Saturday, February 2, 2013

Community Supported Agriculture - an example of Project Based Crowdfunding

Step 1: (Insert Great Idea)
Step 2: ???
Step 3: Profit!!!

Though amusing, it has a grain of truth - there are several stages a business has to go through to make money.  Usually these include:
  1. Research & Development (R&D) - figuring out what will sell and how and when to make it.
  2. Financing - getting the money to front the costs of production.
  3. Production - making the product.
  4. Selling -  getting customers interested in buying it.
  5. Distribution - getting it to them.
This is a risky process.  Lots of money can be spent on R&D without getting anywhere.  Financing may not be available when it's needed.  A breakdown can cut production.  Sales can be unpredictable.

Business Risks in Agriculture
All of these concerns are magnified in agriculture, which deals with a perishable product with a very long and unpredictable production process.  Farmers might borrow money to do the planting, and later run into trouble when a bad crop or low prices at harvest time left them with insufficient money to pay back the bank. 

Current Risk Management Process - Futures
Presently, farmers can deal with this using futures.  This is essentially pre-selling the harvest at a set price now.  Though this provides protection against price changes, it adds a transaction cost.  Furthermore, futures are typically only available for a few years ahead.  At the end of the day the farmer is still at the mercy of global commodity markets.  

Community Supported Agriculture (CSA) - an overview
CSAs are a form of project-based crowdfunding where customers' payout depends on how well the crop does, as opposed to a fixed interest payment.  
  1. Research & Development (R&D) - figuring out what will sell
  2. Financing & Selling - customers buy a share of what the farm will produce.  Note that unlike a future, which is to buy a fixed quantity at a fixed cost, a customer buying a CSA share buys a variable quantity at a fixed cost.
  3. Production
  4. Distribution
 Aside from warm fuzzy feelings and other intangible benefits CSA provides, it provides the following economic benefits:
  • Farmer has less risk of losing money if harvest isn't good.
  • Farmer has reduced financing transaction costs since it's now combined with marketing.
  • Farmer has reduced marketing costs due to repeat customers.
  • Customer has lower cost food due to lack of middlepeople and the taking on of some risk.  Note that presently most CSAs focus on organic produce and other high end food so the price appears high, even though CSA food is generally cheaper than purchasing food of equivalent quality from a store.  
  • No food wasted at farm - everything produced goes to the customers.
CSAs started in Europe and Japan in the 1960s, and expanded to the USA in the 1980s.  As one of the earliest forms of modern project based crowdfunding, the CSA-style model has been adapted for producing books, art, and small-run manufacturing by Kickstarter

Project based crowdfunding appears most suitable for industries with the following characteristics:
  • Consumer product.
  • Long (but not overly long - several months to a couple of years is likely the practical limit) production time.
  • Economies of scale in production or significant minimum quantities.
  • All product is delivered over a short period of time.
Industries suitable for project based crowdfunding:
  • Real estate - new construction.
  • Movies.
  • Specialized electronic gadgets or software with short lifespan before obsolescence.
  • Concerts, shows, other live events.
  • Biofuels.
  • Package vacations.
  • Fashion.
  • Specialized services (such as music teachers in a rural area).
  • Fractional ownership of custom luxury vehicles.
Minimal R&D needed prior to production helps.  Farming is the classic example of this - everyone knows what an apple will taste like, whereas a movie or gadget needs some investment in concept design or prototyping before crowdfunding can begin.

Full size header image.

The header graphic is inspired by old-fashioned Victorian-era stock certificates, and muses on some topics that future posts will cover, such as renewable energy investment trusts, small business financing, limited equity housing cooperatives, community supported agriculture, global development, crowdfunding, and participatory budgeting.  

For those who want to view all the details, click the thumbnail image below for an enlarged version of the header image.  It is available under a CC-0 Public Domain License.  Feel free to use it for anything! 

Limitations to Peer to Peer, or why equality matters

Since communal finance relies on individuals using their own knowledge and social networks instead of paid professional experts to judge whether something is worth funding, communal finance works most efficiently when wealth is evenly distributed. 

Why?  Let's say you have $1,000 to lend or invest this month.  You could easily set aside a couple hours to think about where to best put it.  That's about an hour of thought for every $500.

Now, let's look at someone who has $1,000,000 to allocate this month..  If they were to spend an hour thinking about each $500, they'd be thinking for 12 weeks without sleeping!  Sure, they could hire someone to help, but that adds a transaction cost.  What typically ends up happening is that the rich person will end up financing a handful of large companies and projects, even if there are hundreds of vegan hot dog stands that are more profitable.  They just don't have the time to deal with crowdfunding

Globally, 1% of humanity owns nearly half the wealth.  The diagram here illustrates what's going on.  There are actually one and a half Earths depicted since humanity is presently exceeding the planet's carrying capacity and using resources faster than they are replenished. 

That's a lot of money that is probably not going to make it into communal finance.  Instead, it will most likely go to megaprojects like new airports or billion-dollar companies. 

In the United States, the distribution of wealth is similarly skewed.  Five Earths are shown to the right - the amount of Earths needed if all of humanity were to live like Americans.  Almost 2 of them are owned by the 1%.  The bottom 80% of Americans own less than 20% of the country's businesses, buildings, natural resources, land, and money. 

What does this mean for crowdfunding?  As long as wealth remains unequal, large amounts of money will not go into crowdfunding.  The good news?  By cutting out the Wall Street middlepeople in getting companies, infrastructure, and home loans funded, crowdfunding can help reduce income inequality by turning back the big sucking sound of money going into Wall Street investment banks. 

