Will crowdfunding change everything?

Crowdfunding, Demohour.com

Are crowdfunding sites such as China’s Demohour a fad that will eventually settle down into a small niche, or will they turn into something more profound?

Once upon a time, two IT workers quit their jobs and ran off to Lhasa, Tibet, to start a youth hostel. But they were short on money. So they went to a fairy godmother named DemoHour who took pity on them and granted their wish.

Rarely seen in recent years, fairy godmothers like DemoHour have begun to make a comeback online, in the form of crowdfunding sites. Those two former IT workers, for example, made a plea to the Chinese site  to help them realize their dream and 2,594 site visitors responded, coming forward with pledges that totaled RMB 146,400 in cash and a number of offers of used furniture. “People just loved it,” said Feng He, DemoHour’s CEO recounting their story in a recent TED talk.  “People went crazy.”

The Lhasa hostellers aren’t alone. Hundreds of people have had all kinds of wishes granted through the good offices of sites such as Demohour.com or Dreamore.cn in China or Kickstarter.com in the US. As odd as it may sound, many of these transactions are neither loans nor equity investments, but donations: the hostel founders, for example, received a lifetime card to stay free at their hostel in Lhasa for their investment–hardly a big cash hit for the founders, given that most Chinese live at least 4,000 km away from Lhasa.

As much as it might sound more like the last reel of a Hollywood movie than a funding mechanism, crowdfunding–a new way to raise cash from individuals through an online solicitation, often without expectation of any real monetary return on the investment–actually appears to be taking off, both in China and all over the world.

Crowdfunding to Double in 2013

Deloitte predicts that crowdfunding portals will raise roughly $3 billion in 2013, double the $1.5 billion they raised in 2011, and some industry boosters believe it could end up being a major new financial channel.

And it’s still early days for crowdfunding sites: one of the oldest, Kickstarter, launched in 2009. Hundreds of start-ups in Asia, Europe and the US are now vying to encourage investors to send financial assistance to do everything from helping young musicians record an album to providing equity capital for early-stage health-related technology companies. Some industry boosters predict these kinds of crowdfunding portals, which range from more general sites such as Kickstarter and Indiegogo to more focused sites, such as Spot.us, a site that tries to fund journalists to follow stories the established media have overlooked, and Unbound, a publishing house running on a crowdfunding basis, will eventually grow into a trillion-dollar channel for capital and perhaps even upend the traditional capital markets.

At the moment, capital raised from the crowd is growing fast. In 2013, Deloitte estimates, consumer loans could yield $1.4 billion in 2013, donations could amount to $500 million, venture capital maybe $50 million (but almost $1 billion-plus if some US laws are changed), and rewards-based sites could raise $700 million. But is crowdfunding a fad that will settle down into a small niche, or will it turn into something more profound?

From Critic to Patron

In a world almost as hungry for hope as for capital, crowdfunding seems to be satisfying two needs at once: on the one side, giving the donors (or sometimes investors) a chance to participate in the creation of a new venture or project they might not have otherwise heard of, and for entrepreneurs, artists and other dreamers, a new potential source of cash to bring their plans to life–a need that’s been especially strong in recent years, as most traditional sources of capital have become more reluctant to lend, particularly in Europe and the US.

Business models vary, but most sites operate as for-profit middlemen who take a cut of the money raised. Their roles vary. Some will simply set up a peer-to-peer loan, or coordinate the joint purchase of an investment. The more radical, however, promise only a set of rewards. On Kickstarter, for instance, a donor who gives $20 to a band to help it complete a recording might receive a copy of its new CD, a $100 donor might get the CD and her name on the liner notes, and a $500 donor might get all those things plus a backstage pass to a concert.

Sheen Levine, a scholar of organizational innovation at Columbia University, says he thinks the appeal is a bit like that of watching one of the talent show programs, but with the difference that “you become the judge”.

