13

Crowdfunding

Introduction

One development that demands the attention of all entrepreneurs is crowdfunding.. A crowd is defined by the Macmillan Dictionary as “a large number of people in the same place.” But a crowd can also be people who have a common purpose. This is the foundation of crowdfunding—when a group of people join in the effort to fund a common project. Using the power of social media, entrepreneurs can take advantage of the potential energy and resources of crowds.

For example, less than 24 hours after David Henneberry’s boat had been ruined in Massachusetts, a total stranger from Texas named Craig Dunlap started a campaign on Crowdtilt.com titled: “Let’s Fix David Henneberry’s Boat (That Got Ruined in the Boston Bomber’s Standoff)!” Dunlap had written brief comments in the campaign in support of 66-year-old Henneberry, who was in Dunlap’s mind an everyday American boating enthusiast whose boat had the misfortune of being used as Dzhokhar Tsarnaev’s hideout. Dzhokhar and his brother were found guilty of setting the bomb that exploded during the Boston Marathon. Dunlap started the campaign with a goal of giving Henneberry $50,000 to purchase a new boat of his choosing.¹ A second complete stranger, Jeffrey Griffeth, saw the Crowdtilt.com campaign and created a Facebook page to widen its exposure. In five days, the campaign had raised $13,662.26 from 430 contributors (strangers!) from 42 states and eight countries when the Florida-based Boston Whaler company surprised everyone and donated $37,000 so that Dunlap’s goal could be met. According to the campaign comments, a total of $50,597.50 was successfully given to Henneberry by Crowdtilt, only 22 days after the campaign began. The story was covered by Time magazine, Bloomberg Businessweek, and several other media outlets. Let’s examine this phenomenon to see how it can be useful to you.

This chapter discusses (1) crowdfunding with pledge-based capital (financial commitments made by customers before they receive the item); (2) the steps in carrying out a crowdfunding campaign; and (3) crowdfund investing, the term for financing a venture by raising equity or debt capital from large crowds through licensed portals, which is made possible through the April 2012 JOBS Act (Jumpstart Our Business Startups Act).

Crowdfunding with Pledges

Crowdfunding refers to publicizing products or services while generating financial commitments through a web-based platform by creating an appealing website presentation and offering perks (rewards) for early orders of the product or premium add-ons that complement the order. One of the earliest and famous users of crowdfunding was Spike Lee, the independent filmmaker who wrote and directed the Oscar-recognized movies Malcom X and BlacKkKlansman. On August 21, 2013, he completed his first Kickstarter campaign for “The Newest Hottest Spike Lee Joint” movie by raising $1.42 million from 6,421 backers, which was $169,000 more than his $1.25 million goal.² His campaign generated 1,136 comments, most of which were supportive, but some of which raised concerns that his celebrity status detracted from the efforts of less-well-known independent filmmakers. Kickstarter answered these issues with statistics showing that Spike Lee in fact helped independent filmmakers by bringing his 30 years’ worth of fans to the crowdfunding platform to support his effort, which led to their support of additional campaigns. Lee himself claimed that before there was a Kickstarter, he was performing many of the same crowdsourcing tasks, just without the benefit of technology. While Spike Lee is one of the most famous people to raise funds via crowdfunding, one of the most unique products to receive this type of funding was “DopeKicks,” which are the “world’s 1st eco-friendly shoes made from hemp, that are also waterproof!”³ The company goal was to raise $10,000. It raised $211,927 from 2,000 backers in four days!

Table 13-1 shows the top four crowdfunding sites based on funds raised and number of supporters.

TABLE 13-1 Crowdfunding Sites and Supporters

Individual campaigns on the Kickstarter platform tend to raise the most money. Table 13-2 shows five of the top fund-raising campaigns on that site.

