Is Crowdfunding a Good Alternative to Finance a Business?

crowd sourcingCrowdfunding has quickly become a popular way to obtain business financing. It’s gaining media attention as a cool, innovative way to get a business or project funded by interested folks. But is it really a great way to finance a business?

Let me give you the short answer first: it can be a viable way to fund a business for certain products that have mass appeal. But, in my opinion, it’s not a viable way to finance most businesses. And there is an opportunity for serious backfire. By the way, I am not against crowdfunding at all. I am just very cautious, especially given all the hype that surrounds it and all the potential legal issues.

Crowdfunding basics

Crowdfunding, also known as crowdsourcing, allows many individuals (a crowd) to monetarily contribute to a project. A project can include anything from a startup, to software, to a product, and even research. Depending on the structure, individuals can pre-purchase a product or make a donation to a project. There are discussions about being able to sell equity through this format, but this activity can run afoul of securities law at this time (mid-2013).

Well-known platforms include Kickstarter, Fundable, and Indiegogo, among others.

A great use for crowdfunding

I actually love crowdfunding as a market discovery tool. The right combination of a good product and well-edited video can help you create a buzz about your product. More importantly, it can help you determine the size of the demand for your product. And this is not some nebulous demand calculation either. It’s demand from folks who are placing orders and who are willing to pay – my favorite kind of folks.

This information can be priceless and extremely useful for entrepreneurs.

An added benefit is that crowdfunding provides a platform where the creators can interact with potential customers, providing them with critical feedback. This feedback is particularly useful for great, innovative ideas such as Dan Shapiro’s Robot Turtlesthe blink,  or Coffee Joulies.

Obviously, having firm orders before manufacturing a product can do wonders for your bottom line. So, with these benefits…what’s not to like? Quite a bit, actually.

Intellectual property

This may sound obvious, but whatever you disclose on the crowdsourcing site becomes public knowledge immediately. For a product idea, this means that you need to have all your patents and copyrights in place. If you don’t, you could end up giving away valuable information.

Things get trickier if you are using crowdfunding to finance ongoing projects, especially research. By definition, research is designed to create intellectual property in the form of discoveries or inventions. The people who funded your idea could want a partial claim on the intellectual property that results from the project, especially if the results are groundbreaking. Some entrepreneurs think that they can get around this issue by asking for donations. More on this in a second.

What if your company is wildly successful?

Imagine that you have a product, service, or invention that becomes wildly successful and eventually makes you a lot of money. Believe it or not, this can actually be a big risk. Folks who contributed money – either by buying a product or by making a donation – could feel disenfranchised and want a piece of your company.

I suspect this is less of a risk if you are selling products since it’s a sale of tangible goods. But it may be less clear in other cases. The risk is that the crowd of folks who help fund your business could turn into a mob with pitchforks that wants its “fair share.”

Selling equity could be illegal

There are talks about selling equity through this process. At this point, it could get you in legal trouble and run afoul of securities law. Even if selling equity does become legal, it could become a problem and open the risk of litigation.

But – what about donations?

Let me clarify – I am not an attorney and I cannot give legal advice or legal opinions. I know some sites allow you to fund a project or company through a donation. The sites have iron-clad legal language that presumably protects the recipients of money in the transaction.

I wish it were that simple. Think about it this way: how do you think the folks who donated money to create a great company – or make a great discovery – will feel when they see the founder getting rich? More importantly, how do you think class-action attorneys will feel? My guess is that they will sue and try to get the agreement changed or nullified in court.

By the way – this happens all the time. So-called “iron-clad” agreements get ripped to pieces by judges in all jurisdictions every single day. And even if you win, the legal costs of defending yourself are significant.

In conclusion

There is no easy answer. If it were me, I’d consider crowdfunding if I were starting a company that is selling a unique product because I could gauge true market demand. By selling an actual product in exchange for money, you could classify it as a sale and have protection against someone wanting a piece of your company if it becomes successful later on. However, if I were in any other type of for-profit venture, I’d try the more traditional routes first.

I guess my only true advice is that you speak to an attorney and be sure to understand all risks before using this type of funding.