Is Crowdfunding a Disaster Waiting to Happen?

Is Crowdfunding a Disaster Waiting to Happen?
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Crowdfunding is all the rage today. By mid-2012, more than 50,000 projects had been listed on Kickstarter alone, of which something like half had reached their (typically very modest) fundraising goals. By early 2013, Kickstarter passed the $1 billion milestone in amounts pledged. And these numbers are growing fast. Crowdfunding takes many forms, of course, but the form I worry about is equity-based crowdfunding that is intended to start an ongoing entrepreneurial business.

Why do I worry? First, on average, crowdfunding projects, many of which have more to do with one-off artistic or cultural projects than for-profit businesses with growth potential, have raised very modest sums. On Kickstarter only 30 had raised more than $1 million as of mid-2012. Says Kickstarter co-founder Yancey Strickler, “The typical project raises five grand and is supported by 85 people.” Such modest sums won’t take an ambitious entrepreneurial venture very far.

Second, generating these modest outcomes takes lots of work. Crowdfunding projects that do well often have prototypes already developed, typically use professionally produced videos, and usually bring their own “crowds”—the proverbial friends, family and fools (or followers)—who, perhaps with their extended networks, actually contribute most of the funds. Indeed, data from Kickstarter suggests that, of those who invest in Kickstarter projects, some 85 percent do so only once.

Related: 4 Famous Crowdfunding Fails

Third, most ambitious entrepreneurs hope to create and build fast-growing companies.  But customer traction from the crowd lacks both the credibility and repeatability of customer traction from those whose problems your business will actually solve going forward. Crowdfunded money from your family and friends—and, if you are lucky, their networks—is often provided for quite a different reason than the fundamentals of the idea: They love you! But real customers may not.

Finally, “While Kickstarter has helped people make things, everything else still needs to be figured out,” observes Yves Behar, founder of the design consultancy Fuseproject in San Francisco.

Indeed, adds Brady Forrest, who runs a startup accelerator in San Francisco, “There is a big difference between being a product and being a company.” There’s the rub.

Thus, 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 about to get burned. And when Aunt Minnie gets burned, she won’t be happy about it. It’s a public policy disaster waiting to happen.

Related: Why Equity Crowdfunding Is a Terrible Idea

But is there an alternative, short of going hat-in-hand to angel investors or venture capitalists or the proverbial three Fs: family, friends, and fools? Banks don’t fund start-ups, so what is a cash-starved entrepreneur to do? I suggest that you consider funding your startup with your real customers’ money, through one of five models:

  • Matchmaker models (for example, the U.S. companies Airbnb and DogVacay)
  • Pay-in-advance models (the USA’s Threadless, India’s Via and Loot)
  • Subscription models (India’s TutorVista, the USA’s H.Bloom)
  • Scarcity models (Spain’s Zara, France’s venteprivee, the USA’s 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.

Crowdfunding is a subset of the pay-in-advance model. 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. And you won’t have to worry about losing credibility by being a part of the crowdfunding disaster that’s waiting to happen.

Related: What the U.S. Can Learn From the Netherlands About Equity Crowdfunding