TABLE 13-2 Successful Kickstarter Campaigns

But not all fund-raising efforts are successful. One of the biggest campaigns that failed was by Canonical Software Company. Their campaign was on the Indiegogo platform and was for the creation of the Ubuntu Edge Phone, which was described as being a smartphone and desktop PC in one using the Linux open-source operating system. They sought to raise $32 million. The interest was immediate and productive! They received pledges of $3.4 million in the first 24 hours. But the interest seemed to quickly wane, as they received only a total of $12.8 million in pledges, falling over 60% short of their goal, which necessitated refunds to 27,000 backers.⁴

While all of the aforementioned stories involved millions of dollars, the crowdfunding story that is most heartfelt to me involves $30,000. It was a successful campaign implemented by entrepreneur Kristen Harper. Kristen is a 27-year-old chef who raised the money to fund her new restaurant called Cleo’s Southern Cuisine located on Chicago’s South Side. Her food is absolutely delicious, making her restaurant my favorite in the world!

Crowdfunding Campaigns

This could be a lot of work. Consulting firms such as Crowdfunding Planning.com can assist in all phases of crowdfunding: setting goals, choosing the right platform, setting up the campaign, managing the campaign, and completing the effort. For some entrepreneurs, delegating this new type of work makes sense so that the core effort of the enterprise can remain the entrepreneurs’ primary focus. For the “do-it-yourself” types, Figure 13-1 outlines the steps involved in launching the best possible campaign to raise either pledge-based, debt, or equity capital. Liz Wald, head of international and business development at Indiegogo.com, who provides encouragement and practical guides for each champion of a campaign, reviewed this list and provided several valuable additional steps. She provided an example of a student-run campaign and an example of an academic researcher’s campaign from among the many that are available to consider.⁵

FIGURE 13-1 Crowdfund Campaign Steps

An entrepreneur who planned his campaign using the steps in Figure 13-1 is Hunter Hillenmeyer. Hillenmeyer, a former linebacker for the National Football League’s Chicago Bears and one of my former MBA students, posted a campaign on Kickstarter featuring a mobile application (“app”) produced by his venture, OverDog, Inc. OverDog gives sports fans the chance to meet (digitally) with a professional athlete through this iPhone app, schedule a multiplayer game on Xbox or other platform, then record who won and by how much. For fans, it offers an opportunity to play a game with a celebrity. During the 29-day campaign, Hillenmeyer’s pitch for OverDog’s service raised pledges (offers by site visitors to prepay for his service) of $37,472 from 310 backers. That might seem like a lot or a little to you, but either way you look at it, this method of crowdfunding proved that it worked for him. If you look up Hillenmeyer’s campaign on Kickstarter, you will see that it says, “Funding Unsuccessful.” What? Well, at the outset, Hillenmeyer had set a pledge total goal of $100,000, so his campaign fell short by a whopping $62,528. On Kickstarter, if you do not reach your goal, you do not collect the pledges and your campaign is declared unsuccessful. On Indiegogo, by contrast, the entrepreneur can collect a pledge balance that is less than the goal. In Hillenmeyer’s case, however, he believed that the campaign was successful, despite the fact that he did not collect the funds. He learned a lot about the process of putting up a crowdfunding campaign while also making sure that OverDog had enough fans involved so that the athletes always had somebody to play against.⁶

Crowdfund Investing Through the Jobs Act

The April 5, 2012, legislation titled Jumpstart Our Business Startups Act, or JOBS Act, was passed into law as H.R. 3606 during the 112th Congress (2011–2012). This law stirred up passion, interest, and excitement within the entrepreneurship community from the time of its introduction in December 2011, and this continues today. Aren’t entrepreneurs among the least interested in policy and legislation? What is in this law that has entrepreneurs so interested? What are the implications of the law for entrepreneurs now and into the future?

In a town hall event in June 2012 in Chicago by Sherwood Neiss, cofounder of the advocacy group Startup Exemption, which was the entity through which he and the other two cofounders, Jason Best and Zak Cassady-Dorion, pressed for the passing of the JOBS Act, he said that this congressional bill initiated an entire new financial asset class, similar to what happened when the money market fund and the exchange-traded fund (ETF) were invented. When an asset class is invented, so is an entire set of supporting trade organizations, financial firms, and products and services. Part of the excitement was for entrepreneurs to participate in the birth of a new industry whose goal was to help entrepreneurs gain access to additional sources of capital.

