The Dark Side Of CrowdFunding

By George Zack,  Though it sounds like a great new idea, crowdfunding comes with its own pitfalls. Bidness Etc, in its follow-up article on the subject, explores how it can go wrong.

Many analysts consider crowdfunding the next big disruption in the investment landscape. Boasting cutting edge advantages like improved transparency, the democratization of the fundraising processes, and lesser red tape for lenders and borrowers alike, it is no wonder that crowdfunding is rapidly gaining global traction.

In 2013, companies of various scales and sizes raised $5 billion through this channel, nearly double what they had raised in 2012. With the SEC currently working on a set of regulations that will allow even non-accredited investors (individuals with a net worth of less than $1 million) to participate in crowdfunding platforms, this new paradigm seems all set to effect some serious changes.

 

But before you think you can use crowdfunding to raise easy money for your brilliant idea, or donate money to support a brilliantly-phrased business plan, you need to grasp its shortfalls.

The Inconvenient Truth: Most Startups Fail

The ease with which some companies can suction money out of the pockets of naïve investors poses an interesting problem. Companies can hype their products or use lofty sales projections to impress an investor who has little to no knowledge about the business and the industry at large, and does not have the experience, time, resources, or willingness to dig for more information like a venture capital (VC) firm would before pouring money into a business.

As a result, crowdfunding is, to a great extent, likely to fund companies that have poor business models and are therefore likely to fail. VCs, in comparison, will use their decades of experience in funding related businesses to pinpoint even the finest of loopholes and pitfalls in a business plan. And still, three of every four startups VCs will fund will fail to emerge as established businesses, according to a study conducted by Harvard Business School lecturer Shikhar Ghosh.

It Is Hard To Sell Technical Funding Needs To

Crowdfunding may attract a larger pool of investors, but the likelihood that you’ll see any of their money reduces drastically once you start getting into the technical stuff. These investors are, after all, largely laymen, and as such will have unrealistic expectations from their investments.

So if it’s a non-tangible high-tech product you are looking to disrupt a market with, an institutional investor, an investment bank, or a VC is who you should be looking to for your financial needs.

Moreover, even existing companies with non-technical product offerings can find it hard to convince investors on crowdfunding platforms. The New York City opera, which was founded in 1943, marked a famous crowdfunding failure when it announced in September last year a desperate need for $20 million to fund productions for the 2013/2014 season. One of the other sources it used to raise funds was the popular crowdfunding platform, Kickstarter, where it sought $1 million. However, investors pledged only $301,000. The New York City opera eventually filed for bankruptcy in October 2013.

You May Lose Your Shirt In Public

A self-funded private company may have the luxury to flop without agitating investors, and a startup funded by a VC is answerable only to its primary lender – the VC itself. The failure of a crowdfunded business, however, can easily be followed by a vocal whiplash from thousands of investors who may have bought into the lofty claims made by the company during the fundraising process.

Most importantly, the increased transparency in crowdfunding also brings with it the disadvantage of increased visibility of the funding process. A failed attempt to raise funds can severely constrain a venture’s chances of raising funds in the future not only through the crowdfunding channel, but also through channels like VC firms and institutional investors.

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