulation and participation risk, the economic possibilities for capital generation could be some of the most exciting that the market has ever seen.
Perfect fit
The equity-based model is an almost perfect alignment with Shariah compliant methods of finance, due to its fundamental reliance on risk sharing. “Crowdfund investing is both timely and authentic,” confirmed Aamir A Rehman, managing director at UAE private equity firm Fajr Capital Advisors. “Timely because it helps address the need for entrepreneurial finance in key Muslim markets. Authentic because it encourages risk-sharing, channels savings to real economic activity, and enhances financial participation-core principles at the heart of Islamic finance.” A recent report co-authored by Aamir notes that: “Islamic commercial law strongly favors equity over debt financing, which suggests that crowdfund investing platforms are especially well suited to Muslim-majority countries. In our view, crowdfund investing and Islamic financial services are inherently compatible and mutually reinforcing.”
The model not only encourages increased access to financing, but has a knock-on effect for the wider economy which is of particular importance to the Islamic industry, which emphasizes positive social benefits and involvement in the real economy. “The opportunity to allow private investment in an efficient and effective online marketplace could dramatically impact job creation,” explained Jason Best, co-founder and principal at US-based Crowdfund Capital Advisors (CCA). “You can have all these incubators and talent development plans and start-up loans — but at the end of these, you need to provide these companies with access to capital.” Before crowdfunding, this meant access to angel investors or venture capital players: and in many Muslim markets, these sectors are not yet well established — thus the opportunity to give people a chance to raise early capital from their communities is vital to encourage a culture of entrepreneurship and private sector involvement. “I am hopeful that we can have more conversations with more regulators more quickly to begin moving down this path,” commented Best.
Bridging the gap
Not only are the basic principles a close match, but crowdfund investing also has the potential to fill a key gap in the spectrum of Islamic financial services available to SMEs. “While the Islamic financial services industry has successfully designed interest-free alternatives to debt-based SME financing (typically based on Islamic trade instruments), Islamic equity financing for this segment has been more elusive,” said Aamir.
This access to an alternative source of funding has the potential to create an entirely new financial market outside of the traditional framework, which some believe could revolutionize the way we do finance. Kavilash Chawla, CEO of Nur Global Strategies, explained to IFN that: “In the markets where retail Islamic banking is thriving, crowdfunding platforms that empower individuals to transact with one another directly, outside of the formal banking system, could be a very big threat, especially in markets where the ‘Islamic value proposition’ of the Islamic banks is being questioned.” In fact, he continued: “The opportunity for equity-based crowd funding to replace certain forms of bank finance, especially for the SME sector, is almost limitless.”
Not everyone agrees, however. “This is a method to provide shared risk, shared reward financing and that can align very well with Islamic investors. But it won’t eliminate the role of banks,” thinks Best. “As the opportunity gets larger, it might instead take the place of something that actually is not happening today at all — funding many people who are not able to access traditional forms of finance — or who have been rejected from banks.”
Barriers to growth
So far, Shariah compliant involvement in the sector has got off to a relatively slow start, and a number of factors have inhibited its growth. However, with the astonishing pace of growth these are being surmounted fast and Islamic interest in the area is growing. “No one has yet developed a purely Shariah focused crowdfunding platform at scale, and there is an enormous space for that,” thinks Thomas Woolf, the MENA mission chief of charity funding platform JustGiving. “If someone were able to do that the potential could be huge — no one has filled that gap in the market yet.”
He believes that one of the factors inhibiting rapid growth is a lack of faith in e-commerce, despite the strong appetite for digital products in Muslim markets. “In the UK and US, there is a natural convergence between retail and online commerce. However, the majority of the Muslim population is unbanked, so there will probably be a five to 10 year lag in crowdfunding penetration. But the latent potential is much higher, given the average donation volume and speed with which it is growing.”
Other issues include a lack of energy and technology infrastructure impeding the ability to deliver the platform in a cost-efficient and reliable way; as well the eternal problem of human capital in Islamic markets. “Building a globally competitive crowdfunding platform, whether on a commercial or philanthropic basis, requires a very strong technology skill set, financial services/Islamic finance skill set, and social sector/social impact skill set. Getting access to that talent and bringing it together as part of a unified team… is a very difficult thing to build,” highlighted Kavilash. “You essentially need a team that brings together Silicon Valley tech talent, Islamic and western financial services, and a social impact track record. And because building the tech side of the platform and the legal and regulatory work involved is a significant initial investment, you need to be able to fundraise or be able to bank-role the development of the platform on your own. Being able to do all of that is very uncommon.”
