Crowdfunding raises cash, but also questions | #8 Most Viewed

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This article was originally published April 1, 2013.

By Evan Marczynski
The Bellingham Business Journal

After spending six years as a supermarket meat cutter, Chad Johnson is certain that demand exists for a locally owned butcher shop in downtown Bellingham, especially one that would offer a direct supply route between Whatcom County meat producers and local customers.

But in a business with thin profit margins and high equipment costs, Johnson believes asking banks or venture capitalists to help finance a start-up meat market would be extremely challenging, if not impossible. Instead, he’s turning to the Internet and the viral money-raising strategy known as crowdfunding.

Using the website Kickstarter, Johnson has managed to raise more than $12,000 (as of the press deadline for the April print edition of The Bellingham Business Journal) that will help him purchase the equipment he needs to start his butcher shop, called Carne Bellingham.

Online crowdfunding began primarily as a cash-raising vehicle for artists, musicians, filmmakers and other creative professionals. But a growing number of local entrepreneurs see the strategy as an easy and inexpensive method to raise money for new projects or inventions, generally with promises of incentives to donors, including first dibs on shipments of products or other promotional items.

“More businesses are grabbing a hold of it now,” Johnson said.

Yet while websites such as Kickstarter continue to build a small-business following, securities regulators and other market experts say business owners and investors should be cautious over just how deep a reach crowdfunding is given into the start-up entrepreneurial world.

And depending on whether the Securities and Exchange Commission acts soon on a Congressional directive to exempt crowdfunding portals from securities registration laws, that reach could extend further.

Regulators hold keys

The 2012 Jumpstart Our Business Startups Act—commonly called the JOBS Act—opened the possibility for small-business owners to use crowdfunding websites as intermediaries to offer shares of their companies to investors.

Current federal laws do not allow business owners to offer equity in their companies through crowdfunding sites. Instead, those who use crowdfunding tend to ask for money to complete single projects in exchange for incentives.

The JOBS Act allows companies to raise up to $1 million per year by offering shares to investors through crowdfunding websites without the need for those companies to register with the SEC.

But before this can happen, the SEC must adopt rules to regulate the practice. The agency missed a January 2013 deadline to do so. As of now, it is not known when new rules will be in place.

Crowdfunding advocates, a broad group that includes business franchisers, social-media marketers, commerce associations and others, believe the new investment opportunity could spark job growth and make it easier for startups to access the money they need. It might also bring new demand for legal, financial, accounting and marketing services, they say.

But a review of the recent public comments sent to the SEC regarding regulation of crowdfunding equity rules shows that not all financial and legal professionals agree on how the digital money-raising strategy should be set loose on the world of investing.

Bill Beatty, the securities division director for the Washington State Department of Financial Institutions, said his office has concerns with online crowdfunding. He worries about the potential for fraud should crowdfunding’s popularity continue to rise and relaxed regulation makes the practice more common in the financial industry.

“We fear it will also attract the attention of people who want to scam folks,” Beatty said.

Whether the SEC will have the time, resources and budget to enforce the crowdfunding rules it will likely adopt is another fear, he added.

The Kickstarter model

As one of the largest and most prominent crowdfunding sites, Kickstarter has become synonymous with digital fundraising. Hundreds of other platforms exist, including other popular ones such at Indiegogo and RocketHub.

Since launching in April 2009, Kickstarter claims its users—people who donate to projects are called “backers”—have contributed more than $500 million to more than 90,000 successful projects.

Creators of projects are given a page on Kickstarter’s website to include information, photos and videos describing how they plan to use donations. Projects must meet a predetermined funding goal before hitting a deadline.

Kickstarter is an all-or-nothing platform, meaning that projects must reach their funding goals in order for creators to receive any money. Not all crowdfunding sites follow this method. Other aspects of the process also vary between different platforms.

For fully funded projects, Kickstarter takes a 5 percent cut of the donations collected. Placing projects on the site is free, but project creators handle online payment processing fees, which Kickstarter says range between 3 to 5 percent of a total payment.

About 44 percent of projects succeed in meeting their funding goals, according to Kickstarter.

In order to attract donations, project creators offer tiered sets of incentives. These typically include actual products or promotional items such as stickers and T-shirts.

On the page for Carne Bellingham, for example, Chad Johnson offers cuts of beef and home butchery classes, as well as apparel items, depending on how much money a backer is willing to give.

Controversy in crowdfunding comes largely out of questions over accountability, since Kickstarter does not provide a guarantee that the creator of a successfully funded project will be able to deliver any incentives they promise. The site’s terms of use also place legal liability for fulfilling those promises on project creators.

Financial regulators worry that should crowdfunding platforms be used by scammers to collect funds while giving nothing in return, it could leave many backers with little to no recourse other than undertaking the difficult task of trying to track down their money by themselves.

The Washington State Department of Financial Institutions advises investors to be “extremely cautious” when donating money to a project through a crowdfunding platform.

