Small and medium-sized businesses use social networks as an advertising platform. Artists have used it to spread the word about their works or small bakeries have used it to promote their wares. Filmmakers, photographers and social workers, among others, have begun turning to social media to find people willing to fund their next project. Known as crowdfunding, it uses social networks to solicit money, usually small amounts, from people willing to back an artistic or philanthropic project, often for no other reason than fulfilment. Lawmakers in the US have now introduced a bill that would enable startups and other companies to raise money through crowdfunding in exchange for a stake.

Crowdfunding works by raising money in small amounts, often from hundreds of people. It helps entrepreneurs hedge their chances of raising money by focusing on smaller amounts from a large number of investors rather than one big amount from a single investor. Given that most of the success stories on crowdfunding websites come from product and B2C (business to consumer) firms, it offers accurate, real-time feedback on the idea from people who will eventually be the target customers. This is more reliable than the pronouncements of a single investor. Crowdfunding websites have rules to ensure that only those products that have met their fund-raising targets get the money that was pledged. In case the target is not met, the money is returned.

When Casey Hopkins of Elevation Labs, an industrial and mechanical engineering product design firm based in US, decided the plastic dock made by Apple for their iPhones and iPods was in sore need of a design overhaul, he realised the money needed for design and development would require external funding. He turned to Kickstarter, a crowdfunding website that focuses on connecting firms like Elevation Labs with people interested in funding them. Hopkins shot a video, and together with a project description, uploaded it onto the site. With a target of about $75,000, he hoped a large number of netizens would open their wallets and contribute small amounts. Contributions above a certain threshold would get the investors the Elevation Dock at discounted prices. Higher amounts invested meant steeper discounts. The results far exceeded his expectations. With nine days still left, the Elevation Dock project posted by Casey Hopkins has gone viral, generating about $763,000 and counting, more than ten times the original amount. Kickstarter, the website that hosted Hopkins’ project, gets 5% of the amount pledged by users.

Crowdfunding, though a very recent phenomenon, has grown rapidly on the back of similar success stories. Apart from Kickstarter, a site that is chiefly for non-philanthropic projects, websites such as Kiva or IndieGoGo cater to other niche areas such as social enterprise or philanthropy. Users can pledge anywhere between one to thousands of dollars for a project of their choosing. Crowdfunding websites release the amount pledged only when the funding threshold set by the project owner is reached, taking a flat fee (5-10%) of the amount committed. While venture capitalists or angel investors invest for strategic and long-term reasons, investors on websites such as Kickstarter do so for a variety of reasons. Some are looking for instant gratification or even better deals (often in the form of large discounts on future products). This model of funding thus works best for product-based companies who have some tangible output to show for their efforts.

Kickstarter requires each participating company to have a promotional video that showcases the product. Slick production values are still no substitute for an investor who does a thorough evaluation of a company — the core team, the management, the marketing strategy that are all essential for not only building great products but great companies that deliver sensational products. A long-term investor also invests in the people who run the company. A VC or angel investor brings not only advice and contacts but also mentorship and greater professionalism, traits that are invaluable to entrepreneurs for their continued success.

The traditional model of investing demands that investors be given a stake in the company for their money. This, according to the rules of most countries such as the USA and India, constitutes a securities transaction, which would require that crowdfunding websites such as Kickstarter register themselves as brokerage houses. Most websites have thus restricted companies to offering only finished versions of their products in exchange for money. Lawmakers in the US have taken note of the rising popularity of crowdfunding among the general population and introduced a bill that would make them legitimate, given certain limitations and restrictions, the offering of stakes in companies in exchange for investments. While it gives a fillip to the crowdfunding industry, it also opens up a significant debate about the push and pull that a large number of investors will exert on a startup in its early stages.

While it is still very early for crowdfunding in India, most efforts have been made in philanthropy. Milaap, a crowdfunding website, connects donors with people in need of funds to start their own small businesses. There is an increasing amount of talk from different quarters about the need to bring legislation that allows common people to invest in startups for a stake. Any such legislation, should it be introduced, should be fortified with appropriate legal measures to prevent instances of fraud.

While crowdfunding is posited as the next big thing, one must take any sweeping pronouncement with a pinch of salt. While immediate feedback on a product is one of its biggest advantages, entrepreneurs relying on this method alone will lose out on other, more significant sou­rces of advice, such as from venture capitalists. The idea behind entrepreneurship, after all, is not only to put out great products, but set up great companies.

(The writer is an engineer and is involved in developing technologies such as speech recognition and text-to-speech systems for Indian languages)