As Crowdfunding Grows, the Rewards Increase — but So Do the Risks

The campaign to front a movie based on the cult television show “Veronica Mars” through crowdfunding broke records for the fastest project ever to raise $1 million on Kickstarter. It was the website’s biggest film project so far, and it has the most backers of any project to date.

What it probably didn’t do, Wharton experts say, is throw open the doors of crowdfunding to major motion pictures. But that’s OK: Crowdfunding is successfully helping entrepreneurs raise capital without the need for them to go Hollywood.

What the “Veronica Mars” case does illustrate, however, is that Kickstarter and its crowdfunding brethren have proven their mettle as mainstream, reliable avenues of funding for both start-up businesses and established firms. Not only do crowdfunding websites provide a cheap, easy way for individuals to seek start-up funding, but would-be investors are also doing an excellent job of picking winners out of the crowd, according to Wharton management professor Ethan Mollick.

Similar Cues of Success

According to Mollick’s recent paper, “Swept Away by the Crowd? Crowdfunding, Venture Capital and the Selection of Entrepreneurs,” a draft of which was published in March, entrepreneurial quality is being examined in similar ways by donors on Kickstarter, one of the largest and most well-known crowdfunding websites, and also by venture capital firms, which for decades have been the go-to source for start-up funding.

“They are looking for similar signs of quality,” Mollick notes. “There are things that increase the chance of being [crowd]funded if your backers don’t know whether you’re going to be successful yet.” These factors include: “Does the project creator have experience in the field? Do they have a prototype? Do they have an endorsement from a prominent organization or individual? Those factors increase the chance a company is going to be successful, and they’re things a venture capitalist looks for as a signal of success. They seem to be the things crowedfunders look for, too.”

In an earlier paper, “The Dynamics of Crowdfunding: Determinants of Success and Failure,” Mollick writes that while most projects that were funded delivered their goods with a mean delay of more than one month, “very few projects did not appear to be making a good effort to fulfill their obligations.” In other words, the crowdfunding community was fairly adept at picking initiatives with a high probability of success.

What crowdfunders aren’t looking for — or at least, aren’t concerned with — is the gender or location of the entrepreneurs seeking funding. By analyzing 3,200 technology projects from Kickstarter in the fields of hardware, software, video games and product design — areas that traditionally attract venture capital investment — Mollick found that crowdfunding “is more democratically distributed than VC funding” and that “the proportion of crowdfunded start-ups with female founders was larger by an order of magnitude than that of VC-backed firms.

“You either believe that we have an existing system that makes sure the best computer science people work at Google and the best entrée funding is given by venture capitalists … or you believe that talent and opportunity are more widely distributed and that because of differences in opportunity, geography and background, people don’t have similar chances,” Mollick states. “What makes crowdfunding so interesting is that this puts the possibility of creating things in the hands of more people.”

That’s especially important as the availability of small business loans has dried up, adds William Cunningham, CEO of Creative Investment Research, an economic analysis firm based in Washington, D.C. “Large financial institutions have abandoned this field. It’s easier for them to invest in derivatives than to invest in small business loans,” he says. The technology to crowdfund new ventures “makes all the difference in the world. It’s a force multiplier; it’s a cheapener.”

Small Audiences, Big Dollars

The “Veronica Mars” Kickstarter campaign was probably unique, but it still caused rumblings through the entertainment industry.

Launched March 13, series creator Rob Thomas set a $2 million goal for the movie, with the franchise’s owner, Warner Bros., pledging to kick in marketing and distribution support for a limited theatrical run. At that price, Thomas said in a Kickstarter message, a small cast could pull off a modest film that would continue the story of the high school student sleuth. Any more than that would allow Thomas and company to make a more ambitious film, but $2 million was the bare minimum needed.

Eleven hours after Thomas announced the campaign via Twitter, the initial funding goal had been reached. When the 30-day fundraising window closed last week, the “Veronica Mars” campaign had raised more than of $5.7 million with 91,585 backers, a site record. Not bad for a show that went off the air in 2007 and only averaged 2.5 million viewers during its three seasons (two on the WB network and a third on the CW network.)

“The ‘Veronica Mars’ case is a little bit weird,” Mollick points out. “It may or may not be an embrace [by movie studios] of crowdfunding. By far, it’s the exception to the rule. I’m not sure that method is going to work outside of a particular set of circumstances.”

