What is P2P Lending and How Does it Differ from Crowdfunding?

People often lump peer-to-peer lending with crowd-funding, but between these two types of business finance, important distinctions exist as they involve people joining to ensure financial support for a cause.

Crowd-funding is often a catch-all term for various financial activities. Crowd-funding refers to two specific finance norms: equity crowd-funding and reward-based crowd-funding, and then we study how these two stack up to peer-to-peer lending.

Reward-based crowd-funding

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Reward-based crowd-funding is popular on websites like Kickstarter, where entrepreneurs with innovative projects, seeks funds for the project and some returns/rewards are sought. The point to be noted is it’s not a conventional investment as an investor is funding the project, without expecting financial returns. They want the project to succeed, but neither gain or lose money.

Equity crowd-funding

Equity crowdfunding is basically an investment in shares or equities. Typically, a young business, or just a start-up idea, could raise money to grow the business. Individuals and institutions funding businesses through this route, acquire a stake in the business which might fail, and the investor could lose the investment. It might succeed, fetching the investor, a tidy return. If seeking funds, this model has advantages, as business failure ensures its shares are worthless, and entrepreneurs need not repay. While unfair for the investors, prospects of substantial returns exist, if the business succeeds.

Crowd-funding risks

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For investors, the equity crowd-funding risk is that the business backed could fail, despite due diligence and lose their entire investment. While it’s easy to sell a share in a listed blue-chip company like Apple, shares in small, early-stage start-ups are very illiquid and are volatile. Investors might not access their money after investment is done. Crowd-funding risks need to be considered by Investors, before investment is done.

Peer-to-peer lending

Peer-to-peer lending is very different; without owning a stake in the business, the investors’ money is matched on an online platform, to a loan for a person or business. A loan is not equity as specific funds are repaid over a defined period, and investors earn as per interest repayable for the loan. The risks and rewards are very modest in peer-to-peer lending. RateSetter facilitated £1.4 billion of loans, without any investor losing a penny, but there is no guarantee for the future, as investors earned a 4.7% return. Such lending platforms specialize in lending to businesses or individuals, or may diversify risks across borrower types.

Peer-to-peer lending Risks

The major risk while lending money is when the borrower is unable to repay. Some peer-to-peer platforms offer a Provision Fund, using contributions from borrowers as part of their loan, to tide over a missed payment. This enables in providing assistance to investors in dealing with such risks. But it must be remembered, that this still remains an investment, and peer-to-peer lenders cannot forever guarantee that the investors’ money will always remain very safe.

Peer-to-peer lending vs. crowd-funding

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Comparing both loan models, equity crowd-funding is high- risk, but the rewards reflect this. Equity crowd-funding platforms are aimed at sophisticated investors, with high level of financial knowledge, as also some understanding of early-stage business risks involved. Peer-to-peer lending provides predictable returns, and risks and returns are low. Obviously, review specific platforms to find many variations of the models mentioned, with its specific strengths and weaknesses.