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The Magic Bullet of Crowdfunding

posted Jul 30, 2014, 8:51 PM by Siamak Ebarhimi

I am not against crowdfunding. I think it's great for funding small projects including art, community projects, and even to develop a new product. Crowdfunding gives people an opportunity to help get a project or company going with an initial injection of capital from the public (or, perhaps a group of wealthy individuals). However, I think people are starting to confuse equity crowdfunding with investing. Similarly, I think some entrepreneurs are starting to believe that they can completely replace the traditional fund raising process with crowdfunding. Crowdfunding is not a magic bullet for the startup world.
crowdfunding marketing

If you're thinking about investing via a crowdfunding platform, do it with only money you can afford to lose, and realize that you have a high probability of losing your money.

If you're thinking about raising money via crowdfunding, carefully consider the downside and limitations of crowdfunding. The amount of money which you can raise is probably limited, and you may have to spend lots of your time dealing with investors.

The investor perspective: Crowdfunding has undeniable appeal. Who doesn't want to get in on the "ground floor" on the next Facebook? Or, go out to a restaurant in which you're a part owner? There is an emotional reward and excitement to investing in a business.crowdfunding advertising

But, there are several problems with this early stage investing. First is most new businesses fail. Within five years of starting, around half of all new businesses fail.Second, even if the business which you invest in doesn't fail, there is no guarantee that you will receive any financial reward or will be able to sell your investment. The business may not generate profits to pay investors, or may reinvest everything back into the business. If the business does succeed from a financial standpoint, it does not always result in the initial investors reaping a big reward. For example, a business may require additional funding, and give the new investors a deal which provides them most of the upside.

I haven't gotten into the technical problems with crowdfunded investments. The initial valuation for the businesses is generally being set by the companies themselves. While investors can choose not to invest, or negotiate, they probably don't have an extensive enough knowledge of current market conditions to determine a fair valuation. Secondarily, the terms and conditions of the investment may not be favorable. Will an investor putting in $10,000 spend $4,000 having a lawyer going over documents and try to negotiate different terms?indiegogo marketing

The company perspective: I don't think most CEOs of early stage companies like raising money. Even getting the attention of a venture capitalist can be very difficult. The due diligence process takes an enormous amount of time and can seem to last forever. There is also the issue of control. Most venture capitalists want to have a some influence over major company decisions. Crowdfunding would appear to be a way to quickly raise money without having to give up control of the company.

Plus, there is an added bonus. Getting customers to become owners can establish greater loyalty and potentially create brand evangelists. I saw this effect up close and personal after I bought my nephew a single frame share of the Boston Beer Company (Sam Adams) around his 21st birthday. For a while, I remember Sam Adams becoming his favorite high end beer.kickstarter marketing

There are a couple major problems with having lots of individual investors. First, they expect that you will keep them informed of the progress of the company. Many of them will have questions and expect timely responses. More investors means more time (or expense) handling investor relations. The CEO of BucketFeet, which early on raised money through crowdfunding, indicated that he probably wouldn't have done it had he known the time investment it would entail. His remarks were made during a Q&A session during the most recent Chamber of Commerce -Small Business Summit.

During the same event, the CEO of CheezBurger put forward another reason for getting venture capitalists involved. They provide more value than just money. They have resources, connections and advice which can speed up the company's growth.kickstarter project

Lastly, there seems to be a limit as to the amount of money that most companies can raise through crowdfunding. I just took a look at recently funded deals through one of the more popular platforms, Fundable. In looking at dozens of successful deals, I could only find one company that raised more than $2 million dollars. A glance at other platforms confirmed that companies were not raising, or trying to raise, large amounts for investment. These are primarily companies getting their first round of capital. What happens when a company needs to raise a bigger round? Well, they are probably going to need to find an institutional investor to provide it. In other words, they might end up with the worst of both worlds. Many individual investors demanding their time and institutional investors demanding control.

That said, I think there are some situations in which crowdfunding makes sense. For example, every once in a while I think about owning a professional sports team, a professional women's soccer team to be specific. This is a business that I don't think a venture capitalist would be interested in backing given the historical failure rate of such ventures. Furthermore, creating a tight relationship with a fanbase would be critical to success. If I wanted to raise money for this, I think crowdfunding would be a good option.

What are some other options for funding a very early stage business? Here is an article that I wrote recently for Fit Small Business.CrowdFunding advertizing

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By David Khorram