Know When to Take the Risk- A Guide to Crowdfunding

There are quite a few misconceptions about crowdfunding that may make investors a bit hesitant to enter this world that seemingly exists outside the funding spectrum most are used to. Perhaps you have heard stories like the infamous Kobe Beef Jerky scam that raised over $120k and almost succeeded in pulling a fast one on its 3300 backers, or you are peripherally aware of several projects that failed to get delivered over the years due to limitations and other unforeseen circumstances. You are not alone in feeling a little adverse, which is why Dr. Douglas Cumming and Dr. Sofia Johan’s comprehensive book on crowdfunding is a much-needed resource to help you easily navigate the many different forms of crowdfunding, as well as the regulation and policy practices behind it. Here is an overview of some of Cumming and Johan’s research, as presented by Cumming himself on his DotsLive stream.

Crowdfunding Platforms: What Do They Do?

Though facilitated mainly by internet platforms these days, crowdfunding as a practice has actually existed for quite some time, only now has it really been gaining popularity in North America. It uses the quantity over quality methodology in a sense: you get a small amount of money by a large number of people instead of an exorbitant amount of money from one source.

The platforms do not only work as the middleman facilitating this process, but they actually add value by being a matching service that better connects potential investors with entrepreneurs they may not have been aware of. They also add an extra layer of security to this transaction by requiring due diligence from entrepreneurs. This includes background checks, site visits, credit checks, cross-checks with suppliers and customers, account monitoring, and third-party proof on funding projects. In a recent article written by Cumming and Johan published in the ‘Journal of Banking and Finance’, they determined that when you compare platforms, the ones that do more due diligence are usually more successful. This in part also ensures that “lower-quality entrepreneurs” are unable to enter the marketplace. The second service these platforms offer are value adds that can help boost the performance of an entrepreneur’s project. This includes periodic updates, pre-listing evaluations, strategic guidance, pitch planning, business planning, contract help, and promotion services (videos and other tools).

Crowdfunding: When to Use it

In most cases, crowdfunding is usually utilized by entrepreneurs in the earliest stages of the business lifecycle. A venture capitalist, bank, or an angel investor will only get involved with a project if they can guarantee a return on investment since they tend to be more risk-averse. Crowdfunding is a great way for entrepreneurs to accrue capital quickly if they can obtain a large enough backer base and also prove to the above-mentioned investors that there is in fact a generated interest in the product or service they are trying to create. No one wants to stay in the so-called “Valley of Death” which hits most startups early since they accrue their most expensive costs right in the beginning; and crowdfunding can be used to ensure a project stays on track and on budget.

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Dr. Douglas Cumming Explains to our audience the different stages of a startup’s life, and what funding models they have available to them, including crowdfunding.

Other Benefits of Crowdfunding Platforms

One of the major reasons entrepreneurs use crowdfunding platforms is because of the standardized contracts and standardized fees that tend to be much cheaper than other funding options. Dr. Cumming recounts a case he heard where an entrepreneur secured $150k from an angel investor, but due to the high legal fees and contract negotiations, $70k was used on legal fees. No wonder a crowdfunding platform’s standard fee of only 5% earned during the campaign seems so much more reasonable.

The Drawbacks of Crowdfunding

On the investor side of things, there is still the element of risk that can result in you losing out big time on your investment. This happens because of a large variance in the types of products being delivered, making it hard to monitor the quality standards for every campaign. There are still cases of fraud that can occur, particularly on platforms that ask for less due diligence. There are also agency problems where entrepreneurs use the money raised to pay themselves higher salaries instead of using the funding to upgrade their product. And of course, mistakes always happen, sometimes there are problems during development that add limitations to the end result of the product being delivered (if it is delivered at all). On the entrepreneurship side of things, you can also be opening yourself up to idea theft by putting your product online when it is in such an early stage of development. This can only be mitigated by having a strong business plan and ensuring your idea is not easy to replicate quickly.

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Dr. Cumming demonstrates how different types of crowdfunding models can be utilized and what risks and rewards you can expect to see.

Choose Wisely

Crowdfunding is a lucrative and exciting way for many entrepreneurs to secure funding in situations where that otherwise would not have been possible. It has essentially opened up the market to new and novel ideas and has made many dreams a reality. The best thing both an entrepreneur and an investor can do is ensure that the project strategy matches the finance strategy so that everyone can win in the end. For example, there is no such thing as half of a drone, it is either all or nothing, so using a funding model where a project cannot go through unless all funding is secured is recommended (Kickstarter). However, something more artistic may be able to get away with going ahead underfunded, which is an option given to entrepreneurs on Indiegogo. One chapter of a book versus the entire book might be enough to warrant future successful crowdfunding campaigns, and everyone still goes home happy. The best advice we can give? Read the fine print!

For a deeper look into crowdfunding, funding models, and an international perspective into this exciting new form of funding, check out our free and interactive stream only on DotsLive.

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