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Alternative Assets and the “Average” Accredited Investor Installment #5: Crowdfunding

Rewards-based Beginnings

Crowdfunding is a method of collecting many small contributions, by means of an online funding platform, to finance or capitalize a popular enterprise. This is the first of three installments that deal with the development of crowdfunding.

Crowdfunding gained traction in the USA when Brain Camelio, a Boston musician and computer programmer, launched ArtistShare in 2003. It started as a website where musicians could seek donations from their fans to produce digital recordings and has evolved into a fundraising platform for film/video and photography projects as well as music.

ArtistShare’s first crowdfunding project was Maria Schneider’s jazz album “Concert in a Garden.” Above a minimum contribution amount, Schneider offered a tiered system of rewards. For a $9.95 contribution, for example, a backer got to be among the first customers to download the album upon its release in 2004. Fans who contributed $250 or more (in addition to receiving an album download) were listed in the booklet that accompanied the album as participants who “helped to make this recording possible.” One fan who contributed $10,000 was listed as executive producer.

Schneider’s ArtistShare campaign raised about $130,000, which enabled her to compose the music, pay her musicians, rent a large recording studio, and produce and market the album (it was sold exclusively through the ArtistShare website), which won a 2005 Grammy Award for best large jazz ensemble album.

Rewards-based Crowdfunding Explodes

Thanks to ArtistShare’s success, more rewards-based crowdfunding platforms were launched, the most prominent of which were Indiegogo in 2008 (which also began offering equity-based crowdfunding in 2016) and Kickstarter in 2009. In addition to the arts (including fine art, comics, dance, design, fashion, film and video, music, photography, creative writing, theater), these sites host funding campaigns for social causes (animals, community, education, environment, health, politics, religion) and entrepreneurs and small businesses (food, sports, gaming, publishing, technology).

From its launch in 2009 to August 2018, Kickstarter has hosted more than 408,991 funding campaigns, of which 36 percent were successful. The 148,417 campaigns that succeeded raised a total of $3.827 billion from more than 15 million backers. That’s more than 100 backers for each campaign. The average contribution, based on those figures, right around $250 (although because of outliers the median is lower). The business categories with the most successfully funded projects on Kickstarter are dance, theater, comics and music, followed at a distance by art, films and video, games, design, publishing, and six other categories. Kickstarter charges a fee of 5 percent of the funds collected in a fully funded campaign and third-party payment processors charge fees of 3 percent plus twenty cents per pledge (with pledges under ten dollars receiving discounted processing fees of five percent plus five cents per pledge).

Not all projects are funded, of course. In an all-or-nothing funding model, 36 percent of Kickstarter projects are fully funded based on their stated goals, while the majority walk away with nothing. All-or-nothing means that if a project does not reach its stated funding goal within a stated campaign period, the campaign fails and the funders’ credit cards are not charged—and the platform earns nothing. (Indiegogo allows both all-or-nothing and keep-it-all rewards-based and equity-based campaigns. In the keep-it-all campaigns, the project may keep all the funds it raises even if the goal is not reached.)

One of the most outrageously successful, and subsequently famous, Kickstarter campaigns is the Pebble Smartwatch campaign.

Pre-Apple Watch, a group of entrepreneurs in Palo Alto, CA, created a digital, customizable wristwatch that runs downloadable sports and fitness apps, and connects wirelessly to an iPhone or Android smartphone. The team sought $100,000 during the funding period for their first Pebble watch, spanning April and May 2012. With a pledge of $99 or more, backers could pre-order the Pebble watch, the retail price of which was estimated at $150. Pledges of $220 or more were rewarded with two Pebble watches, etc. The campaign raised a whopping $10,266,845 from 68,929 backers (average pledge $149), making it the fifth most successful Kickstarter campaign as of January 2019.

Thereafter the Pebble team went on to fund two additional Kickstarter campaigns both even more successful than the first. In 2015 they raised $20,338,986 from 78,471 backers for the Pebble Time, the most successful Kickstarter campaign to date, and in 2016 they raised $12,779,843 from 66,673 backers for the Pebble 2, the third most successful Kickstarter to date.