The JOBS Act includes seven sections, Titles I to VII. While the full text of the bill is available online,⁷ the most significant sections to discuss are Titles I, II, and III.

Title I of the JOBS Act included a series of amendments to the Securities Act of 1933 (SA), the Securities Exchange Act of 1934 (SEA), the Sarbanes-Oxley Act of 2002, and the Investor Protection and Securities Reform Act of 2010 (Dodd-Frank). Each of these prior laws had a tremendous impact on the regulation of financial capital in the United States. Creating amendments to such lauded legislation was a powerful achievement. In Title I, the JOBS Act established a new category of company called an Emerging Growth Company, or ESG, and by so doing, added new features to the 1933, 1934, 2002, and 2010 acts. An ESG is an entity that generates less than $1 billion in revenues per year and had not issued securities before December 8, 2011. Under the new legislation, ESGs were given special privileges and exemptions from each of the existing laws, relieving them from what would otherwise be a regulatory burden intended for larger companies. Table 13-3 summarizes the key exemptions.

TABLE 13-3 Title I ESG Exemptions

Essentially, Title I lessen the regulatory burdens on small companies while they are raising funds.

Title II allows ESGs that are in the process of raising investment capital to advertise or make “general solicitations,” something that is not allowed for larger companies. The implication of this section is that small companies can place advertisements on billboards, at transit stations, in magazines, or on websites promoting their intention to raise investment capital. Typically, this type of advertisement is not allowed under Securities and Exchange Commission (SEC) rules for companies that are raising investment capital from qualified investors (e.g., accredited investors). Also, this section allows nonfinancial professionals (people other than brokers) to assist in soliciting funds, as long as they do not earn commissions and do not own shares in the company. Essentially, this gives advertising professionals the authority to do what they do best, as long as they do not participate in the proceeds of the transaction.

Title III is known in short as the “Crowdfund Act,” and it establishes the rules under which an entrepreneurial firm can raise investment capital from the general public (nonaccredited investors). The bill requires that the securities of an ESG be offered through an intermediary, which could be a person registered as a broker or could be a new entity called a funding portal (essentially a professionally developed website dedicated to this specialized purpose). Human brokers are a fairly well understood element of the financial industry; however, this new entity, a funding portal, requires clearer definition. This section said that brokers and funding portals must be registered with the SEC and with a “self-governing authority” under the SEA of 1934, which, after the passage of the bill, was understood to be FINRA, the Financial Industry Regulatory Authority. Furthermore, the section declared that several efforts must be made in the name of protecting prospective investors: they can invest no more than 5% of their annual income or at most $2,000 if their income is less than $100,000, and no more than 10% of their annual income if their income is greater than $100,000. The funding portal has to verify income information in order to allow an investor to provide capital. Additional communications must be given to investors alerting them to the risks inherent in investing in the securities being offered and to the risk of fraud perpetrated by the ESG. Importantly for the entrepreneur of the ESG, a provision (302.4A.a.7) states that the intermediary can withhold all offering proceeds from the ESG until the target amount has been reached, and any investor can cancel his investment at any time before the proceeds are released to the ESG or the entrepreneur. It is possible that in one situation or another, an entrepreneur will not get the proceeds of his offering if communications with his hired intermediary were to become contentious for any reason. Also, this section requires intermediaries to communicate with one another in order to ensure that investors do not exceed their investment limit across all the investments they make. That will be difficult to manage—investors will be regulated through these offerings, which is not great. Among other items, the entrepreneur must disclose the names of all owners of the ESG/issuer who own more than 20% of the shares of the ESG. As a last item of note, once an investor owns the shares, she may not trade or sell them for one year unless that sale or trade is to an accredited investor, to a family member, part of another offering, or back to the issuer. Essentially, securities cannot be traded among nonaccredited investors.

