Is Crowdfunding a Good Alternative To Finance a Business?

crowd sourcingCrowfunding has quickly become a popular way to obtain business financing. It’s gaining media attention as cool and great 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

Crwodfunding, also known as crowd-sourcing, is a way that allows many individuals (a crowd) to monetarily contribute to a project. A project can include anything from a startup, software,a project, 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 can run afoul of securities law at this time (Mid 2013).

Well know platforms include Kickstarter, Fundable, and Indiegogo among others.

A great use for crowfunding

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 that are placing orders and who are willing to pay – my favorite kind.

This information can be priceless and extremely useful for entrepreneurs.

An added benefit is that it provides a platform where the creators can interact with potential customers, providing them with critical feedback. This is particularly useful for great and 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 crowd sourcing 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 it to finance ongoing projects, especially research. By definition, research is designed to create intellectual property in the form of discoveries or inventions. The people that funded your idea could want a partial claim on the intellectual property that results from the project, especially if the results are groundbreaking. Some folks 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 that 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 a tangible good. 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 their “fair share”.

Selling equity could be illegal

There are talks about selling equity through this process. At this point, it also get you in legal trouble and run afoul of securities law. Even if it 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 where that simple. Think about it this way. How do you think the folks that 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 about this? 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 will be high.

In conclusion

There is not an easy answer. If it were me, I’d consider crowd-funding if I were starting a company that is selling a unique product because I could gauge true market demand. Since you are 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 any other type of for profit venture, I’d try with the more traditional routes first.

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