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Crowdfunding: Saviour or scam?

Digital distribution, alpha funding, paywalls; the last few years have seen a glut of new business models encroach on the technology sectors, each claiming to be the future of the market. Some have managed to secure successful footholds, while others have been little more than flash-in-the-pan successes.

Enter crowdfunding; potentially an exciting new way for start-ups to do business, but one that’s still yet to prove it’s more than just a transient trend.

How crowdfunding works is simple: start-ups pitch their ideas online just as they would to investors. Customers pledge money in response and when the company has raised as much money as it needs, the plan moves forward. Crowdfunding pitches are typically hosted on dedicated online platforms, but in theory can be hosted anywhere. What’s crucial is that the money comes from large numbers of potential customers, not from single investors or other companies.

(opens in new tab)What has helped popularise the model though, is that the platforms most closely associated with crowdfunding, such as Kickstarter and Indiegogo, go beyond this basic setup and actually structure the process like a competition. Time limits and funding goals act as finishing lines, with companies pressed to raise the minimum sum before the time runs out and customers - or ‘backers’ - act as both the arbiters and means of success. Pledge enough money and backers will usually earn a small prize too, meaning it’s a competition where everyone’s a winner.

Well, unless the company fails to raise enough money in time, in which case it gets nothing and no money is charged to the backers. But, anyway...

It’s this competition-like structure that has helped the crowdfunding model take off so convincingly in recent months, drawing in the excited attention of social media networks and large communities. As with any sort of competition, involvement snowballs; those who’ve backed just a single project will soon look for others or will seek a greater level of involvement, as well as telling others about their ‘investment’. The crowd just keeps getting bigger and that creates a sizable resource for crowdfunders to draw on.

“I think one of the reasons crowdfunding has gained popularity is that it's about more than just raising money,” says Danae Ringelmann, Founder and Chief Operating Officer of Indiegogo. “Many of our campaigns are for ventures just starting out, and not only have they been able to raise money, but they get customer feedback along the way and ultimately improve their product - resulting in a very successful full launch.”

Indiegogo launched five years ago and is generally regarded as the largest crowdfunding platform.

So far, the most successful crowdfunded projects are those which have taken full advantage of this dialogue too, such as Eric Migicovsky’s campaign for his e-paper watch idea, Pebble (opens in new tab). Offering a limited number of rewards to drive anticipation, the Pebble campaign included rewards specifically targeted at developers and hackers as well as a means by which potential backers could ask questions or suggest ideas.

“Indeed, we used our backers as a means of vetting some of our features and helping direct development for things like colour selection,” says Rahul Bhagat, Pebble’s Head of Operations. “We also hired help to manage backer relations by answering questions and interacting with the Pebble community.”

The result of this community-focused iteration and constant dialogue - not to mention the exciting potential of the product - was that Pebble’s Kickstarter campaign was a rousing success. The team smashed through their original $100,000 goal and went on to raise more than $10 million in just 30 days - all directly from customers.

Money for nothing?

Publicity and customer feedback aren’t the only benefits which crowdfunding presents to start-ups either; it allows them to raise funds without surrendering control too.

“We tried crowdfunding because we wanted to retain control of our product and intellectual property,” says Dennis Dryden of Glass Bottom Games, which last year tried to raise $25k in funding for a new videogame project. The team looked at other fundraising solutions, but saw that crowdfunding was the only way to finance the project while retaining the level of control they wanted.

The twist is that crowdfunding only offers companies that sort of certainty because of legal limitations drawn from the language used, however. The law is clear that while backers are supporting the companies, they are emphatically not investing in them - and equity is therefore not on the table no matter how much money changes hands.

“We always use the word ‘contribution’ because it doesn’t have the same implications as words like ‘investment’ or ‘donation’,” says Danae, outlining Indiegogo’s position on the matter. “Until the SEC finalizes the rules and regulations, Indiegogo – and any crowdfunding platform for that matter – will not be able to offer equity crowdfunding, so no investments are legally allowed.”