Title IV enables “small companies” to issue up to $50 million publicly and still be exempt from several regulations in the 1933 act. Title V limits an ESG to issuing no more than $10 million to 2,000 total investors, of which no more than 500 may be nonaccredited. Title VI applies those same limits to Bank Holding Companies (essentially allowing bank holding companies the same limits as other firms, up from the prior ceiling of 1,200 total investors) and 300 nonaccredited investors. And finally, Title VII directs the SEC to conduct marketing outreach on this act to the public, with an emphasis on small and medium-sized businesses and on women-, minority-, and veteran-owned businesses.

When Neiss spoke in Chicago, he emphasized that this mix of initiatives, even this entire funding portal industry that in principle created access to a wider set of investors, was not allowed to formally start or prosper until the administrative rules were determined and published by the ruling authority, in this case the SEC. Furthermore, no timeline for releasing its rules had been imposed on FINRA, Neiss mentioned. The effect of such a delay has been to dampen the excitement about funding portals. The domestic community of entrepreneurs awaits the issuance of the rules by the SEC and FINRA in order to launch this industry.

Alternative Crowdfund Investing Approaches

In the meantime, as anyone who knows entrepreneurs would suspect, several funding portal domain names have been purchased by entrepreneurs who are anticipating the release of the rules at any time. Some entrepreneurs with sufficient resources have been able to launch portals in advance by adhering to the rules, including Fundable.com and AngelList. Fundable.com organized its offerings to be consistent with the JOBS Act. To adhere to the waiting period on the SEC rules, all equity investments are processed manually rather than through the portal. Once the rules are announced, Fundable will be ready to process equity investments through an automated, digital process. AngelList, a widely popular platform (online at angel.co) on which founders list their new ventures and investors publicize their support, is actively preparing its stakeholders for the ability to advertise for investment capital. On the day of each SEC announcement, AngelList is a site to watch.

Another pair of entrepreneurs had the savvy insight to take advantage of the publicity of crowdfunding but remain within the historical SEC regulations for private offerings of securities (also known in part as Reg. D). Larry Baker and Charlie Tribbett, cofounders of Bolstr.com, organized their website to comply with all 50 state laws and US law for private offerings of securities. With this approach, which is essentially digitizing a financial service that would otherwise be encumbered by differences in state laws, Baker and Tribbett can proceed to meet the needs of entrepreneurs without having to continue waiting for the SEC. In 2013, Bolstr assisted Mr. Mike Connelly, co-owner of Rebell Conditioning, in raising $12,000 in under 48 hours from friends, family, and community members. This is crowdfunding at its finest.

Another important crowdfund investing platform for entrepreneurs, which is now quite a mature marketplace, is crowdfund investing with angel investors. As stated earlier, an angel investor is an individual or a small group of individuals who privately invest their own personal capital into entrepreneurial ventures. They are called “angels” because their investment capital can be a godsend to an entrepreneur at the right time. Contrast that genteel term with the names, including vulture capitalist, given to venture capitalists (professionals who invest primarily other people’s money), and you can guess why it is sometimes better to be an angel. Substantial research and energy have been focused on angel networks for more than a decade now, and we cannot explore all that in detail here. Suffice it to say that one of their historical practices, hosting live, in-person pitch sessions, is nearly dead as a result of the power of crowdfund investing over the Internet. All the resources needed to organize people to get to a venue, assess a pitch, assess the entrepreneurs, wait for angels to ask questions (if they get to ask questions at all), evaluate the investment offer, and feel that relationships are forming pale in efficiency relative to the outcomes made possible by browsing the list of thousands of angels on Angel.co or Gust.com.

At this time, crowdfund investing with angel investors using the Internet is essentially an organized information exchange, and will remain so until Title III of the JOBS Act is put into effect. Actual monies do not change hands through the website (if money is exchanged, the site must register as a crowdfund investment portal, explained earlier). Rather, all the components of a pitch, including the investment offer, are shared between the entrepreneur and the prospective angel or angels. The online marketplace helps angels to see a variety of opportunities without using up much of their own time and resources during the search phase.