Chris Abdur-Rahman Blauveldt, founder of US-based Shariah-focused platform LaunchGood, emphasized to IFN that the limitations in terms of jurisdictional sophistication are also a problem. “It’s painfully difficult to transfer money between countries with lots of funds lost on exchange rates and fees. Some countries don’t even allow locals to donate online unless we had a bank account open in their country (Algeria is one example), and other countries are off-and-on government watch lists, like Pakistan and Somalia.”
Picking up the pace
Nevertheless, with such enormous potential it is inevitable that the sector is starting to see significant interest. “These are still early days for crowdfunding and crowdfund investing in Muslim markets, but the rate at which new platforms are being launched suggests that a fundamental shift is underway,” observe Best.
The Muslim community is one of the most generous in the world — a 2013 JustGiving poll of 4,000 found that Muslims donated the highest amount (on average £371 (US$600) each per year), with a growing number of Muslims making their donations online. And with almost two thirds of the overall Muslim population under 30, a new generation is driving progression, innovation and entrepreneurship in Muslim markets — creating the ideal setting to receive the new concept.
Malaysian lead
Malaysia has already seen a significant take-up on the conventional side, with multiple platforms set up in the last few years: including a reality TV show-based model called Make the Pitch, along with other players such as myStartr and pitchIN. Not all are successful — some, such as the charity platform SocialSharity — have already closed. But in time-honored tradition, the country is taking the lead in terms of state involvement in order to promote the sector through regulatory encouragement. Last week, the Securities Commission (SC) released its proposed regulatory framework on equity crowdfund investing following a public consultation launched in August, which Best describes as: “The most exciting thing happening” in the Islamic crowdfunding arena, and which could hopefully increase the interest level of other Muslim majority nations in the channel as a way to provide start-ups and SMEs with access to capital.
Islamic opportunity
However, interest is by no means restricted to Malaysia, and growth is spreading throughout the Muslim world. Indonesia is an already active market with sites including Bursalde, Pantugan and Wujudkan; while Egypt (through Shekra.com) and Turkey (including Biayda and FonlaBeni) are also getting involved.
The Middle East is of course a key market to access, and has already seen activity pick up in recent years with successful sites such as Eureeca, Goodgate and Aflamnah. “There are nearly 20 crowdfunding platforms [currently] operating in the MENA region, and we expect to see the launch of Shariah compliant equity crowdfunding platforms in the Gulf in 2015,” confirmed Dr Richard Swart, partner with CCA and director of research at the UC Berkeley Program on Innovation in Entrepreneural and Social Finance, to IFN. “Countries and large institutions in GCC need help allocating resources to help SMEs. We expect to see co-investment models, where governments and funds will invest alongside retail investors — this is a signal of support, a way of decreasing risk, and of allocating capital into the SME sector.”
With formal participation by governments and trusted institutions, experts hope to see increases in private Islamic finance. “I expect the first country to make major moves will be the UAE,” predicted Swart. “Given the preference for later stage financing by Islamic banks, this should help drive more investing into earlier stage companies, which are significant employers of young workers. So there are geopolitical, economic and Islamic factors that suggest that countries should invest into their equity crowdfunding infrastructure.”
Western promise
Neither is the growth in Shariah-focused crowdfunding limited to the Muslim world. The US has seen an exceptional take up, with Fred Wilson, the founder of US venture capital firm Union Square Ventures, ** suggesting last year that if even 1% of total US retail savings were directed towards crowdfunding it could create a market worth over US$300 billion. And the country is well on the way — in the 12 months since equity crowdfunding regulations were introduced, over US$350 million has already been raised for small business and start-ups.
This potential is not only being recognized but leveraged by US Muslim communities. Multiple new platforms have been launched across North America, including LaunchGood and UmmahHub; as well as in the UK, with HalalFunder and MuslimCrowdFunding. “We’re definitely seeing an increase in interest from US Muslims,” confirmed Blauveldt to IFN. “We’ve had a huge take-up in the last several months in the US. It was slow to start, but after six months of operating people started to understand crowdfunding better and as a result there’s been a constant stream of projects in the last few months.”