In some ways, Levine argues, the crowdfunding technology may be taking us back to earlier consumption patterns. “I think that people always wanted to register their preferences, people always wanted to say, ‘I like this, I don’t like that’, and people could do that in the past. With the Industrial Revolution this pretty much disappeared: the good news is that people could afford shoes; the bad news is they are the same,” Levine says.

Whether these post-industrial patrons will back great projects is another question. Levine, for one, isn’t sure that a market that is not “mediated by professional arbiters of taste” will be able to produce work that appeals to more than its narrow group of supporters.

But others argue that this crowd is actually fairly adept at predicting what the larger crowd will like. Ethan Mollick, the Edward B. and Shirley R. Shils Assistant Professor of Management at the Wharton School of the University of Pennsylvania, has researched crowdfunding platforms, and found that the crowd actually does a surprisingly good job in sorting out which projects seem more thought-through and deserving of funding. “They can smell a rat,” he says. In his analysis, it turns out that the crowd tends to look favorably on things that more sophisticated investors would look for–working prototypes, experienced teams, a track record.

The fact that it is even more of a buyer’s market for the arts than usual probably adds to the vibrancy as well: three of the top categories at Kickstarter–music, publishing and films–all belong to industries that have been deeply affected by digitalization. But Kickstarter is having an impact: 10% of the 2012 films at the Sundance Film Festival had Kickstarter funding. Some people now, in fact, also seem to be using the site as a way of calculating market demand.

Some Dreams aren’t Dreamy Enough

One thing that most–but not all–successfully crowdfunded projects have in common is that they tend to tilt toward something that has a tangible end product. “Crowdfunding works well when you get a good [i.e., a product] at the end, or an experience,” Mollick says. However, if say you have a better idea for enterprise resource management software, the crowdfunding world may not beat a path to your door. Levine, for one, is skeptical that the crowd will ever fund things that don’t have “a cool factor”.

The other reason may have to do with the nature of the reward, in Mollick’s view. A Facebook or an Instagram wouldn’t have had anything special to offer as a reward.

Alex Sheshunoff, CEO of Foodstart.com, a rewards-based start-up that focuses on fundraising for restaurants, agrees. “I do think the areas where reward-based crowdfunding will resonate most are verticals where people have an emotional relationship to the project—whether it’s raising money for a neighbor’s medical care or wanting to see a friend’s new restaurant succeed.”

But he thinks there will still be many applications, despite its limitations. “Rewards-based crowdfunding has a role to play in almost every aspect of the economy—from small business financing to the non-profits sector,” says the Alaska-based entrepreneur.

Sheshunoff speculates that the crowdfunding process may increase the total amount of capital going into those sectors. “Will rewards-based crowdfunding increase the total amount of capital going into those sectors or just reroute it through other channels?” he asks. “I doubt anyone knows for sure, but anytime you make something easier and align incentives properly, you’re going to see an increase in activity.”

Feng He of Demo Hour, in his TED talk, argues that ultimately, the crowdfunding he offers is really about self-expression–not just of the person making the pitch, such as his two hostellers, but of the donors as well. “[W]e soon realized that what we were doing was more than just funding creativity, what we really did was create this space where people can express themselves…” he said, “making decisions that reflect your values and supporting something that you believe in.”

And that, Feng says, is “bigger than the VCs. It’s as big as all of us.”

Nothing Quite as Wonderful as Money?

Other sites are focusing more on using crowdfunding as a new way to attract narrower pools of investors.

For example, a variety of crowdfunding sites are trying to entice investors into taking on a variety of stakes such as stocks or apartments. Crowdbaron, a Hong Kong- and Jakarta-based site, is trying to convince accredited investors to pool their resources to buy shares of luxury apartments and other properties, in tranches ranging from $10,000 to $50,000. These aren’t timeshares–which although marketed as a share of ownership is actually a pre-funded vacation–but an actual share in the property, which will be managed exclusively for investment.

Co-founder CEO Saeed Hassan says he believes that the simplicity of the proposition will attract investors, particularly Muslims who are proscribed from taking interest on their investments.