It is important to note that many backers pledge amounts less than the minimum required to get a reward. In other words, rather than expecting a tangible reward, they simply want to support the project team and/or their product. To run a successful crowdfunding campaign, “You don’t want to merely sell people a product, you want to sell them a dream,” says one successful Kickstarter campaigner.

New rewards-based crowdfunding sites are emerging that focus on a narrow product category or niche market. Experiment, for example, is a crowdfunding site for scientific research projects; funders are rewarded with “insight behind the science.” Teespring is a Kickstarter-inspired site for designers of custom t-shirts.

Significantly, all rewards-based crowdfunding campaigners retain their intellectual property rights: patents, trademarks, and copyrights. In other words, Kickstarter is not a producer or publisher or marketer, but a sophisticated intermediary that connects campaigners with backers and enables them to communicate among themselves in order to assess the merits and prospects of the campaign.

Backers assume risks. Even when projects are fully funded, there is no guarantee that the entrepreneurs will fulfill their promises to backers, or do so on time. Two prominent studies found that at least 70 percent of projects miss their delivery deadlines. In that sense, contributing money to a project is risky, but the promised reward is perceived as sufficient to justify the risk. Kickstarter does not mediate or intervene when funded companies fail to keep their promises.

You might expect that giving hundreds of thousands of dollars to a bunch of startups in exchange for promises of products that haven’t yet been marketed would result in a high occurrence of fraud. The fraud rate appears to be quite low so far, however. Ethan Mollick, assistant professor of management at the Wharton School, University of Pennsylvania, concluded based on 2015 survey of 47,188 randomly selected Kickstarter project backers that 9% of Kickstarter projects fail to deliver promised rewards.

In an earlier study, in 2014, Mollick noted that the low rate of fraud is likely a result of “[t]he interplay between a number of features of Kickstarter – including threshold funding, active participation by large communities, frequent interaction between founders and potential funders, and the ability of founders to broadcast signals of quality through rich descriptions and biographic information … .”

The continuous presence of the crowd and its highly social nature serve as a kind of screen or deterrent against possible abuses. Anyone considering contributing or investing a significant amount of money in a crowdfunding campaign should read The Wisdom of Crowds, by James Surowiecki (2005).

Debt-based Crowdfunding for Investors

Following the 2008-2009 financial crisis, credit dried up measurably for a large portion of small borrowers. Debt-based crowdfunding—also known as peer-to-peer lending or simply P2P—has taken up the slack big-time.

Debt-based crowdfunding emerged as an investment vehicle in 2006 in the USA, and a year earlier in the UK. The debt version of crowdfunding lets individual borrowers apply for unsecured loans (not backed by collateral) and, if accepted by the platform, borrow money from “the crowd,” then pay it back with interest. P2P platforms generate revenue by taking a percentage of the loan amounts (a one-time charge) from the borrower and a loan servicing fee (either a fixed annual fee or a one-time percentage of the loan amount) from investors. The application process is free for borrowers. Investors earn interest on each loan (or package of similar loans), assuming the borrowers make timely payments.

From the borrower’s point of view, getting a P2P loan can be simpler, quicker, and cheaper than borrowing from a bank. It is cheaper (that is, fixed interest rates are generally lower) because most of the P2P platform’s services (application review and verification, credit check, loan disbursement, payment processing, collection, compliance and reporting, etc.) are automated. This results in lower overhead.

Only a small percentage of applications are approved. For example, Lending Club (launched in 2006 in San Francisco), the largest P2P platform in the world in terms of issued loan volume and revenue, had an approval rate 5.8 percent as of December 2014.

Interest rates are high enough to generate strong returns for investors (assuming sufficient diversification of their loan portfolios)—potentially better returns than traditional money markets and bonds, with less volatility than stocks—and a fairly reliable monthly cash flow of interest and principal payments throughout the term of the loan. In August 2018, Lending Club was charging borrowers a rate of 35.89 percent for its riskiest loans, sliding down to 6.16 percent for its least risky ones.

