By Patty Do
Generally, a crowdfunding capital raise is structured as either equity or debt. Equity is issued as stock, representing a form of ownership in a company with no defined maturity date. On the other hand, debt capital is raised in the form of a loan or promissory note to be paid back at some point in the future, usually with a fixed interest rate. Debt offerings on equity crowdfunding platforms tend to be open for a shorter duration. Let's discuss the basics of debt-based crowdfunding and why investors should consider using debt instruments to better position their portfolio against market volatility.
Debt-Based Crowdfunding Basics
In a debt crowdfunding deal, the Private Placement Memorandum (PPM) will outline the complete provisions and terms of the loan or promissory note. Thus, investors should first understand some key terms before investing in a debt instrument, and examples of loans structures.
Crowdfunding - the practice of funding a project or venture by raising capital from a large number of investors through an online platform
Private Placement Memorandum - the legal document that describes the details of the offering such as objectives, terms, risks, etc.
Principal - the amount of capital originally invested in the project
Interest Rate - the percentage rate, usually quoted annually, at which interest is paid by the borrower to the lending party (investor) while the loan is outstanding
Interest - the cash paid to the investors by the borrower until loan maturity calculated as: Interest = [interest rate/ payment frequency] X [outstanding principal balance]
Maturity - the date at which the outstanding principal balance must be paid and returned to the investors in full
Collateral - the property or other asset that the borrower offers as a way for the lender (investor) to secure the loan
Default - failure to make timely payments of principal or interest
Amortization - the act of paying the principal balance off overtime between the issuance of the loan and loan maturity
Example 1: Figure 1 below illustrates a paid in full at maturity loan structure on a $100,000 3-year note at 5% interest rate (pay quarterly)
Figure 1
Example 2: Figure 2 below illustrates an amortized loan structure on a $100,000 3-year note at 5% interest rate (pay quarterly)
Figure 2
Pros & Cons of Debt-Based Crowdfunding
Debt-based crowdfunding offers great advantages with low entry levels, passive income, security and tax savings. It also minimizes risk in a single project while providing cash flow generated through interest payments, usually on a quarterly or monthly basis. In most cases, debt sits at the very top of the capital structure, making it the first to be repaid with the assets of the borrower in the event of liquidation or bankruptcy. Depending on the deal structure, some debt crowdfunding deals can provide provide passive income for self-directed IRA investors without incurring Unrelated Business Income Tax (UBIT).
Like all forms of investing, there are a few disadvantages to debt-based crowdfunding. Debt can come in a plethora of complex financing structures, for example, asset-backed securities, mortgages, unsecured, convertible, and more. Plus, the rate of return is typically lower than its equity investment counterpart.
Debt-Based Investment Risks
Of course, with any form of investment including debt-based crowdfunding, there are substantial risks that investors need to take into consideration. Here are three of the top debt-based investment risks to consider.
Default Risk - The risk that a company may be unable to make the required payments of principal or interest and may result in the loss of some or all of the principal invested.
Inflation Risk - The chance that cash flow from an investment won’t be worth as much in the future because of changes in purchasing power due to inflation.
Interest Rate Risk - The risk that an investment’s value will change due to a change in the absolute level of interest rates. A potential increase in market interest rates is a risk to the value of fixed-income debt investment.
Investors should understand the specific risks that affect their investments and be informed about factors like location, condition of a specific market, and general economic conditions. However, crowdfunding is a smart investment channel that enables investors to mitigate risk exposure through smaller and more diversified investments.
As with all crowdfunding investments, investors should do their own due diligence to understand the risks involved and the value of return offered by the debt investment. The key point is never to invest more than you can afford to lose.
Despite your level of knowledge on debt-based investment risks, its important to note that they are still a great investment option.