Other platforms are taking more of what Healthfundr COO Sean Schantzen describes as a “curated approach” to crowdfunding. Healthfundr, for example, showcases a small group of healthcare technology companies for the consideration of accredited (US Securities and Administration-speak for high-net worth) investors. Schantzen says his group is trying to fill a gap in the market for companies that are not early stage enough to be of interest to angel investors, and are unlikely to grow to a size that would interest venture capitalists, but are still likely to grow up into profitable companies.

Some of these for-profit sites also brush on unconventional territory. For example, one American site, Upstart, is setting up transactions that allow young people looking for seed capital or money for education to trade funding now for a share of their future earnings.

In the end, Mollick predicts that there will be a few general-interest sites and then more specialized sites.

But others are skeptical about whether crowdfunding can work to fund high-tech startups.

Stephen Bell, a Beijing-based venture capitalist, is skeptical about the value of crowdfunding in early-stage investing. As a way to slip $20 to a band you like, it makes sense, he says, but it would make little sense for most start-ups,” he said.

The reason, adds the Beijing-based co-founder of Trilogy Ventures China, is that he finds ideas rarely matter. Most people will have similar ideas at the same time. Skype, for instance, was far from the first VoIP (voice-over internet protocol) company to be funded; and Google was a late arrival as far as search engines go. What tends to matter more for early-stage commercial success is the ability of a team to execute its plan, he says. And in his experience, it’s not always easy to judge.

“I don’t think early investors care about ideas at all. It’s all about what they have done… there are very few new ideas. There’s just execution.” Even that isn’t something he thinks can be demonstrated with a CV: “I don’t care about experience, but I like to see what they’ve built.”

Others are more optimistic. Mollick believes crowdfunding could democratize start-up fund-raising by making it easier for companies that don’t happen to be located in Silicon Valley. Right now, most venture capital (VC) investments take place within 70 miles of the VC’s headquarters, which means a lot of ideas in other places are overlooked.   Bell, however, is not so sure that great teams actually have much trouble attracting the eye of a serious venture capitalist.  It’s usually possible to get a meeting, if the team seems serious, he insists.

From the perspective of the company looking for investment, however, crowdfunding may solve another set of problems: “I was speaking with someone the other day who raised $6.5 million in a public offering but after paying accountants and lawyers, they netted only $2 million. Essentially, it was a marketing process. Remove some of those inefficiencies and a lot more capital starts to make it to its intended destination,” Sheshunoff says.

A Skinnier Middleman

In the end, however, the killer app of crowdfunding may prove to be not as a platform for technology investors or a digital-age arts patron, but peer-to-peer (P2P) lending sites that cut out traditional bankers. By cutting out the bank, the P2P lenders such as the UK’s ZopaKiva or Funding Circle, can offer extremely competitive rates for loans and savings accounts.

A kind of 21st century credit union, the P2P portals claim they can offer individual investors interest rates that are higher than they could get in a conventional account and at the same time offer borrowers a more affordable rate than many of the traditional banks offer. For instance, at Zopa, it’s possible to borrow money at a 5% fixed rate and deposit it at 4.9%. Another site, GraduRate, specializes in student loans–and offers such unusual options as being able to buy the loans of grads with A averages.

Simplicity may be a big part of P2P’s appeal, particularly compared to global banks. Zopa, for example, takes just three lines on its website to explain its business model:

  • Lenders put money in
  • Borrowers borrow money
  • Everyone is happy

It remains to be seen whether “everyone” will stay happy. As attractive as that simplicity is right now, some critics have warned that P2P lenders are still relatively unregulated, and not all offer deposit insurance.

However, as the Western financial services sector continues to struggle to regain the credibility it lost in 2008 and has not yet entirely recovered, banking directly with other individuals is apparently looking attractive to many consumers–at least compared to using the kind of complex global institutions US Attorney General Eric Holder described not too long ago as “too big to jail”.