Kavilash also pointed out the wider benefits to the Islamic finance industry. “In the North American market, where retail banking regulations are not aligned to the requirements of retail level Islamic banking, a crowdfunding platform such as a Shariah compliant P2P lending platform can enable consumers to execute Islamic finance transactions directly with one another, thereby opening up the market to Islamic finance at the retail level.” In addition, the use of crowdfunding rather than bank financing by mainstream players opens up the possibility of increased Islamic investor participation even in conventional projects that they may previously have avoided. For example, entrepreneur Stelios Haji-Ioannou of EasyJet fame last month partially funded his new EasyProperty project with GBP1.4 million (US$2.24 million) using the UK-based CrowdCube platform. “Islamic investors can now take an equity stake in the company, as there is no Riba-based bank loan funding it,” pointed out Woolf.
A world of opportunity
Nevertheless, it is in emerging economies that the trend really has the potential to make its mark. The World Bank in its 2013 report on ‘Crowdfunding Potential for the Developing World’ noted that: “The crowdfunding market is in its infancy, especially in developing countries, but the potential market is significant.” There are an estimated 344 million households in the developing world (with annual income of over US$10,000 and at least three months of savings), which the World Bank predicts could have the ability to deploy up to US$96 billion a year by 2025 in crowdfunding investments. The model should appeal strongly to these economies due to its potential to drive growth by “leapfrogging” the traditional capital market structures and financial regulatory regimes of the developed world.
“We really believe that there is an opportunity here for developing economies to move faster and more effectively than developed economies in this space, especially as so many people are unbanked or don’t have access to conventional financing,” emphasized Best.
Innovation & hybridization
And as the sector develops new opportunities and innovations emerge which promote even greater access and involvement across all sectors of the economy. One of the most interesting of these is the possibility for large corporations to utilize crowdfunding in various ways — whether to access new talent, find new ideas or fulfil their corporate social responsibility objectives in a manner that is profitable for all parties.
Another new trend is the growing involvement and cross-collaboration of multiple investor levels. “One of the things we are seeing on the conventional side of finance is a hybridization of models,” commented Best. “We are seeing angels coming together with crowd coming together with venture capital, with private equity, in new and different ways. And so I think that there is great opportunity for there to be innovative new structures within Islamic finance that could be created, that are aligned and that could be very beneficial to the community.”
In markets that have already developed relatively sophisticated crowdfunding sectors, such as the US and UK for example, venture capital firms that would normally enter in the later stages of a company’s life are telling their potential targets to go and crowdfund the first round of financing themselves, to demonstrate the appetite and potential for the product. “These things all lower the risk for those follow-on investors; so they see crowdfunding as a beneficial innovation,” explained Best. “I can see later stage investors who are looking for new products in the Islamic economy to be able to leverage crowdfunding as a great way to access a larger volume of deal flow.”
Regulation & protection
However, just because the growth opportunity is there doesn’t mean that everyone will be successful, and there is a danger in being too optimistic about a process that it must be remembered has no guarantees. “It is a difficult thing, to raise money for a business,” Best warned. “This just provides a new avenue to do that, but it doesn’t make it an easy process.”
Investor protection and rigorous regulation are also vital, to protect unsophisticated private investors from being carried away with excitement and losing out. Erman Akinci, the director of business development for leading early-stage digital investment firm Catcha Group, closely involved with the venture capital and online start-up space in Malaysia, raised his concerns to IFN regarding the need for stronger safeguards to protect retail investors. “This is a positive step and a great opportunity, but it has to be done properly,” he warned. “Without the appropriate investor protection and regulation, small private investors with limited experience could get badly burned — and in that scenario the adverse publicity could do the cause more harm than good.”
This issue has also been highlighted by the World Bank, which noted that: “In the case of crowdfunding, it is important that regulators rethink investor protection given an array of new tools that now are available with the rise of the Internet and the social web. To streamline bureaucracy and protect private information, individuals should be allowed to self-certify their income or net worth brackets on funding platforms and allow the technology to limit them from going over their investment allocations.”
