Dismembered hands putting coins into a piggy bank labelled crowdfunding

Crowdfunding for tech companies

The limited choices of finance often mean that technology startups have to pan-handle the men in pinstripes. Could crowdfunding be an alternative source of funding?

Forty years ago, the only place to obtain financing for a new startup idea for the vast majority of businesses, including technology ventures, was the bank.

If you charmed the bank manager, he (as would invariably would be the case) may grant you an overdraft facility but this could be taken away at the whim of head office bank-lending policy. Clearly, this was far from ideal.

Then came the 1980s and financial deregulation, which encouraged a great deal of interest in alternative investments. Thus there was a growth in venture capitalists and angel investors searching for a possible flutter in technology businesses.

Investing in risky technology projects became popular and grew massively until the dot-com bubble burst at the turn of the millennium.

In the current austere times, tech entrepreneurs have had a tougher run of raising finances than the previous decade - when even absurd propositions attracted millions of dollars and pounds. Now, however, startups have the option of asking complete strangers for cash - a'strategy known as crowdfunding.

Crowdfunding was originally conceived as a way to fund mostly unprofitable creative projects such as films, music and books. US websites have used this method to raise millions of dollars to fund a variety of creative ventures.

In the UK, money for new businesses is tight - Bank of England figures point to lending that has shrunk steadily since the beginning of the banking crisis in 2008.

Today there are hundreds of crowdfunding platforms around the world, with fundraising reaching billions of dollars annually. In 2012, crowdfunding platforms raised $2.7bn and successfully funded more than a million campaigns.

Crowdfunding research organisation Massolution claims that the technique raised $5.1bn last year alone. "In the past it would have been impossible for ordinary investors to get in on the ground floor investing in companies such as Google, Facebook or Twitter," says Kevin Berg Kartaszewics-Grell, research director for Massolution.

US sites Kickstarter and Indiegogo are the largest in the crowdfunding genre. On these crowdfunding platforms, donations are sought in return for special rewards such as a free product or even a chance to be involved in designing the product or service.

The most well-known example of this is Pebble Technology, which launched a Kickstarter campaign in April 2012 with an initial fundraising target of $100,000. Backers pledging $115 were promised a Pebble smartwatch when they became available - in effect, they were preordering a product that did not yet exist for a discount.

Within six days, the project had met its $100,000 goal and within the first month it had become the most funded project in the history of Kickstarter, raising over $4.7m. By mid-May, funding closed with $10m pledged by almost 70,000 investors.

Do-it-yourself crowdfunding

It is also possible to set up a crowdfunding platform on your own website using open-source crowdfunding platform software such as Selfstarter.

This is what software and hardware engineers Mike Farley and Nick Evans did when they started a new campaign. They used the software on their own website for their product Tile - a matchbook-sized, Bluetooth, low-energy device that aims to use peer-to-peer networking linked to social media to recover lost items to which it is connected. The Tile pre-order campaign ran from summer 2013 and reached its target of $20,000 before the end of that year.

"We decided to use our own crowdfunding platform so that we could make the decision'to go ahead and not rely on third-party rules," says Evans, chief executive of the company.

For the Pebble and Tile examples, none of the investors were promised equity, as financial regulation is very strict on selling shares in your company outside the remit of the Securities and Exchange Commission (SEC). However, this may soon be a possibility.

Two years ago, the US passed the Jumpstart Our Business Startups Act (Jobs) with the aim of allowing the general public to receive company equity in exchange for funding. But, even for Americans, equity crowdfunding comes with limits and caveats. The new law only permits investments of up to 5 per cent for individuals with an annual income of less than $100,000, and up to 10 per cent for those who make over $100,000.

Although the law was passed almost two years ago, the Securities and Exchange Commission has still to set up the regulatory framework for equities crowdfunding. But at least they will have a framework in place in the near future. The UK, on the other hand, has not enacted any similar legislation.

The regulatory future is uncertain in the UK, which focuses on protecting investors from 'unsuitable' investments. The general rule is that for funds to be offered to the public the funds themselves have to be authorised, as do those who manage them. Unregulated funds can be offered, but only to specific classes of investor - which would exclude your average consumer backer.

The inherent vagueness of UK regulation is leading some within the industry to lobby for a similar law to that in the US for crowdfunding platforms to be applied.

Regulating your campaign

With the current model of crowdfunding for technology companies, there are a number of pitfalls to circumvent. The obvious is the stigma attached if your crowdfunding campaign fails.

The main crowdfunding platforms have strict rules and time limits on campaigns. For example, on Kickstarter you would have to raise your target by a given date and if you fail to do so, no funds would be released.

You could end up losing money if you do not do sufficient research and development, however. Producing a prototype consumer product, for example, is the first step. You need to consider the economics of mass-producing the product at the price that you state - it could end up costing a lot more once you have retooled the product and taken manufacturing into account.

Additionally, consumer law needs to be taken into account. Developed economies tend to have well-tested legislation to protect consumers from entering into unfair consumer contracts.

"I have seen people who haven't been able to manufacture at the price they thought they would be able to and they have dropped off the face off the earth," says Salvador Briggman, a blogger and expert on crowdfunding whose site www.crowdcrux.com reports on the global crowdfunding industry. "It's really crucial to concentrate on the preparation phase - particularly if you are a first time engineer who doesn't have experience in manufacturing."

There is a strong argument to be made that angel investors and even the high-street bank managers can offer more than just money; they could also provide entrepreneurs with advice. Tech enterprises could miss out on such mentorship by ignoring traditional investors and turning to crowdfunding.

Starting up a company is a very risky and challenging journey. Besides finding sufficient funding, there are always additional expenses that are impossible to forecast as well as challenges in market validation and people who want a piece of your venture in return for helping to get it off the ground.

However, having said that, crowdfunding provides a welcome strategy when the main banks are unwilling to invest. A successful crowdfunding campaign creates a base of customers who have a vested interest in the success of your business. It also allows an entrepreneur to gain market validation and avoid giving up equity before going all out and taking a product concept to market.

Crowdfunding can be good for publicity. Many platforms incorporate social media mechanisms, making it painless to get referral traffic and greater sales. This cannot have been lost on the founders of Pebble.

The past year has seen tremendous growth of interest and funds available from the different types of crowdfunding platforms. It's the adorable baby of the finance world. What will it grow up to be?

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