Most angel investments involve some form of equity. Occasionally investments by angels are arranged as convertible debt, which is a type of quasi-equity that is underwritten as a loan or liability to the entrepreneur until such time as a “professional” investment establishes customary terms. Even convertible debt is a type of equity, however, in the sense that the investment principal is not expected to be returned on an amortized basis, as it is with a typical loan agreement. Therefore, at some point in the discussions between the entrepreneur and the angel, a legal document needs to be written that explains the rights and benefits of each party. While communication between the entrepreneur and the angel crowd can remain online, at some point a document outside the website has to be signed. This step is consistent with historical practices.

Crowdfunding is also possible for obtaining a loan (obtaining debt capital from a source other than a bank), so let us examine peer-to-peer lending. Have you ever asked a friend for a short-term loan? Did you establish a contract and spell out the terms in detail (duration, interest rate, and what to do in case of a default or missed payment)? Did your friend check your credit score? Your credit score is a number on a scale of about 300 to 850 that is calculated by credit reporting services such as Experian, TransUnion, and Equifax and reflects your ability to repay all your personal debts (mortgage, credit cards, auto loans, and so on). A higher score represents a higher likelihood that you will repay your debt, which is a good thing. Most people with “good credit” have scores above 700. Today, a person’s credit score is a big factor in a lender’s decision to lend to that person or her entrepreneurial venture. Since the banking system “shock” in 2008, bankers are increasingly tying an entrepreneur’s personal credit to her business credit. Up to an estimated revenue of $15 million, your personal credit matters when it comes to what terms are extended for your business credit card application or revolving loan, if you are accepted at all. It is likely that your friend did not look up your credit score, nor did he think that such an effort was necessary at the time when the loan agreement was made and his money was put into your account.

Peer-to-peer lending, which is a practice that goes back centuries, has evolved to become an efficient process through websites such as Prosper.com, in which the legal language in the contract and the terms, such as interest rate, duration, and principal amount, have all become more transparent and efficient. The Prosper Marketplace boasts a current membership base of 921,432 people, who have collectively lent $15 billion to each other.⁸ Wow, that is an effective marketplace for capital. For entrepreneurs with reasonable credit scores, a first-time borrower can obtain a five-year term loan at 11.6% APR for an amount between $2,000 and $35,000. Applications and repayments all occur online. I suggest that, as with any other fund-raising activity, it is better to apply for a loan before you desperately need it. One successful strategy is to take out a small initial loan, pay it back early, then apply for a second loan at a better rate. It’s also plausible to earn income as an entrepreneur by taking the role of investor on a peer-to-peer lending marketplace. The marketplace handles all the terms and helps to provide risk management and portfolio diversification. Maybe all this interpersonal “relationship” banking is getting obsolete? It may be too early to answer that question; however, experimenting with such a system makes a lot of sense to entrepreneurs.

A Note on Crowdfunding Versus Crowdsourcing

Crowdfunding differs from the broader umbrella term crowdsourcing in that the first is a subset of the latter. Obtaining money (through payments or similar online transactions) from the crowd (unrelated strangers in widespread geographies) is distinct from obtaining ideas, feedback, and services. Crowdsourcing requires making requests for tasks and generating information and feedback; crowdfunding indicates making appeals for sales or donations to support an early initiative; and crowdfund investing, as we have discussed earlier, indicates making offers of investment capital through an authorized funding portal. Accepting money requires that you provide the promised goods or services in return; ideas have no such tether to payments.

Entrepreneurs can crowdsource for several reasons. Let’s briefly look at how to get the crowd to perform tasks and generate information.

