What’s Crowdfunding and the Capital Stack?
Crowdfunding is a way of raising funds through the collective effort of multiple investors(friends, family and/or individual investors). This method allows capital to raise quickly generally via internet.
Types of Crowdfunding
There are 3 primary types of crowdfunding: Donation-Based Crowdfunding, Rewards-Based Crowdfunding and Equity-Based Crowdfunding.
Investors in this type of crowdfunding will get nothing in return. Generally, it is used to help those in need. Examples donation-based crowdfunding are natural disaster relief, charities, medical bills and non-profits.
Here an incentive such as a product or service will be offered to investors. Popular rewards-based crowdfunding site are Kickstarter and Indiegogo.
Equity-based crowdfunding is where investors directly invest capital into a company. This allows the investors to be part owners with equity shares. This is great for start-up companies and small businesses.
Benefits of crowdfunding
Can get investors worldwide instead of just local investors and connections.
Having many investors worldwide will also cause you to think about the look of things. Is it easy to understand? Is it appealing to the eye?
You can market your product in more ways. Examples are via news, social media and most used just the internet.
Putting your product on a crowdfunding site can allow criticism. Which can tell you if your product is worthwhile or what you can improve on.
Probably one of the fastest and easiest ways of generating capital for a project. It allows people to find you instead of you looking for the right groups. I also allows you to build trust with possible future investors if it is a success.
Most commercial real estate acquisitions or developments receive investment from more than one source, and from investors with different goals. The capital stack is a unique concept in real estate investments to show how capital is generated and priority in distributions. The bottom of the stack is to be paid first ,thus having lower risks/returns, while moving up the stack you are paid after those in the stack below and will have a higher risks/returns.
There can be any number of stacks, but generally there are 2 main divisions to the capital stack: debt and equity financing.
Primary source of funding where capital is lent to buy or build property. This the primary source of funding due to the fact most buyers and developers won’t have enough capital on hand to do deals. Debt can be broken down into 2 categories: Mezzanine Debt and Senior Debt.
At the bottom of the stack, senior debt is a company’s first level of liabilities. They are first to be paid from investment income or if the company fails. But, since it has the lowest risks, it also has the lowest returns. Some senior debt holders will be able to voice their opinions on how much subordinated debt a company assumes.
Mezzanine debt is borderline equity and debt, due to the fact it is usually used to displace some of the capital that would usually be invested by an equity investor. This is more expensive for the borrower than the lender. Generally, senior debt will invest in only 60%-70% of the total capital to make a deal work. The other 30%-40% should be filled up by equity investors. Most of the time it will not so that’s where mezz investors come in to fill the gap.
Equity funding takes its name from equity markets. Investors of this stack invest capital directly into a project and become partial owner. Corporate shares are often placed into one of two divisions Preferred Equity and Common Equity. (Generally, investments here will be backed by the developer’s own capital.)
Preferred equity investors are paid after the debt side, but paid before common equity investors. This type of equity is similar to the Mezz debt and has a way of gaining property appreciation.
Developers and sponsors will fall in this category. At the top of the stack, they have the highest risks but also the highest returns. Equity investors, unlike debt, participate in the success of the investment, meaning that their upside or potential returns are not capped but can increase or decrease depending upon the performance of the investment.