Social networking started as a 20-something fad, yet it's matured into a force that may revolutionize business, politics and society at large. Will financial systems follow suit? According to a recent article in the Wall Street Journal, they already have.
Entrepreneurs are increasingly tapping social networks to raise capital, and several companies have built frameworks that allow individuals to solicit investments from the community at large. "Crowdfunding" Web sites such as ProFounder.com, Peerbackers.com, Kickstarter.com andIndieGoGo.com* provide services to individuals who want to raise small capital investments that traditional financial institutions typically decline to support.
Through these sites, entrepreneurs create a profile listing their monetary goals, an explanation of funds allocations and an end-date for the campaign. Investors can pledge contributions online. The capital raised is usually less than $10,000, and the return for the investor ranges from token compensation (such as coupons or invitations to events) to revenue sharing in the invested company. The host site typically collects a small percentage of the funds raised.
Some crowdfunding sites are taking the concept to the next level, focusing on larger investments structured around revenue sharing. Businesses set aside a percentage of their revenues to pay out to investors over time. According to Profounder.com, revenue sharing carries less risk for entrepreneurs than debt with a fixed interest rate because pay-out amounts are proportionate to the success of the business in any given year.
The system is not foolproof – investments made via this medium are subject to many variables that are often controlled in traditional lending programs. For example, crowdfunding sites may conduct preliminary checks to ensure businesses are legitimate, but they cannot be held responsible if they are not. In addition, the sites usually don't enforce allocation of the funds or ensure that supporters receive their promised gifts.
Finally, success isn't guaranteed. Some sites, such as Peerbackers.com, try to mitigate failed investments by requiring entrepreneurs to return all funds if they don't reach at least 80 percent of the defined goal. In contrast, IndieGoGo.com releases funds regardless of whether the goal is met.
According to Russ Yelton, president and CEO of the Northern Arizona Center for Emerging Technologies in Flagstaff, Ariz., people in the incubation industry are cautiously optimistic about crowdfunding as a possible alternative to angel or venture funding, but he cautions that investors still need to practice due diligence. "The same danger of failure exists; the difference is simply the source of funding," he says.
As with all innovation, the system is changing quickly and may have the potential to change the way we do business – or not. It all depends on what level of success entrepreneurs can build using this framework.
This is part of a longer article that originally appeared in the Feb. 8, 2011, edition of Memberabilia, a biweekly e-newsletter exclusive to members of NBIA. Members received more information about how incubator clients are using crowdfunding. To learn more about becoming an NBIA member, click here.