7 Reasons to Avoid Crowdfunding

In the wake of tight credit markets, crowdfunding -- also known as crowdsourcing -- arose as a source to provide capital to startups, especially the creative types. This new form of equity financing enables a company to raises funding through small contributions from a large group of individuals via an online platform. Essentially, an entrepreneur makes an online pitch to a virtual audience, which then decides whether or not to support the venture by pledging money towards it.

Here's how it works: an entrepreneur posts a description of his or her project, product or service, outlines the business plan, proposes the amount of capital needed, and explains what contributors will receive in return. Retail businesses sometimes provide product in return for the funds they provide. (You give me startup funding for my bakery, and I will deliver gourmet cupcakes to you for the next 10 Fridays.) Other times, the entrepreneurs pledge cash repayment or they may offer an equity stake in the venture.

In April 2012, President Obama signed the Jumpstart Our Business Startups Act (JOBS Act) intended to spur economic growth by enabling small businesses to raise capital more easily. Title III of the legislation is known as the Crowdfunding Act, which amends the registration requirements of the Securities Act of 1933. The new law thus enables start-ups to raise small amounts of equity capital through crowdfunders without having to register with the SEC.  (The online platforms themselves must be registered, however.)  The maximum amount of securities that a company can sell to its investors cannot exceed $1 million during a 12-month period.  The Crowdfunding Act is still a work in progress; its provisions have not been finalized.

Meanwhile, a crowdfunding portal is not permitted to provide investment advice or make recommendations; cannot compensate lead generators for providing the crowdsourcing platform with the personal information of any potential investor; and its directors (or any person with a similar status or function) must not have a financial interest in any issuer that utilizes the services of the crowdsourcing platform.

Once thought of as a fad, it is estimated that more than $1 billion will be made available to companies through crowd-funding platforms. Kickstarter alone has channeled $100 million and launched 30,000 projects at about a 46% success rate. IndieGoGo is another large crowdfunding website. Founded in 2008, the crowdsourcing pioneer has helped raise millions of dollars for tens of thousands of campaigns in 194 countries. RocketHub is another leading crowdfunding site for artists that has gotten a lot of press attention.

Other crowdfunders fill niches. For instance, StartSomeGood helps raise funds for social causes and charitable initiatives. This is all very innovative, however in my opinion crowdfunding has its drawbacks.

No. 1: Crowdfunding works best for projects that require relatively small amounts of capital.

This method of raising money may prove inadequate for larger ventures requiring millions of dollars worth of financing. Although it can be done, such was the case with Pebble Watches, but it doesn't happen often and can be quite challenging. Serious, established businesses should look for other methods of funding.

Further, some companies promise repayment in product, as Pebble Watch did. Now they have to provide thousands of people with product, distribution has been delayed by months, and Pebble funders are wondering if they will ever get their watches. Making a product and distributing it involves costs. It's easier to make wire transfer payments.

No. 2: Lack of prestige.

While it may be hip for artists and film makers to raise capital in a trendy, technology-driven way, professionals including physicians, lawyers and others likely would not want it to be known that they posted their business plans online in search of funding. Would a doctor really want one of his patients to be a partial owner of his medical practice?  Probably not.

 No. 3: Negative impact on future financing options.

Companies that issue shares through crowdsourcing ultimately are beholden to large numbers of unsophisticated investors who own tiny stakes in the business. This structure could deter venture capitalists or angel investors leery of investing in a firm that is owned by thousands of inexperienced shareholders.

No. 4: The value of shares sold to investors during a 12-month period cannot exceed $1 million.

If an entrepreneur raises $1 million or more through equity crowdfunding, he or she cannot look for additional for one year. Otherwise, the business owner must comply with securities registration requirements. What happens if the company experiences rapid growth and needs more money?

No. 5: What if your project is not "sexy"?

While it may be appealing to artistic-minded investors to fund art exhibitions or documentary films, online support for a traditional business's working capital needs will likely be lackluster. In these instances, companies are better off securing lines of credit or merchant cash advances.

No. 6: Speed

If a business owner needs a lot of money quickly to take advantage of a discount deal on inventory or requires a rapid infusion of cash for a building project, he may not be able to wait for the idea to catch fire on a crowdfunding site. A cash advance or business loan from a bank are better options to make it happen.

No. 7: Potential lawsuits

Investors expect returns and may not be patient if a company does not generate profits.  Lawsuits arising from failed business ventures can occur. Plaintiffs may accuse the entrepreneur of fraud, breach of contract or mismanagement. Since only relatively small amounts of money are involved, it may be cost prohibitive for investors to pursue legal claims. However, they can file complaints regulatory enforcement agencies that might lead to government investigations. No business owner wants that headache.

While crowdfunding works for many startups searching for an alternative means of financing, it is not for everyone. There are many instances when a traditional small business loan or business line of credit will be just as effective and much easier to obtain.  The basic rules of business still apply. An entrepreneur seeking crowdfunding still needs to have a sound business plan, and the skills, employees, and resources to deliver on its promises. Investors, even small ones, are not going to throw their money away on a company without sound business goals and the capability of obtaining them.

My advice to anyone considering crowdfunding is to research all the options available, including traditional sources of capital, and then determine what will be the best deal.

This opinion column was written by Rohit Arora, co-founder and CEO of Biz2Credit, an online resource that connects small business owners with 1,100+ lenders, credit rating agencies, and service providers such as CPAs and attorneys via its Internet platform. Since 2007, Biz2Credit has secured more than $600 million in funding for thousands of small businesses across the U.S.