The Ouya games console raised over $8 million in a Kickstarter campaign, but has yet to launch.

The downside of this security though is that pitchers have to pay for it, with platforms such as Indiegogo typically taking a fee of between three and five per cent of the raised total - a sum that, though it may seem small, still allows for significant revenue. Indiegogo launched over five years ago and is generally seen as the biggest crowdfunding site, but even the comparatively new Kickstarter has still seen more than $306 million in successful pledges since launch.

Some have argued that it’s not clear what that three-to-five per cent fee is buying the pitchers and backers, however - other than the brand appeal and replicable billing framework built into the sites. Most pitchers and backers initially approach crowdfunding with the assumption that the function of the platform is to protect both parties, but close inspection of the process reveals that’s not the case at all.

The Fundamentals

If there’s one problem that looms over crowdfunding then it’s quite simply that there’s no possible way for either companies or backers to know that the other is capable of delivering. A pitch may promise the moon on a stick for $100 and a backer may pledge a million dollars in return, but until the final exchange of goods there’s no assurance that anyone is who they say they are - and the platforms aren’t in any apparent rush to solve this problem.

“Indiegogo is not a gatekeeper to what projects can or can’t be funded on our platform,” says Danae. “We’re open to anyone, anywhere, for anything. Indiegogo presents the community with projects that are asking for contributions, and it’s up to you, the funder, to decide if you want to contribute or not.”

How do funders know that the fundraiser will actually use the money as they indicate? They don’t - and Indiegogo is clear in its Terms of Service that it takes no responsibility for promises made in pitches. If that perpetual motion machine you invested contributed $1000 to never materialises, that’s just too bad.

Fraudulent pitches aren’t the only threat either, as all manner of issues can crop up to trouble a new company - including inexperience with crowdfunding itself. Mobile game developer Warballoon seemed to be doing well when it smashed its funding target last year, for example, but the funds quickly disappeared. Platform fees, unfulfilled pledges and the cost of reward fulfilment for backers meant the team was only able to keep $22k of the $36k it raised - of which $16k was then spent on basic equipment and business costs. That left just $6000 to fund development of the pitched project...a third of which was then taxed.

"We didn't fully appreciate the cost of printing posters, shirts, and more than anything shipping,” the team said after fundraising had finished, admitting it had accrued a further $50k in private debt since the Kickstarter campaign. A second Kickstarter campaign was then launched which saw the team raise over $150k for development of a PC and Mac version of the same product.

The fact that crowdfunding platforms such as Kickstarter - which refused to comment for this article - don’t take a more active role in protecting backers and pitchers is an issue of self-preservation. There’s just no way they could remain viable if they were to offer any sort of guarantee to either party - though their inability to protect customers isn’t the only complaint levelled at them.

The Pebble ‘smartwatch’ achieved massive success by involving backers in development.

“Kickstarter isn’t the greatest when it comes to gathering backer information and is really geared towards smaller backer sizes,” said Rahul Bhagat of Pebble’s experience with the platform. “For example, a creator can only send out one survey after the end of the project to gather shipping information from their users. We ended [up] having to design an account system for our backers – one where they could log in and change their addresses.”

Following high-profile successes such as the Ouya games console (opens in new tab) - which promised to revolutionise home entertainment on a budget of $950k and raised $8 million as a result - Kickstarter has started to confront these sorts of concerns directly, however. New guidelines have been put in place requiring pitches to discuss the challenges ahead, as well as limiting the types of product demonstrations that can be shown.

These are guidelines which many have been welcomed, with the overall consensus seeming to be that they’ll encourage more informed pledging and pitching all round. The real question though is whether the guidelines have arrived in time; with so many projects still yet to deliver on their promises there’s still a chance that success stories could turn into business nightmares.

Kickstarter and Indiegogo may present a confident face for the crowdfunding business model, but how scalable their methods are is something that won’t be proven for many months yet.

If you have invested in a crowdfunded project let us know how it went and whether you'd do so again in the comments below.