BY ADAM GROSSMAN, FULLSTART
he majority of people today think crowdfunding is a new way to raise capital. What many of them do not realize is that crowdfunding has been used for hundreds if not thousands of years. For example, the Catholic Church has been collecting donations from members in order to fund its operations. The original method of crowdfunding is based on the principal of simple donations.
The four main types of crowdfunding are donation based, lending based, equity based, and reward based. The latter of the group is something that only recently popped up about ten years ago. Equity crowdfunding is a more traditional exchange of cash for an ownership stake in the company, but was not possible until recently when Title II of the JOBS (Jumpstart Our Business Startups) Act was passed in 2012. In my opinion equity-based crowdfunding was a necessary evil to combat the rewards based model. In general, I believe that crowdfunding is a bad choice.
“What? Did you say crowdfunding is a bad choice?” I can already hear the negative reactions and anticipate all the comments from irate people who love the concept.
Yes, but this isn’t because crowdfunding itself is a horrible idea. Rather, it is due to the way the general public has attempted to deploy crowdfunding in recent years. The majority of campaigns I have seen go for the rewards based method. This is likely due to the founders’ interests to keep as much equity as they can prior to a larger fundraise down the road. The problem in this strategy is twofold: First, founders tend to try to raise too much money through a rewards model; and second, rewards models used to get to equity models need to prove a strong demand for the product, which is a hard task to accomplish through a lean crowdfund marketing campaign as opposed to traditional marketing campaigns that can be sustained with funding. Crowdfunding is probably the worst choice you can make to try to raise money 99% of the time.
Here are three simple reasons why crowdfunding is a bad idea.
1. Signaling – Nobody likes a beggar
In 2001, Michael Spence, George Akerlof, and Joseph E. Stiglitz were awarded the Nobel Prize in Economics for their research of markets with asymmetric information. Their findings were in part based on Spence’s theory of signaling. According to Spence, signaling is the act by which an agent shares information with its counterparty (the principal) through its actions. More so, the principal is able to infer certain information about the agent based on the action he or she takes. Companies raising money are the agent and potential investors the principal. When asking the public for money the size and valuation of the contribution, the way in which the contribution is solicited, and what the contributor receives in return all signal the worthiness of the contribution.