Clamour for regulation raises doubts over wisdom of crowdfunding

December 12, 2013 10:43 am

Clamour for regulation raises doubts over wisdom of crowdfunding

By Jonathan Moules, Enterprise Correspondent

The use of the web to drum up funding for ventures has caught the popular imagination.Crowdfunding platforms such as Kickstarter, Seedrs and Indiegogo have helped inventors and campaigners raise billions of pounds for concepts that would not otherwise have been funded.But it could not save the New York City Opera. This 70-year-old Manhattan institution, which had been struggling for many years, turned to crowdfunding to raise $1m through a 22-day Kickstarter campaign.

Even if it were successful, this would have barely dented the $20m that the organisation estimated it needed to fund productions for the rest of its 2013-14 season. In the end, the Kickstarter campaign gathered commitments of only $301,019 by the September 30 cut off, meaning that the Opera doesn’t get any money from the project’s backers.

“The people’s opera” filed for Chapter 11 bankruptcy on October 3.

The problems caused by failed crowdfunding campaigns are likely to become a lot more public. Although UK-based Seedrs is an equity crowdfunding platform, its much larger American counterparts Kickstarter and Indiegogo have to date only allowed people to donate money through their platforms because offering shares has been illegal in the US.

This will change now that the Securities and Exchange Commission, the US regulator, has proposed rules to govern an equity crowdfunding industry. The UK’s Financial Conduct Agency has said existing rules can be adjusted to regulate that market. Consultation on its plans to do so ends December 19.

Moving to equity investments is inevitable, according to Danae Ringelmann, Kickstarter’s co-founder. “It will be messy,” she says. “We have got to figure it out.”

According to John Mullins, associate professor of management practice in entrepreneurship at London Business School, the warning signs are already there from some entrepreneurs attempting to raise equity finance in the UK through crowdfunding.

“Much of the venture capital industry has a dismal record at picking companies to invest in, not to mention often delivering negative returns to their investors. It’s unlikely that Aunt Millie [the slang term for an unsophisticated investor] will do any better, and she may not be very happy when she soon discovers that the crowdfunded investments she’s made have all turned to dust. A backlash is likely, in my view.”

One of the dramatic changes that the internet has created on commerce is the ability to make it much easier and cheaper to connect those with something to sell with those with money. Crowdfunding applies this matchmaking process to people with a need for cash and donors or investors . . .

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Early data on crowdfunding suggests that the average amounts raised are in the neighbourhood of £1,000, Mr Mullins notes.

“Doing a successful crowdfunding campaign involves lots of work: perhaps creating a compelling video, building a prototype, and even bringing your own network,” Mr Mullins says.

“Is it worth all that effort for such meagre returns? Might that effort be better spent on finding some real customers and convincing them to buy?”

Entrepreneurs are already finding this to be the case. One technology company founder, speaking on condition of anonymity because his campaign was still running, admitted that the process had been much tougher than he imagined.

“I am currently experiencing lack of interest from my previous investors on a major crowdfunding platform given that we’ve had some delays in web development and therefore are behind schedule,” he explained.

“If I had an investor who I could explain the situation to, he might understand and keep supporting – these things happen. However, Aunt Millie is more likely to think, oh, it’s not working as well as I thought, I’m pulling out and not investing any more.”

To date, crowdfunding platforms where people give money rather than take equity stakes have been very effective for projects offering a relatively cheap product and related intangible benefit to donors.

Jeffrey Woolf, a prolific inventor, whose grandfather designed the Jif lemon container, has raised more than $46,000 through Indiegogo for his latest creation, a folding bike helmet.

It is not just the money but the validation of the product’s popularity that makes crowdfunding useful for inventors, Mr Woolf notes.

“It is not an exact science but it is a better indicator than any other way, short of making some prototypes and sticking them in Halfords,” he says.

Others note that crowdfunding platforms that do not allow equity offers don’t tend to work for early stage companies seeking to raise money to pay salaries and other operating expenses.

“Crowdfunding platforms may help the lucky few raise money, but start-ups need more than just money,” Mark Payton, managing director of Mercia Fund Management, notes.

“Start-ups need active investment – that is partners, skills and support that will nurture the business through growth over the medium to long term. With crowdfunding, you get a cheque. Period.”

Business growth often requires additional funding, which can substantially dilute the shareholding of the early crowdfunding investors, who seldom hold the appropriate levels of protection, Mr Payton adds. “Who looks after the investors’ interests and who accelerates the growth of the company?”