February 13, 2014
The following answers are provided by the Young Entrepreneur Council (YEC), an invite-only organization comprised of the world’s most promising young entrepreneurs. In partnership with Citi, YEC recently launched StartupCollective, a free virtual mentorship program that helps millions of entrepreneurs start and grow businesses.
“If everyone is thinking alike, then no one is thinking.” – Benjamin Franklin
Since its emergence, crowdfunding seemed as if it was the panacea for all early stage startups seeking funds. Although it has undoubtedly changed the capital landscape, crowdfunding poses some downsides that entrepreneurs often overlook.
What are these drawbacks that you should be aware of? We solicited the advice of our friends at the YEC to share the nine biggest risks associated with crowdfunding. They are below. Enjoy.
9 Things to Consider Before Crowdfunding
1. Lack of Due Diligence
Amateur investors who contribute their small funds to a startup are unlikely to require significant due diligence. This could result in unprepared companies without a solid business plan — not the kind of company that could ever get institutional funding on a larger scale. So startups going the route of crowdfunding should be sure to spend as much time developing their business plan and setting milestones as they spend creating a splashy marketing video to promote their offering on a crowdfunding platform.
2. Accountability to Investors
The one big risk associated with equity crowdfunding is that the young startup will be accountable to investors from day one. This is much different from traditional investing, where the investor typically doesn’t have as much of a say. The young startup should be fully aware of this added pressure before considering equity crowdfunding.
3. Unclear Boundaries
Strong boundaries make for strong relationships. Crowdfunding is great, but be careful if you have 1,000 small investors. What are their expectations? Do they each want weekly phone calls? Some angel investors may give you $100K and only want to hear from you once a year, while others will give you $1 million and call you once a week. By crowdfunding on the Internet, you often lack control over who becomes your investor. However, to be an entrepreneur you have to be all in, so do whatever you need to do, within reason, to get your business running profitably.
4. Equity Management Nightmare
A big risk of equity crowdfunding is that you now end up not only the founder of your company’s product or service, but also in charge of the management of stock, which is similar to a publicly traded company with shareholders. This includes anything from dissemination of proprietary information to becoming more public in success or failure. Think carefully before you decide on crowdfunding. The SEC hasn’t formalized its opinion on the topic yet and is still changing the rules.
5. Desperate Appearance
Equity crowdfunding is a complex process. Because it’s much simpler for the top startups to get funding from one venture capitalist versus 100-plus small investors, it’s likely that the best companies will continue to pursue traditional funding routes. Thus, startups that choose equity crowdfunding options will often look more desperate or risky by comparison.
6. Value of Investors
The value of equity-based crowdfunding in its current model is only monetary. An experienced angel who is a veteran in your industry can add cash to your account and also offer access to a money-can’t-buy network and years of expertise. But, this is often not the case with the investors who are active on crowdfunding portals. This decreases the value of the capital and also raises questions with future investors who will doubt your previous ability to raise higher value capital.
7. A Doubled Marketing Workload
You effectively have to market your company twice — and to two very different audiences — to raise enough money through crowdfunding. You have to put together a marketing campaign that will convince multiple people to put money into your company, as well as put together a whole separate approach to marketing your actual product or service. It’s not an impossible level of work, but for a startup, it can mean splitting resources among multiple needs, which makes it harder to get off the ground in the first place. Think very carefully before taking on such diverse marketing obligations.
8. Reporting Requirements
Be sure to consider all the reporting and disclosure costs when using equity-based crowdfunding. The most recent draft of SEC regulations require founders to have their financials reviewed or formally audited by a CPA. Additionally, companies are legally required to publicize a detailed business plan, a list of all large shareholders in the company, a description of the financial condition of the company, as well as file an annual report with the SEC.
9. Unrealistic Expectations
Any startup founder who’s raised money from friends and family can attest to this: novice investors often have unrealistic expectations about the business development process. Founders have to be very clear about the timeline, give regular updates and adjust for hiccups along the way to avoid upsetting investors. Frustration from unmet expectations can have an even greater impact on crowdfunded startups due to the sheer volume and also because, unlike acquainted investors, these novice investors won’t give the benefit of the doubt based on a personal relationship.
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