As with many other issues such as climate change, consumer action can only play one part of the effort towards a more humane financial system.  Political action such as higher taxes will also be needed. Only when money is more evenly distributed and can it get the attention it deserves. 

Peer to Peer Loans - Reducing Transaction Costs

Let's say you had $100 available that isn't needed for any immediate purpose.  You could put it in the bank and earn a little interest, or you could lend to your friend Bob who wants to start a vegan hot dog stand.

Presently, interest rates on savings accounts and certificates of deposit at banks and credit unions are very low - often 1% or less.  But if one were to go borrow money from the bank, it might cost more, perhaps around 5%.  The other 4% goes towards the bank's profit, and a portion also goes towards covering the bank's transaction costs, which include:
  • Staff salaries.
  • Bad debts that never get paid and have to be written off.
  • Office rent and other expenses. 
Now, not satisfied with the 1% interest from the bank, you go to Alex.  Now since Alex isn't able to get a loan from the bank, he's willing to pay a higher interest of 10% a year.  Though he she has a solid business plan, it's such an unusual idea that the bank doesn't have any formulas to use.  It would have to spend staff time analyzing the vegan hot dog market, further adding to the transaction cost. 

Still, it's hard to say if Alex's hot dog stand is going to make it, and maybe you don't want to risk $100 on her.  $10 or $20, maybe.  But now you need to find four other friends who need money and evaluate if they're going to pay it back, and when payment time comes, you need to track them down and hope they don't flake... in short, that's a lot of transaction cost.

At the end of the day, it makes more sense to just put money in the bank, even though you'll only get a measly 1% a year, and the world will miss out on Alex's delicious hot dogs.  Instead, your money goes to fund mountaintop removal coal mining

Net Return refers to net return on investment - in other words, how much money you earn by lending your money out.

Now, along comes online peer-to-peer lending.  A new model less than a decade old, this takes the form of a website where you can lend directly to other people.  The website handles all the payments and other formalities.  You don't need to lend the whole amount, just a portion.  And if not enough people think Alex's vegan hot dogs are a viable business, the loan won't get funded and you'll get your money back.  Equally important, Alex's success in paying back that hot dog loan will determine if she'll be able to borrow more in the future. 

In short, transaction costs are cut dramatically.  Now it's possible to diversify over several loans without having to deal with lots of paperwork.  It's also possible to find potential borrowers much more easily.  Maybe you know that vegan hot dogs are the next big thing.  Alex is only in your town, but you discover on the website that Ben in Portland also has a similar idea.

At the end of the day, more unconventional but profitable businesses get funded, the financial industry still gets to make money (and in fact can now serve additional markets), and you the lender earns more interest.  It's  win-win-win.

This model can also be applied to equity investments, where instead of getting a fixed interest payment, you own a share of the business and get a portion of its profit paid back as a dividend.

Examples of peer to peer crowdfunding include:
Lending Club and Prosper - personal loans
Mosaic - funding solar panel installations

More detailed analysis of these and other crowdfunding websites to follow in future posts.

Note that transaction costs are still somewhat higher for crowdfunding than putting money in a bank, which creates a limitation to this model for folks with lots of money.   This will be explored in the next post. 

Why Communal Finance?

In the modern world, personal finance has become one of those ever more important life skills, ever more necessary for access to education, housing, and retirement.  But realistically, how much financial literacy can the average citizen be expected to have when even experts in business and government often get it wrong?

As for those with the skills and good fortune, eventually one runs into the law of diminishing returns - also known as "Money can't buy happiness".  While the latter statement kicks in only after reaching the upper middle class income range, it does call to attention an important point - that the economic health of one neighbors and friends and the society one lives in is just as important as one's personal financial situation.

Is Wall Street still a necessary evil?
Finance - the practice of deciding where how resources are allocated - is going through an exciting time.  The 2008 global stock market crash and subsequent recession have raised questions on the effectiveness and fairness of current financial systems.

However, technological innovations such as crowdfunding and peer to peer lending have opened up alternatives to the existing bank and stock market model.  Once these new markets grow big enough to carry the borrowing and project financing needs of the economy, Wall Street will no longer be too big to fail.

What is Communal Finance?
In the existing financial system, people who have extra money to loan out or invest give it to experts such as investment bankers or analysts who pick and choose companies to buy or governments to lend to.  Even when people decide to pick stocks individually, it is often based on statistics compiled by specialists.  Doesn't sound very democratic, does it?

Communal finance cuts out the middlepeople, bringing lender and borrower, investor and entrepreneur together.  It's a communal approach to resource allocation that relies on collective wisdom instead of expert knowledge to decide what is worth funding.  Maybe you have a bit of local or personal knowledge that isn't captured in a formula. 

Unlike existing corporate or personal finance, where real companies and real people and real places are reduced to standardized numerical abstractions, communal finance can take in the full richness of the human experience and ultimately make more humane, safer, and more profitable decisions.

Communal finance can take many forms.  It could be thousands of people funding a movie on Kickstarter, providing a portion of a loan to a stranger overseas, or investing in a new local business.

Coming up in this blog:
  • Examples of communal finance websites and projects.
  • Communal finance case studies.
  • Key concepts explained.
  • Musings on the history and future of finance.
Your contributions are wanted!
This wouldn't really be a communal finance blog if it was just me doing the writing.  Got an idea?  Some skills to share?  A project to publicize?  Email me at mail -at -