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Microfinance and the power of the crowd

by Rebecca Wilson , 30.11.2012

Crowd-funding platform Kickstarter presents big opportunities for small ideas, but what does it mean for traditional financial ‘middle men’? This article maps the evolution of ‘microfinance’ from its origins in the third sector into the powerful finance model it is today, and considers how the power of the crowd in our increasingly connected world is undermining the role of traditional ‘middle men’.

So, what exactly is microfinancing? To start with, ‘microfinancing’ is often used as an umbrella term to describe a broad range of financial practices including microfunding, microcredit, crowd funding, crowd sourcing and microlending. To those not familiar with the term, microfinancing is a concept originating in the third sector designed to provide financial services to low capital micro-entrepreneurs who are not served by traditional finance institutions (i.e. banks).  The high transaction costs involved in administering loans to this group means they are not desirable recipients of traditional finance, given the limited return on a small loan.

How does microfinancing work? The old proverb “Give a man a fish, he'll eat for a day. Teach a man how to fish, he'll eat for a lifetime” is the principle behind the initial concept. Struggling entrepreneurs, generally in the third world, receive small loans from microfinance institutions in return for repayment with high interest rates (typically between 30-50%) as a way of lifting themselves out of poverty. Microfinance site Kiva, launched in 2005, partners with these microfinance institutions to connect internet users around the globe to borrowers in the developing world in need of investment. This type of microlending has been controversial: some view it as a vital tool in the fight against poverty; others are sceptical of its long term benefit to the poor, given the sometimes crippling interest rates. The main problem is that even well intentioned Kiva investors still rely on local microfinance institutions who charge high interest rates to administer the loan.

Tweaking the microfinance model: crowd funding and the power of the internet. Zidisha, a site launched in 2009 and hailed as the ‘eBay of microfinance’, comes closest to solving this problem. The platform takes microfinancing one step further by eliminating the need for a local intermediary altogether. It does this by facilitating direct peer-to-peer lending between global web users and internet savvy entrepreneurs in the developing world. Borrowers who have been vetted by Zidisha connect directly to potential investors to negotiate credit terms, often through village smartphones or solar powered laptops. It may sound risky but it has a surprisingly high success rate: 98% of Zidisha loans are paid back (with an average of 3% interest). It is this concept of sourcing small investments from multiple sources through the internet (known as crowd-sourcing) that has been adapted as a financial tool for entrepreneurs in the West. In the last few years a tough financial climate has meant banks are less forthcoming with loans and therefore potential start-ups in our own developed nations look to more innovative ways to raise the necessary funds.

Enter Kickstarter. Self-described as a ‘funding platform for creative projects’ Kickstarter, launched in 2009, allows project creators to build a project portfolio on the site around an idea and set an all-or-nothing funding target and deadline. In return for small donations the creator offers rewards (these are not financial but linked to the outcome of the project, i.e. a copy of what is being made) and if the funding target is met the project goes ahead; if not then no-one is charged.  The model is a great success, with over 32,000 projects successfully funded. Its most famous success story is Pebble, a customisable watch that syncs with your smartphone to deliver notifications without you needing to get your phone out of your pocket. Pebble Technology turned to Kickstarter when they were running out of money in April 2012 and it has now raised over $10m, ten times the original funding goal of $100,000.

Top ten largest successfully funded projects

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The benefit for tech entrepreneurs. The success of microfunding is especially beneficial for tech entrepreneurs; nine of the top ten most funded projects on Kickstarter are technology or gaming projects. Given that traditional investors are unlikely to take a risk on some of the more adventurous projects that feature on Kickstarter, the ability to connect with users who have a personal interest in your idea can allow projects to be realized that otherwise might never have seen the light of day. In this way, the ability to raise funds through crowd sourcing allows for a greater degree of freedom and creativity as there are no compromises to be made in order to get an investor on board. This is particularly true of the gaming sector where the high risk nature of investment in such projects can deter funders. As well as this, the fast-paced nature of change in the technology sector means the ability to raise funds quickly in order to stay ahead of the trends is a real asset (Pebble raised its $100,000 goal within two hours of going live). Unsurprisingly, the strong online community presence around tech in particular provides a fertile ground for new ideas to be shared and realized, which explains why 92% of money pledged for tech projects with Kickstarter is successfully invested.

Wider trend: cutting out the middle man. In the last few years the microfinance model has been increasingly used for commercial purposes to replace bank loans. Platforms such as Kickstarter and Funding Circle (a UK based peer-to-peer platform) are being utilised by medium sized firms as well as small entrepreneurs to raise capital as they turn away from the process of securing funds through banks. The increasing popularity of crowd sourcing as a financial model is disrupting traditional models of investment and the role of financial middle men. Moreover the power of the internet today connects people all over the world in ways that removes traditional financial intermediaries. Banks and lenders are finding themselves bypassed as communities connect online and work together to bring a business to fruition. This current trend moves the power away from the banks and puts in the hands of the consumer and the crowd, and this looks set to last as the microfinance model continues to evolve.

To find out more about microfinancing, you can contact the author Rebecca Wilson