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Is Crowdfunding a Train Wreck Waiting to Happen?

Posted on Monday, Jul 28th 2014

By guest author John Mullins

Crowdfunding is all the rage today, with more than 50,000 projects funded, and more than $1 billion raised to date on Kickstarter alone. It takes many forms, of course, but the form I worry about is equity-based crowdfunding that is intended to start an ongoing entrepreneurial business, rather than to fund a one-off creative project.

It’s no wonder entrepreneurs are turning to crowdfunding in droves. Those who sign up for crowdfunding pitches don’t typically ask the same tough questions that a seasoned angel investor would ask. Crowdfunding is a platform where many of the investors are likely to be faceless to the entrepreneur, and therefore, he or she is less worried about having to explain if targets are not subsequently met. Even the most naive entrepreneurs will privately admit that they really don’t know for sure that their businesses will succeed. And money can be raised in as little as a few weeks! Here’s a roadmap for budding entrepreneurs to understand the problem of crowdfunding all the way to what are the best options available that offer a solution.

THE PROBLEM:

  • The sums raised are typically very modest, less than $5,000 per campaign on average. Most businesses won’t get very far on such paltry sums.
  • It takes lots of work to create a successful crowdfunding campaign: prototypes, professionally-produced videos, and more. Some of that money might be better spent in other ways – trying to get real customers to buy, for example.
  • And the brief history of equity-based crowdfunding to date suggests that, in order to run a successful crowdfunding campaign, you need to bring your own crowd, or most of it!

THE BIGGER PROBLEM:

These drawbacks might not appear all that daunting, one might argue. True. My bigger worry is that to launch a real business with a solid future, there remains – even after crowdfunding – much work to do:

  • Get the right product developed, on-time, on-budget, and
  • Figure out the right target market who will actually be willing to buy at a price that proves profitable for the entrepreneur.

As you can see, raising funds is actually the easy part. Building a successful business that customers will love is much harder! And most of the time, we know from decades of entrepreneurial experience and research, Plan A doesn’t pan out. Perhaps the initial product isn’t quite right. It needs to be bigger (or smaller), faster, easier to use, or whatever. Or the target customer isn’t quite right, or not willing to pay what the entrepreneur has in mind. What then, when the crowdfunding money has run out?

All of the above factors add up to the fact that lots of small and unsophisticated crowdfunding investors are going to get burned! And when Aunt Minnie gets burned, she won’t be happy about it. It’s a public policy train wreck and a media hoopla waiting to happen.

So the question is,  is there an alternative, short of going hat-in-hand to angel investors or venture capitalists or the proverbial three F’s: family, friends, and fools? Banks don’t fund start-ups, so what is a cash-starved entrepreneur to do?

THE SOLUTION

I suggest that you consider funding your startup with your real customers’ money, through one of five models:

  • Matchmaker models (for example, US companies Airbnb and DogVacay)
  • Pay-in-advance models (US company Threadless, India’s Via and Loot)
  • Subscription models (India’s TutorVista, US company H.Bloom)
  • Scarcity models (Spain’s Zara, France’s venteprivee, US company Gilt Groupe)
  • Service-to-product models (Denmark’s GoViral, Puerto Rico’s Rock Solid Technologies).

In each of these models, the entrepreneur gets her hands on her customers’ money before having to pay her suppliers. It’s exactly what Michael Dell did to get his personal computer business off the ground from his dorm room at the University of Texas. It’s what Bill Gates and Paul Allen did to start Microsoft. And it’s what Mel and Patricia Ziegler did to create the mail order and retailing phenomenon Banana Republic.

THE GOOD NEWS!

By seeking to do so, two things can happen, both of which will benefit the entrepreneur:

  • Your customers are so eager to have what you are offering that they pay – usually in advance – to get it. Their doing so validates your proposition like no amount of market research ever can.
  • Or your proposed customers refuse to play ball, thereby mercifully putting to rest a bad or incorrectly targeted idea, and saving you from having to explain to your investors – or your crowdfunding backers – why your idea didn’t fly. Why is this good news? If you fail inexpensively and fast, you can redirect your entrepreneurial energy to a better opportunity, without squandering a lot of your or other people’s time or money.

Crowdfunding is a subset of the pay-in-advance model, of course. But it is typically far less targeted than a more direct approach to real customers with real needs that only you and your new idea can fully satisfy. Why take a scatter-gun approach when a more targeted customer-funded effort – using one of the five models – might take you directly where you really want to go?

Taking a customer-funded approach is not for every kind of business, of course. You probably can’t build a hydroelectric power plant on some fast-moving water this way, for example. But if one of the five models is appropriate for the business you want to start, do it and prosper! It’s the most sure-footed path available.

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