Although other passionate fan bases of beloved-but-defunct television properties started expressing hopes that their favorite show could follow the lead of “Veronica Mars,” even Thomas expressed doubts that he had stumbled on a way to short-circuit the traditional Hollywood funding channels.

“I don’t know that I would bet that a Kickstarter model starts to work across the board and that everyone who wants to make a $3 million, $4 million, $5 million movie can expect to go to Kickstarter and get financed,” he told the Associated Press. “When there is a brand-name product that people have responded to and want to see, and there’s already a built-in following for it, people can be very successful. I hope that, in that respect, we are pioneers and we see more of them.”

Crowdfunding movies is hardly new; about 10% of this year’s entrants at the Sundance Film Festival received money through that method, according to Kickstarter. But for a studio like Warner Bros., who could find $4 million for a movie using the change in its figurative couch cushions, the real value of a Kickstarter-funded film is “much stronger, much more powerful data than you’d get from a survey saying, ‘Yes, I’d like to see ‘Veronica Mars’ made into a movie,'” says Wharton marketing professor Jehoshua Eliashberg.

“From Warner Bros.’ point of view, this is very valuable marketing research,” he adds. “I don’t think we’re looking at an innovative financial arrangement in getting consumers involved in funding movies. But I do think studios will have to get used to the idea that consumers will have greater and greater demands for what movies we want to see get made, and how they get made.”

It’s Equity Time

Crowdfunding has also found approval from the federal government, opening up the fundraising field to more potential risk and reward for investors and entrepreneurs.

The Jumpstart Our Business Startups Act, or JOBS Act, was signed into law by President Barack Obama in April 2012 as an effort to ease funding restrictions for start-ups and small businesses. Among the act’s provisions was opening up equity-based crowdfunding to United States investors. Unlike a Kickstarter-type project, where backers are either making a pure donation or essentially pre-ordering a product, equity crowdfunding would allow potential backers to buy a share of a nascent company, thus opening the door to a financial return.

Although the Securities and Exchange Commission has yet to issue regulations on the JOBS Act promises, equity crowdfunding has been happening in the United Kingdom and European Union for several years. Jeff Lynn, CEO of equity crowdfunding firm Seedrs, says that about 15 similar companies now exist in the United Kingdom and the European Union, and that the funding method has proved to be a game-changer for the angel investment field, which he describes as the step before a venture capital round of funding.

“Instead of it being very rich and clubby, where you have to be at the right place at the right time, we’re trying to democratize it,” he notes. “You’ve now got it open to everyone, everywhere. I see many others coming into this space; I see a world where we have 100 million angel investors.”

The European Model

Seedrs does more due diligence on its hosted projects than a traditional crowdfunding site would, Lynn says, including verifying that the firm is a new business and that it is U.K.-registered. “We only let them on the platform if we’re happy with that,” Lynn notes. “We’re not trying to impose our business judgment, but in practice, only about 25% of businesses that come to us end up getting on our platform.”

Of those start-ups that make it through the company’s oversight process, only about 12% get funded. An average goal is £50,000 (about $75,000), and the company facilitates about £1 million ($1.5 million) of funding a year. After companies participate in one or more rounds of funding at Seedrs or a similar site, Lynn says the firms are more likely to then seek out venture capital and the additional support that comes with it.

Allowing direct investment by investors brings democracy to angel funding, but with it comes the potential for losses, too. At Seedrs, Lynn says that investors have to click on several clearly worded warnings about their potential loss (which, he notes, are more transparent than the long-winded user agreements that accompany most web and software services) and pass a quiz about the policies before they can fork over their money. “We don’t want people thinking this is a safe asset and putting their life savings in it. Most people certainly should not do that.”

With equity crowdfunding coming to the United States as soon as the SEC issues its regulations, and more entrepreneurs likely to seek financial success through its backing, Mollick says many twists could still come to both the crowdfunding field and the establishments it disrupts.

“Something’s happening: There’s a lot of money flowing, there’s policy and there’s promise. It’s the culmination of a bunch of things we care about,” Mollick notes. “Trends like this have been coming together for a long time now. Is it more democratic? Yes. But quality seems to matter, and that’s important and interesting. There are still a whole bunch of interesting questions that we don’t have answers to.”

Source: Knowledge@Wharton


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