Bill Beatty said it is really up to the individual investors to do their homework and check the backgrounds of project creators to see if they are legitimate. According to the Department of Financial Institutions’ advice, investors should assume everything is a scam until they can prove otherwise.

Kickstarter says much the same thing.

“At the end of the day, use your Internet street smarts,” states the site’s Frequently Asked Questions section.

Beatty said this tip will become even more important as the new equity crowdfunding rules develop.

New social marketing 

As controversy continues over crowdfunding equity, those who have used the process to fund new products or inventions, instead of offering shares of their companies, say the digital system offers plenty of business advantages.

For Charles Harris of Anacortes, Kickstarter helped him finance a new product for his startup company. But Harris said crowdfunding might actually have more value as a marketing tool.

He created a Kickstarter project in February to solicit funds for his invention, Lace Anchors, which are small clips that attach to shoelaces on the inside of one’s shoes. They are designed to hold the laces taut without the need for the wearer to actually tie their shoes.

Lace Anchors are marketed toward parents of young children, runners and other athletes, as well as anyone who wants to keep their shoes secure without having to deal with long, floppy shoelaces or laces becoming untied.

Judging by the success of Harris’ Kickstarter project, it’s been a successful idea. He started with a donation goal of $9,500. By the end of March, when his project’s deadline hit, he had raised nearly $150,000.

He said crowdfunding has allowed him to better target his marketing efforts, particularly with Kickstarter’s built-in feedback components, which have let him hear directly from customers.

“It’s allowed us to find out the market of people that are interested,” Harris said.

Insight even in failure

At Disidual Clothing in Bellingham, co-owners Brendan Pape and Christian Harkson saw a Kickstarter campaign as a way to raise capital to grow their company without having to give up ownership shares to an outside investor.

Since founding the company in 2010 as a screen-printing business, Pape and Harkson—the two developed Disidual while they were students at Western Washington University—have begun expanding from a small production firm into a full apparel brand.

The business partners created a Kickstarter project to fund production of a new fleece jacket and a fall clothing line. Yet after 30 days on the website, their project had raised only $13,709 of its $25,000 goal—meaning they received nothing.

But despite being unsuccessful, Pape said the process has helped them realize how online crowdfunding can be useful in allowing a company to assess its position in its market, as well as helping find new ways to reach and interact with customers.

And while Pape said he was confident Disidual would be able to find investors for their expansion through more traditional routes, he had some advice for business owners considering crowdfunding.

He said one downfall to Disidual’s campaign was that some of the company’s fans were not aware of how crowdfunding worked. Pape believes if they had been a bit more proactive with outreach to existing customers, explaining what the Kickstarter project was trying to accomplish and how it worked, then the project might have been more successful.

He also said he thinks a lot of success in crowdfunding depends on the product one is trying to develop. Crowdfunding projects with innovative gadgets or new ideas for business seem to do better, at least on sites like Kickstarter, Pape said.

“You need a hook,” he said. “You need to grab people.”

Charles Harris said project creators should seek out objective feedback from other users on Kickstarter, rather than relying on friends and family to fine-tune an idea before trying to get funding.

He also said that having a product already established in the retail world is a major benefit when time comes to deliver on incentives once a project meets its funding goal. For Lace Anchors, getting out enough merchandise to cover the nearly $150,000 in donations it took in through Kickstarter would be impossible if Harris had not already developed his packaging and supply chain.

“It would be an absolute nightmare,” he said.

Chad Johnson agreed, and said it is important for crowdfunding project creators to know how much of their product or service they can initially produce, in order to be able to meet the demand from donors.

He also said project creators should offer good incentives for donations such as actual products or merchandise instead of relying on inexpensive promotional items. Johnson said he thinks donations are easier to attract when a project has strong incentives, which give donors a sense that they are getting something of value.

“People have a buy-in, and they feel some ownership, which helps it go viral,” he said.

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CROWDFUNDING KNOW-HOW

What is it? An online money-raising strategy, initially begun as a way for people to give small amounts of money to artists, musicians and filmmakers financing projects. The concept is now frequently used to assist small businesses and startups seeking investment capital to get off the ground.

Where does it happen? There are hundreds of crowdfunding websites, also known as portals, that advertise investment opportunities and facilitate payment from investors to project creators. Popular ones include Kickstarter, Indiegogo and RocketHub.

Why do regulators say investors should be “extremely cautious” when investing via crowdfunding? All investments have risk, but small-business investments carry greater risk than normal—nearly 50 percent of all small business fail within their first five years. Regulators stress that potential investors need to understand the risks that go along with small-business investment.

Many issuers using crowdfunding portals to raise money are honest and legitimate business owners, but others might be inexperienced, and their track records could be unproven, unsubstantiated or outright fradulent.

Investors might have limited legal ability to take action  against issuers should investments not perform as they were represented. Due to limited regulation, investors could be left on their own to pursue private lawsuits should things go wrong.

Source: Washington State Department of Financial Institutions

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