In Malaysia, the SC has proposed a RM5 million (US$1.53 million) capital limit on participating private companies, which it believes is currently sufficient. Although the regulator has allowed microfunds onto the platform, it plans to impose rigorous provisions including registration as a venture capital company and a restriction to raise funds only from sophisticated investors. In addition, investors will be given a cooling-off period of six days within which they may withdraw their investment; and 14 days to opt out if there is a material adverse change effecting the project or the issuer.
Ease & transparency
Yet it is a fine line to walk, with others arguing that while investor protection is important, regulation must be loose enough to encourage participation from issuers. “The strength to protect investors also creates barriers for their ability to participate in equity based crowdfunding platforms,” warned Kavilash. “For a successful equity-based crowdfunding platform you need regulatory issues to be addressed and the development of a regulatory framework that enables the crowd to participate but balances that opportunity to participate against the need of the regulator to protect the investor.” Best agreed that: “First you have to protect investors. But secondly you have to make the process accessible. If the process is too onerous, then companies won’t use it and you will have wasted a lot of time and capital and effort.”
In fact, the crowdfunding process could offer regulators potential advantages over traditional investment channels. “One of the things that this market will allow is better transparency for regulators into private company transactions — because all the transactions will be available online, there will be a database available and the regulators will have a much easier job of tracking this,” Best suggested. In addition, current activity suggests that the platforms themselves are ensuring strenuous due diligence processes in order to protect their own reputation as a source of quality deals.
Expanding opportunities
As the sector becomes increasingly sophisticated, opportunities will only grow — and one of the most exciting possibilities in the Islamic space could in fact be the crossover with another key trend of the moment — the rise of ethical investing. Crowdfunding platforms focusing on the alternative energy and ethical investment arenas have boomed in the last few years, especially in western markets such as the UK (see Table 1), and industry observers are heralding the trend as a gamechanger for the renewable energy market — a sector which Muslim countries especially in the Middle East have highlighted as a core focus over the coming decades. US solar crowdfunding platform Mosaic has raised US$8 million so far, with its first four projects selling out in less than 24 hours: and analysts predict that crowdfunding could supply rooftop solar projects with up to US$5 billion over the next five years – 50 times the amount raised so far.
Leading UK platform Abundance Generation has raised US$10 million since starting operations in 2012, while Netherlands-based Windcentrale has raised EUR15.5 million (US$19.54 million) for wind-powered projects – with one project achieving EUR1.3 million (US$1.64 million) in just 13 hours. Windcentrale CEO Harm Reitsma explained to IFN that: “We enable consumers to buy a small part of a windmill. They get in return not a financial return but the produced electricity is subtracted from their power bill.” While not targeted at the Islamic market, the crossover is clear. Despite admitting a lack of familiarity with Shariah compliant investment, Reitsma noted that: “All our (nine) windmills are without any debt. So we don’t pay any interest at all. That is one of the key reasons why the Windcentrale model is unique.”
The emerging model of ethical finance in the developed world is creating a more real and tangible connection between individuals and the use of their money, giving them a vested interest in the success of the project. With Islamic finance based on similar principles, there is an obvious relationship that could be leveraged. “Creating anything new in finance is a slow burn, but we have seen strong and steady growth in both the numbers and size of investment,” said Bruce Davis, the managing director of Abundance. Speaking to IFN he explained that although the platforms were not necessarily Shariah focused or specifically targeting Islamic investors, there was a definite potential for that to come in future. “When we created Abundance, I was aware of Islamic finance in my work as an anthropologist… and we tried to mirror some of the principles and structures in the way we approached the idea.”
One of the most important aspects of crowdfunding is the ability it provides for individuals to express their personal choices through the way they invest. “We will only break through into the mainstream if we become part of the way people save and invest for the future,” predicts Davis. However, he remains optimistic: “We see the potential for hundreds of millions of pounds of investment into ethical projects beyond renewable energy — ultimately we would like ‘democratic finance’ to provide the capital for schools, roads, hospitals and ethical businesses.”
As the sector expands ever outwards, the impact can only be positive for Shariah compliant investors. With seemingly endless opportunities and new possibilities being incorporated all the time, crowdfunding truly could be one of the most exciting new trends ever to hit the Islamic finance industry.