BY David Nilssen | January 28, 2014
Crowdfunding in one form or another has been around for years but has become a sexy buzzword of late. The majority of news articles about it are positive, to the point where many seem to view crowdfunding as a cure-all for small-business funding woes. But this hype has clouded a number of pitfalls both entrepreneurial hopefuls and prospective investors need to be made aware of before jumping on board.
Crowdfunding has little application to business unless an entrepreneur only needs a small amount of money to get started. For projects requiring $5,000 or less, for example, it may be the right route. But for anything larger — especially where the total investment is in the tens of thousands or greater – it usually won’t suffice. Small amounts of capital can certainly help start a business initially but most will need to be recapitalized. Unfortunately, subsequent capital is not as easy to secure as some would assert.
That means that many of these “crowdfunded” businesses are often severely undercapitalized and that could translate to dramatically lower success rates. Some reports show crowdfunded businesses fail at a higher rate than other small businesses. As more crowdfunded businesses fail, fewer entrepreneurs will trust its model and regulations may be implemented. Companies requiring large amounts of capital will likely continue to seek traditional funding or forms of alternative funding.
Several pitfalls are often overlooked in the current crowdfunding conversation. Here are a few.
Buyer beware: While the overall financial risk can be less due to the “donation” or “contribution” being smaller, crowdfunding investors are often far removed from the business they are funding and therefore may not perform due diligence in learning about the startup, the crowdfunding platform, where their money is going or how it is being spent.
Entrepreneurs should choose their investors wisely, being strategic and selective, ensuring they are receiving capital from fully educated “angels” who understand the business, how their money is being spent and what risks they are accepting.
Ongoing obligation: Many crowdfunding models require the business to give something back to investors in the form of products, services, ongoing discounts or deal with the administrative and legal burden of having shareholders (new regulation may complicate this further allowing non-accredited investors to buy in). And while every investment should see a return, businesses must be careful to not over extend what they can deliver, or even negate the value of the funding to cover the cost of fulfilling those obligations.
Entrepreneurs should be upfront about the relationship from the beginning, outlining what discounts or deals are involved, if any. Then investors can make the decision to participate or not.
Platform credibility: With about 450 platforms now on the crowdfunding bandwagon, due diligence has never been more important. Most do not disclose how many businesses even get funding — nor will they share how many of them continue operating after the initial cash injection is accepted. And as with any financial transaction, the rise in options can lead to an increase in potential scams. There have been some reports of instances where entrepreneurs have been unable to withdraw the capital given to them, making the donation worthless.
Both businesses and investors need to carefully investigate their crowdfunding platform options to ensure it is credible and legitimate. Some have better reputations than others, so make sure to do your homework and choose the one that has a good track record of results.
Finally, as a result of its growing popularity, politicians jumped on new regulation for crowdfunding, namely the Jumpstart Our Business Startups (JOBS) Act. The JOBS Act encourages small-business funding by easing securities regulations. While I applaud the intended value, it opens the door to more abuse around soliciting investors. Many people don’t know, however, how or when the many risks associated with crowdfunding will make themselves known and even shape subsequent regulation.
So, is the hype around crowdfunding too good to be true? In a word, yes. While for some it can be a viable option, businesses and investors must start conducting the type of due diligence we have come to expect in traditional financing models to make sure it is right for them. There are inherent risks with every new business venture, but for many, crowdfunding simply has more risk than reward.