The entrepreneur may choose to enlist the crowd to perform tasks to support his new venture using the Internet in several ways. At the time of its launch, Amazon’s Mechanical Turk service was an experimental service in which entrepreneurs or companies posted jobs that needed to be completed, and workers logged on to complete the work. Radically, though, the work is parsed into such small increments that the cost per task completed can be as low as $0.01. That’s not a typo—we are talking 1 cent! Each task is called an “HIT,” or “human intelligence task,” pointing to the fact that many of these tasks require people to complete them, rather than algorithms or machines. “Turks,” or workers, receive pay for completing HITs in the time and manner dictated by the entrepreneur. For example, an entrepreneur based in London, England, who is engaged with website users from locations in both the Commonwealth of Nations (where British English dominates) and the United States (where American English dominates) may need human intelligence to check the spelling of the word labor versus labour. When his Commonwealth customers add the u in labor to make labour, it is not a mistake that is easily found by a spell checker. Rather than investing valuable time sorting in this out himself, the entrepreneur can enlist the Turks with a $0.01 payment per HIT to “find all words unique to British English and convert to American English.” They can input either of those words, being fully concerned with saying what they mean while spelling the word correctly. The amount of time it takes to set up the work on Amazon’s service and pay for all the HITs should be less than the entrepreneur’s cost of her time to do the HITs herself.

Crowdspring.com provides entrepreneurs with the largest pool of designers in the world. This is one of a few specialized marketplaces where entrepreneurs can complete several design services: choose a name for the venture, have a logo designed, have a website designed, and even have a mobile app designed. What makes this marketplace of design talent so useful for entrepreneurs, however, is not what can be seen—it is the detailed and fair legal agreement set by Crowdspring.com for all designers. This seems like an unimportant point; however, the time and expertise that it takes for an entrepreneur to negotiate the legal rights between a logo designer and himself carries a high cost and low value—no one wants a dispute over the rights to a logo. The cofounders of Crowdspring.com include one graduate of the Law School at Northwestern University and one graduate of the Kellogg School of Management at Northwestern University. Jointly, they articulated the fair set of legal statements for both the designers and the buyers of the designs. This is an important piece of infrastructure that allows entrepreneurs to trust the results of the work, both in design and in terms of who owns it.

As for the actual designs, Crowdspring.com brings to the entrepreneur a pool of more than 100,000 designers from more than 100 countries in the world. Compare this to asking friends or asking the entrepreneur next to you at your coworking space, “Who have you used to design your logo? I need one.” Not only is that method of getting your logo done expensive and time-consuming, but one, two, or even three great referrals give you a much smaller set of choices. In a recent example, a US entrepreneur received 203 logo design ideas within 7 days from 39 designers using a similar site called 99designs.com. He ultimately selected a design by a man who works from a small town in Italy. The total cost of the logo was $449.00. Some people might think that that was expensive, but it could also be seen as costing just over $2 per logo idea if you divide the total cost by the number of design concepts that were made available for review. Furthermore, the convenience of arranging submissions through this the marketplace was considerable, compared to the inconvenience of making personal arrangements to meet and see concepts through an individual designer. Coincidentally, the entrepreneur had been born and raised in a nearby small town in Italy before moving to the United States 30 years earlier.

Gathering information is another useful feature of crowdsourcing. It is so useful that an entrepreneur created a service offering in which he enlists a crowd of PhDs to read research papers, make summaries of them, and publish what the reviewer feels are the relevant findings of the research. Dinesh Ganesarajah (“Dino”) founded PreScouter to provide his clients with several benefits from aggregating research papers, hiring more than 200 skilled reviewers (the PhDs) to assess research for the clients. His clients are vice presidents of research from 28 Fortune 500 companies who are interested in the flow of research in technical fields, such as biochemistry, solar energy, or quantum mechanics. In this example, the crowd is a set of PhDs in whom such technical skills can be reliably found (not always the case with a Mechanical Turk, of course), who are needed for a much smaller amount of time (compared to a large company’s army of full-time R&D professionals) and at a precisely targeted cost. Dino’s team of PhDs “scouts” research from 400 universities and 60,000 small businesses and private institutions to find what might be valuable to his clients. PreScouter earns profit from pricing his crowdsourced services higher than their cost, while providing his clients a service at a lower cost than the obvious alternative of hiring one or two of their own “scouts.”