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Riskology

Fund a fledgling business — but don’t call it investing

About the author

Ari has written about financial products and investing for The Wall Street Journal, Forbes, and Pensions & Investments. Find him on Twitter.  

(Harley Schwadron)

(Harley Schwadron)

Want to be a patron of the arts? Give a small business a fighting chance?

On crowdfunding platforms such as Kickstarter and Indiegogo, artists, entrepreneurs and people promoting causes have an opportunity to turn their ideas into reality. And you, Jane and John Chequebook, get to make it happen as long as you front them a little cash.

It’s a simple concept: an individual or group posts an idea or cause and then markets it heavily to attract funding. On the other side, people search for cool new products or interesting initiatives to support.

But one thing crowdfunding is not: investing.

Handing your money over to a crowdfunded idea makes you more a customer than an investor. Customers expect products. Investors expect dividends, interest and returns.

Crowdfunders, unlike investors who buy shares or lend to a company are usually putting money into something un-established, such as an unmade documentary or a new wireless gadget. The money raised through crowdfunding may be a critical part of making that product or idea come to life.

Confused? Consider what crowdfunding is really all about. Marketing. New Concepts. Feedback. Traditional investing is, ostensibly, about return expectations, growth prospects and risk. Investing can earn you cash. Crowdfunding could earn you, well, nothing at all, but the right to boast at parties or on Twitter: “I knew them when...”

Of Cookies and Cash

Young companies and fresh products are always after the “buzzy” customers: promoters and early adopters — those willing to take a chance on an unproven product, hip to share on social media and lurking for cool on Kickstarter. Once they are hooked, it’s not so hard to get the casual consumer to want in on the deal.

From the money raised, the entrepreneur pays anywhere from 4% to 9% to the platform on which they’re advertising. And that’s it. The rest is theirs to keep and fund the project or their business. There’s no promise of returns to those early funders — even if the company becomes the next Google or Prada. What those funders do get can range from nothing (for a low-dollar contribution) to an actual product, a signed book, or perhaps an early look at a film.

In contrast, angel investors — traditionally the first to put outside money into a new company after the founders — could expect to earn annualized rates of return of 18% to 54% on a portfolio of fledgling companies, said David Teten, a partner at ff Venture Capital in New York City.

Consider how investors in crowdfunding sites view the mechanism: as a fee-based platform for promoting new ideas, according to Teten, whose firm invested in Indiegogo. Investors in such platforms aren’t in it for the possible success of the companies that get funded, but rather for the potential profits on the funding transactions that take place online. (Think eBay, PayPal or any traditional brokerage business.)

Competitor Kickstarter tries to make it very clear that it is not a venue for funding a business in the traditional sense of investor to owner — but the lines blur very quickly when you consider the products at the center of an entrepreneurial venture. A venture linked to cycling or brainwaves may very well be expected to produce product and returns of some kind, even, say, the non-spendable kind.

Maybe even cookies

When Randell Dodge, the owner of Red Barn Bakery in Irvington, New York was looking to raise $26,000 to expand her kitchen, her campaign — as Kickstarter calls the fundraising efforts — enticed friends and customers to help finance an expansion with the promise of cookies and care packages.

Such equipment purchases might otherwise be handled by an asset-backed loan from a finance company or drawing down from a line-of-credit or a credit card plunked down with a contractor. In the worst case for a small business, the company might have to sell part of itself to an outside partner or investor to get the “oven through the door.”

Instead, Dodge turned to Kickstarter. The campaign worked and Dodge found new customers across the country who were willing to “buy” cookies in order to help her business expand. She has already begun sending out cookies after the campaign closed successfully in early July. Now, she is just waiting for the credit card transactions to clear and looking to nail down the best prices on the equipment.

Shifting the risk and reward

But it’s not just business expansion that can get kickstarted.  For instance, Summer Kramer, founder and president of SummerSkin, LLC, her Oregon-based company that markets fashionable sun-protective clothing for women used a Kickstarter campaign to help market her new business. 

She raised $15,000 in Kickstarter funds by pre-selling a few items of clothing and offering the opportunity to collaborate on a design. The business launched in May, with a bit of buzz already around it — and crowdfunders to wear her line and keep spreading the word.

“Kickstarter was a great way for me to communicate with customers before our official launch,” said Kramer. 

And therein lies the essence of crowdfunding. Both entrepreneurs and creative types can mitigate some of the returns demanded by banks and investors and transfer the risk to execution and fulfilment, not fundraising.

“Crowdfunding provides people with a distinct opportunity to validate their ideas,” said Danae Ringelmann, co-founder and chief customer officer of Indiegogo in San Francisco.

Raising funds from current or future customers is cheaper and comes with far fewer expectations from the crowd than signing a promissory note with a bank or selling off some equity to an investor. Financial investors’ expectations for returns are significantly higher — unlimited in an ownership stake or fixed in terms of an interest rate — than the average person’s expectation for a care package or sample of the eventual product produced.

And you might not even get that. Avidan Ross of Lion Wells Capital in San Francisco has looked at businesses sparked through crowdfunding and has found that campaigners promising far-out goods may make poor assumptions on their costs.

The result: they are unable to produce or they simply fail to deliver in time. In turn, the platforms have kicked up quality control to make sure that fewer and fewer customers have a bad experience.

And if that experience helps launch a successful project, product or company, well good for you. And that’s about it. 

Handing your money over to a crowdfunded idea makes you more a customer than an investor