From the investor’s point of view, although the minimum investment can be as low as $25, P2P platforms are more complex than rewards-based platforms because they involve securities regulated by the SEC. Unlike the Kickstarter experience, you’ll need to spend quite a bit of time learning how the P2P system works, what the possible risks and returns are for each particular lending opportunity, and what kinds of secondary markets exist before you commit your money to a single borrower or a package of loans. Note that P2P investors do not have to be accredited.

Each borrower whose application is approved on a P2P platform receives a credit-risk score and interest rate set uniquely by that platform, acting as an intermediary between borrower and investor. Higher risks must yield higher rates to stay attractive, of course. Investors can select individual creditworthy borrowers based on their risk/rate profiles, in addition to other characteristics such as the reason for the loan (debt consolidation, home improvement, major purchase, car finance, healthcare expense, small business expense, vacation, etc.). Alternatively, investors may select a package of dozens, hundreds, or even thousands of loans in the same risk/rate tranche, which allows diversification among many borrowers. In all cases, the risk for investors is that one or more borrowers will default, so that some or all of the investor’s capital may be lost.

As of June 2018, Lending Club alone serviced more than 3.1 million loans for well over $38.6 billion. Lending Club notes issued between January 2008 and December 2016 have resulted in median historical returns to investors of between 4.8 percent for prime consumer notes in the least risky tranches and 7.03 percent in the riskier tranches as of June 2018.

Donation-based Crowdfunding

Large charitable organizations began collecting donations online long before Web-based crowdfunding emerged. But by 2010, new donation-based crowdfunding sites allowed very small organizations and individuals to solicit donations from the crowd. Examples include local organizations set up for disaster relief and emergency fundraising, or for a Little League team’s travel expenses to a championship tournament, or for a high school choir’s trip abroad. This online fundraising strategy is also used by individuals who need to raise money from family and friends (and friends of friends) for “personal causes” such as covering medical and veterinary expenses, paying college tuition, or for “life events” like buying someone a graduation or anniversary gift.

GoFundMe, launched in 2010, is a pioneer in donation-based crowdfunding. As of August 2018, the GoFundMe platform has enabled its “organizers” to raise $5 billion from more than 50 million donors. In the United States, the platform takes a fee of 0 percent of donations on personal campaigns and up to 5 percent of donations on campaigns by charitable organizations. Users also pay a processing fee on each transaction to third-party payment service providers, amounting to at least 2.9 percent plus 30 cents in the USA.

When Anthony Borges was shot during the Marjory Stoneman Douglas school shooting, his family set up a GoFundMe campaign to cover his medical bills and the recovery process. The campaign has raised $931,125 in 14 months, making it one of the top 10 campaigns of 2018.

As of August 2018 Kickstarter accepts projects in the United States, United Kingdom, Canada, Australia, New Zealand, the Netherlands, Denmark, Ireland, Norway, Sweden, Germany, France, Spain, Italy, Austria, Belgium, Switzerland, Luxembourg, Hong Kong, Singapore, Mexico and Japan. GoFundMe accepts projects in the United States, United Kingdom, Canada, Australia, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden and Switzerland. Unlike Kickstarter, GoFundMe lets users embed their donation pages on their own websites and blogs, and still track donations and performance from the GoFundMe dashboard.

[Editors’ Note: You may be interested in the following webinars:

  • Options for the Accredited Investor
  • The JOBS Act, a Retrospective and a Look Ahead 2018.]

Read More

This is one in a series of articles dedicated to the 95% of people in the U.S. who have never invested in a startup, a venture capital fund, a private equity fund, or a hedge fund even though they are permitted to do so and even though doing so may make sense to achieve property diversification. While we encourage you to read this series in order, you certainly don’t need to. Each installment is designed so it can be read as a stand-alone article. Here they are in case you want to skip around:

Who are ‘We’?

Alternative Investment Guide

You will notice that throughout this series, I use the term “we.” This is done to acknowledge the great editorial assistance of the Financial Poise Editorial Team. This series is based on my book The Investor’s Guide to Alternative Assets: The JOBS Act, “Accredited” Investing, and You.

©2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.

About David M. Freedman

Dave Freedman has worked as a journalist since 1978, primarily in the fields of law and finance. He is a co-author of Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, 2015). He currently analyzes turnaround stocks for Dave has also written extensively…

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