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Crowdfunding – What is it good at?

My background is creating financial markets – end-to-end markets for IPOs and secondary trading. It included emerging markets and senior markets, cash, debt, and derivatives. It has given me a perspective from which to understand the underlying proposition of any market:

  • What is the nature of the offer?
  • What is the contract?
  • Who are the real buyers and sellers?
  • What roles do the participants play and what and value do they create?
  • Is the market fair?

It really comes down to – what is the market good for? Not surprisingly, the buyers often don’t understand the true nature of the market, surprisingly, the sellers often don’t either. This is accurate in crowdfunding.

The Offer

“Give me X dollars and I’ll try to send you a copy of my really cool new thing”.

Kickstarter has been arguing that it is not a store. It is particularly true of Kickstarter that the most common offering is a discounted copy of an early version of the thing being sold. Many observers have pointed out since people think it is a store, it is one.

There are also crowdfunding services that focus on projects where the contributor is clearly making a donation.

The Contract

As a contributor your contract is with the crowdfunding service, not the issuer. The issuer also has a contract with the service. In no case does either contract promise that your contribution will result in anything. The key word is contribution. The crowdfunding service only promises to give your money to the issuer if the crowdfunding service’s conditions are met.

The crowdfunding service’s promise to the contributor is that they will only pay the issuer when the project succeeds according to the rules for funding. The crowdfunding service’s promise to the issuer is that it will make resonable efforts to collect from the contributors and pay the proceeds to the issuer. The crowdfunding service keeps a percentage of the funds when the project is funded.

In the context of crowdfunding, there is no promise of performance. In the case of fraud, the money is gone – you are generally dealing with a start up with no assets. Piercing the corporate shield to get at the individuals behind the fraud is possible, but expensive and difficult. The crowdfunding service is not likely involved in any fraud, so they are probably immune.

Buyers and Sellers

Compared to financial markets this one is simple. The crowdfunding service is NOT the seller. If you order something from Amazon, Amazon is the seller and is responsible for delivery. The issuer is the seller. The buyer is obvious, it is the person committing funds to the crowdfunding service, but they are not really a buyer. They are making a contribution. In most markets there is a process to guarantee that the funds and asset are exchanged simultaneously and irrevocably. The seller gets the money, the buyer gets the thing. Not so in crowdfunding.

Roles and Value

In most markets the roles are understood, in crowdfunding it is fairly simple, but not necessarily understood.

Issuers

The issuer, the party creating a funding project, creates the idea for a new product or project. In theory they also create the ability to fulfill the promise. They are the creative force. The issuer promises to try to deliver the thing.

Contributors

The contributor provides the funding, and not to be underestimated, demonstrates that a potential market exists beyond the crowdfunding launch (think Oculus Rift). The contributor promises to pay if the project funding targets are met.

Market Operators

The crowdfunding service simply provides a platform where issuers can promote a product or project. It formalizes the market, and it is a focal point for contributors and the media to find interesting new ideas to write about and support. Like a stock exchange, the crowd funding service provides rules that everyone can understand. Similar to the exchange, the rules don’t really favor the investor/contributor, but at least they are clear.

It is very important to consider what the crowdfunding services don’t do. They don’t do background checks, they don’t validate that the funding will be adequate to the challenges of the plan, and they don’t provide any sort of guarantee against misrepresentation.

It shouldn’t surprise anyone that many projects don’t deliver. Often the issuers had a great idea but little insight into what it takes to manufacture and deliver a product, or create a company.

Is the Market Fair?

In my opinion the answer is no. The contributor is on their own trying to decide if the issuer is on the level and can actually do what they claim. If the project fails your money is lost and there are no remedies. If the product disappoints there are no refunds.

So long as the individual contributor is not depending on delivery (most aren’t), and the value at risk is within their tolerance for loss (most can), the unfairness doesn’t matter that much, unless it becomes systemic.

What is the Market Good For?

Lets start with what it isn’t good for:

  • It does not solve the problem of funding good small companies.
  • It does not fix our broken micro cap markets.
  • It only works for ideas that have consumer appeal.

I have never seen an industrial project on a crowdfunding service. Fundamental technologies can’t be funded this way. These are all huge issues for emerging technologies. Crowdfunding doesn’t share the benefit – the contributor is locked out of any value they create by supporting a project (think Oculus Rift).

For issuers it works well for simple consumer products, or social/artistic projects that have a strong emotional appeal. An excellent example is the Karen Klein project to raise $5,000 to give a beleaguered school bus monitor a vacation – it raised $703,168. The Veronica Mars project raised $5.7 million from its fans against a target of $2 million. Many worthwhile projects to support museums or artistic companies have failed.

For contributors it works well for projects without ambitious engineering or production requirements. Some successes have left a bitter taste – either non-or late delivery, or in the case of Oculus Rift, a $2 billion sale of the company that leaves the contributors who supported it feeling cheated. This last point is important – the supporters who get excited and support a project are frozen out of the surge in value they create. That benefit is reserved for those privileged to invest in the company.

Simple Rules for Issuers and Contributors

For issuers, it is your reputation, and on the Internet your failures follow you forever. Avoid projects with complex unsolved engineering or manufacturing problems, including complex software that needs to be written.

For contributors, limit it to what you can lose, and understand that if you ever get a product, it will probably disappoint. At best you are supporting the people behind the idea, often you are buying a prototype. Ask the important question – do you really think they can do it for the money they are raising? And understand the contract.

 


2014-09-11 14.03.46Author: Paul Hanson

Paul is the Founder & CEO of bbotx. He has developed and marketed software products in different market segments in North America, Europe, Asia, Africa and the Middle East over the past 20 years – doing business and working in 40 countries. 

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