Meet Your New Competition

It’s a typical Silicon Valley story. Four undergraduates dream of creating the next great tech startup. Their idea: a new “privacy-aware, personally controlled” social network that allows users to share data on their own terms.

But what’s not so typical is how these young entrepreneurs chose to fund their dream. Instead of beating down the doors of venture capitalists, these students from New York University turned to a website called Kickstarter, a “crowd funding” platform that allows virtually anyone in the world to invest in a company or idea.

On a lark, these four self-described nerds posted a humorous, high-energy video pitch on Kickstarter introducing their startup, called Diaspora, and explaining why they needed $10,000 to get the project off the ground. “No longer will you be at the whims of these large corporate networks who want to tell you that sharing and privacy are mutually exclusive,” they explain. “Why us? Because we are ready to work full time, 12 hours a day—maybe a little more than that. We turned down sweet internships. We are passionate about this idea.”

$10s and $20s

One week later, they were halfway to their goal, having raised $5,000 from dozens of individuals who liked what they saw. And then something unexpected happened. Facebook announced controversial changes to its privacy policies and suddenly Diaspora, as an open alternative, was thrust into the spotlight, garnering mentions in major newspapers, magazines and blogs. Within a few short weeks, the startup raised a stunning $200,000 from some 6,400 backers, mostly in $10s and $20s.

For VCs and other professional investors who had previously dismissed crowd funding as a gimmick, Diaspora served as a wake-up call. “Diaspora is significant because it changed my mind—and many other minds—about what is doable on one of these crowd funding services,” says Paul Kedrosky, author of popular finance blog Infectious Greed. “I would never have expected those kinds of fund-raising numbers so quickly. But after it happens once, it becomes a virtuous cycle. I think you’ll start seeing more interesting companies showing up on these platforms and raising even larger amounts.”

I really don’t think this is something VCs can afford to sneer at. The crowd has the potential to be a larger funding source than anyone of us ever expected.”

Paul Kedrosky

Crowd funding sites have been around for a few years, helping bloggers pay their rent, filmmakers finance their movies and musicians finance production of records. But now several new platforms, such as Grow VC, Kickstarter and Profounders (not to be confused with London’s PROfounders Capital) are targeting the entrepreneurial community with some variation on the crowd funding model.

Each model has a slightly different twist. Businesses that pitch on Kickstarter have to set a cash goal and a time limit in which to raise money. If they don’t reach their financial goals on time, all pledges are returned. Perhaps most appealing to entrepreneurs is that Kickstarter financing is philanthropic, which means that founders retain 100% ownership of their ventures. Kickstarter makes money by taking a 5% commission on all projects that are successfully funded.

Jackley Joins the Crowd

Profounder, which is set to launch this fall, is a crowd funding platform led by Jessica Jackley, who also started peer-to-peer lending site Kiva.org. Jackley is currently keeping a low profile and did not respond to an interview request. Her website says Profounder will enable entrepreneurs to raise up to $1 million in financing by inviting their friends, family members, colleagues and broader communities to contribute, including those on LinkedIn, Facebook, Twitter and other social networks.

Grow VC, for its part, has been operational since February. It currently has about 3,000 registered members who have committed more than $13 million to some 800 startups looking to raise between $10,000 and $1 million. Grow VC collects a subscription fee ranging from $20 to $140 per month from each of its members. The money is pooled into a fund managed by Grow VC, but members get to select which companies they want to support. Just like a regular VC fund, Grow VC charges a management fee based on the amount of capital raised through its platform. Grow VC will also financially reward its members who back the best companies.

Jouko Ahvenainen, co-founder of Grow VC, believes his company has the potential to disrupt venture capital the way the Internet has upended so many other businesses. “I think [Grow VC] is the first step to something bigger,” he says. “There is a need for early stage funding to be more global and transparent and effective. Internet-based crowd funding is definitely one solution to make the market work better.”

Typically a seed financing round only involves local investors, but now we have access to investors across the globe who can be part of our initiative.

John Roberts

Is It Legal?

But some people remain skeptical of crowd funding. For starters, there is still debate about whether some of crowd funding sites are legal. In the United States, for instance, only accredited investors—those with a net worth of at least $1 million—are allowed to invest in privately held companies. That rule wouldn’t affect Kickstarter, since money contributed on the site is a donation, not an investment. But it could impact a site such as Grow VC, where it’s understood that the monthly fee is invested in startups and could result in a financial reward.

To date, the Securities and Exchange Commission has remained quiet about crowd funding, but that could change fast if new ventures are consistently able to raise serious capital this way. “It’s very possible that all these platforms can end up getting screwed,” says Kedrosky.

Jason Mendelson, a managing director at the Foundry Group, is unconvinced crowd funding will ever become a big trend. As a former securities lawyer, he sees nothing but trouble when non-accredited inventors buy equity in private companies. “Sure, some lawyers will figure out ways to make it legal,” he says. “But if crowds are funding a lot of companies that end up going bankrupt, you can be sure that other lawyers are going to figure out how to sue.”

Still, Mendelson can understand why a startup might want to pursue crowd funding to raise seed money to prove out a concept. But he says if that same company later came to the Foundry Group looking for institutional money, he’d probably have to pass on the deal, no matter how promising the opportunity. “I would have to spend a lot of time figuring out what kind of trouble I’d be in if all these little shareholders came knocking on my door asking for their money back,” he says.

Instant Global Reach

There is a need for early stage funding to be more global and transparent and effective. Internet-based crowd funding is definitely one solution to make the market work better.”

Jouko Ahvenainen

That’s a chance entrepreneurs such as John Roberts are willing to take. He recently set up a profile for his mobile advertising startup, Qustodian, on Grow VC. The London-based company has not yet closed a funding round, but it is receiving interest from investors all over the world, including Asia, Europe and India. “Typically a seed financing round only involves local investors, but now we have access to investors across the globe who can be part of our initiative,” he says.

Eric Cheng, CEO of Hong-Kong-based gaming startup Emagist, agrees. “It’s very hard for startups like ours to raise local money, because investors here are more interested in real estate and things like that,” he says. Emagist used the Grow VC platform to connect with potential investors in Europe and the United States.

Critics of crowd funding point out that there’s nothing to stop a scam artist from slapping a phony business plan on one of these platforms and pocketing the cash. “No system in the world is free of fraud,” admits Grow VC’s Ahvenainen. To combat the threat, Grow VC has implemented several security policies to protect its members. It has a screening process to ensure startups have submitted sufficient information about themselves. It also has a network of certified partners, such as law firms, which help with the closing of financing agreements.

Ahvenainen says he isn’t overly concerned about the legal and ethical issues, mostly because he believes companies funded through his platform have a greater likelihood of success. If enough people are willing to finance a company, it stands to reason that an even larger number would be willing to purchase that company’s products or services once they are available, he notes.

So, should venture capitalists be worried about crowd funding growing gaining in popularity and one day becoming a competitor for the best deals? After all, if a company like Diaspora can raise $200,000 in non-dilutive financing in the blink of an eye, you better believe that other entrepreneurs will try to do the same thing, especially if they can retain full control of their company.

“I really don’t think this is something VCs can afford to sneer at,” says Kedrosky. “The crowd has the potential to be a larger funding source than anyone of us ever expected.”