What is Equity Crowdfunding?

What is Equity Crowdfunding?

26 July 2023




What is crowdfunding?

Crowdfunding is the financing of a project or campaign by raising capital from a community of participants.

Conceptually, it is a collection that raises money from many people to arrive at the capital needed for the applicant to carry out his or her project: crowd means crowd and funding means funding.

An online platform (such as Mamacrowd) acts as an intermediary for raising capital and, like a showcase, displays campaigns in which it is possible to invest at the investor's choice.

This form of investment is referred to as an alternative to traditional assets such as bank money instruments, stocks, or bonds, as it allows investors to invest in companies that are not listed and therefore cannot be found in traditional financial markets such as stock exchanges.

What types of crowdfunding exist?

There are different types of crowdfunding that differ based on the reward offered to the investor. There are mainly 5 types that can be classified:

  • Donation-based
  • Reward-based
  • Royalty-based
  • Debt-based
  • Equity-based

In donation-based the investor gets nothing, but funds a cause that can be beneficial to the community.

In reward-based the reward is the product/service itself that is the result of the applicant's activity.

In royalty-based the reward is a predefined percentage of the revenue generated by the project in the form of royalties; this is a mode often used for the creation of intellectual property.

In debt-based (also called lending crowdfunding), the reward is a debt security that provides for repayment of principal at the agreed-upon maturity date plus interest, i.e., a predefined return on the principal loaned. In essence, it is a loan that can be directed to an individual(consumer lending or social lending or peer to peer lending) or to a company. These companies are generally small and medium-sized businesses, if the project is construction in nature then it is calledreal estate crowdfunding (real estate lending crowdfunding).

Inequity-based , as with Mamacrowd's proposals, the reward is a corporate stake, in this case we are becoming partners in the company in that we are buying a piece of the property. This entitles one to participate in company decisions (if the shares include voting rights), to receive any profits where distributed, and, if it were to be dissolved or acquired, to have one's investment returned revalued or devalued depending on the company's economic performance over the intervening time.
Depending on the legal form of the company, corporate holdings take different names: if the company is an LLC (limited liability company) we speak of shares, if, on the other hand, it is a spa (joint stock company) then one speaks of shares.
Equity crowdfunding is used to finance companies that have yet to be born, those that have high growth potential given a scalable business model ( startups), small and medium-sized enterprises (SMEs), and companies formed to carry out a real estate project(real estate equity crowdfunding).

Only the last two types(lending and equity crowdfunding) are considered forms of investment and fall more technically under crowdinvesting.

How to choose between lending and equity crowdfunding?

Crowdinvesting can offer very attractive returns, but a clear distinction must be made between the lending and equity versions.

The difference is the same as between a bond(lending) and a stock(equity): in the first case we are giving the company so-called debt capital, which provides a predetermined and therefore limited return, against a lower risk of failure to repay the investment.
In the second case we are giving equity, or pure risk capital that provides a potentially unlimited return, against the risk of losing the investment made in full.

This means that, in the world of loans, if the company does not repay the debt or goes bankrupt I have legal protection to try to recover what I am owed. In the world of corporate holdings, on the other hand, if the company goes bad there is nothing I can do about it (you can lose the invested capital, but no more than that), so it is riskier than a loan. However, if the company does well there is no limit to the profit I can take home. After all, with greater risk comes greater return.

A loan will have a return in the range of 5%-10% per annum while the return on a corporate holding can reach completely different levels. The way yield is calculated also differs from other types, and yield is considered in terms of multiplying "X" times the invested capital, where "X" can also mean several dozen times (e.g., 10X, 20X, 30X...)

So in lending crowdfunding we are interested in for each loan what is the level of risk that the company will not repay the debt (credit risk), the higher it is, the higher the interest rate of the loan increases.
In equity crowdfunding we care much more that the company does not go bankrupt: we care that it makes as much profit as possible (business risk) because we could benefit entirely. For this we need to understand what is the market in which the company operates and what are its chances of success.

Having clarified this difference, everyone will choose what weight to give to loans versus corporate holdings in their portfolio based on the time horizon they have and their risk tolerance.


Or discover all the lessons from the "Ultimate Guide to Investing in Equity Crowdfunding".

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