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Crowdfunding may soon be a reality in the United States, giving entrepreneurs and would-be mom-and-pop startup investors reason for celebration.

And make no mistake about it: crowdfunding could be one of the most significant changes to hit the startup world in a long time, providing entrepreneurs with a much larger market in which to raise capital for their companies.

As Tim Rowe, CEO of Cambridge Innovation Center, sees it, crowdfunding will "turn the start-up world upside down."

"This is Kickstarter on jet fuel," he writes.

But if and when the ink dries on crowdfunding legislation that is awaiting approval in the U.S. Senate, entrepreneurs will have to grapple with the reality that while crowdfunding gives them a potentially powerful new way to raise funds, it isn't a perfect funding solution.

Here are four things in particular that entrepreneurs should consider before turning to crowdfunding if and when it becomes an option for them.

Crowdfunding could make raising future investment more difficult.

By raising money from relatively large numbers of individual investors, startups may foreclose on the possibility of raising subsequent rounds of funding from professional investors if they are successful and need to raise larger sums of money.

For starters, investors looking for a clean cap table aren't going to give the time of day to a company with potentially hundreds or thousands of small shareholders. More importantly, the share structure of a crowdfunded startup is unlikely to be compatible with the type of share structure professional investors usually impose in their terms.

That means one thing for crowdfunded entrepreneurs: the money raised through crowdfunding may be the only money you raise.

Minority shareholders have rights.

Shareholders -- even the smallest of minority shareholders -- have rights. That means it typically isn't wise to blow off a shareholder (even an annoying one). Respect is required, particularly when shareholders have legitimate questions about finances and corporate governance matters.

Founders who go the crowdfunding route and which do not understand the rights minority shareholders have could find themselves in very bad situations.

Crowdfunded startups may be lawsuit targets.

Even with all of the requirements crowdfunded startups and intermediaries will have to adhere to, crowdfunded startups may find themselves targets of shareholder lawsuits. A single small shareholder, or handful of small shareholders, could easily become a thorn in a company's side, whether or not their claims are legitimate.

The companies most likely to be at risk are those run by inexperienced or careless entrepreneurs who don't understand their fiduciary duties or corporate formalities.

There's no such thing as a free lunch.

Crowdfunding will almost certainly help many startups raise money, but nobody should assume that the money will be free. From legal and compliance costs to fees intermediaries charge, entrepreneurs with $0 in the bank will probably find that raising cash from crowdfunding isn't a walk in the park.

None of the above means that there isn't a place for crowdfunding, or that startups won't succeed in using crowdfunding to raise money. There is a place for crowdfunding, and giving individuals more freedom in raising and investing capital is a very good thing.

But when it comes to what we can really expect from crowdfunding, there is a lot of uncertainty. Experienced, sophisticated entrepreneurs are far more likely to understand the potential pitfalls and headaches of crowdfunding, likely making them less likely to turn to it when seeking capital. That in turn could leave investors with lower-quality startups and small businesses with limited upside potential to invest in.

If that proves to be the way things pan out, it's quite possible that crowdfunding will turn the startup world upside down without anybody really noticing.

Patricio Robles

Published 16 March, 2012 by Patricio Robles

Patricio Robles is a tech reporter at Econsultancy. Follow him on Twitter.

2429 more posts from this author

Comments (5)

Steffan Aquarone

Steffan Aquarone, Owner at Droplet Online Ltd.Small Business Multi-user

It's fantastic that technologies like Kickstarter exist to make an age-old way of getting things done easier and more global.

The key benefit has got to be that you can use technology to access global niches that would be almost impossible to reach without the web.

We funded and made Tortoise in Love (www.tortoiseinlove.com) by getting a whole village to help. We didn't realise at the time that this was crowd-funding, but it was a big crowd, and tremendous fun. (32″25′ at http://www.youtube.com/watch?v=SqhpzXYO_D4 for more on the story of Tortoise in Love - the Village that made the film).

The migration of these approaches into technology funding is welcome news. If you're considering it, why not go one step further and specifically target your potential customers. "Customer funding" might well be the way to save yourself a sales headache when you've developed a kick-ass product and then have to think about route to market.

over 4 years ago

Patricio Robles

Patricio Robles, Tech Reporter at Econsultancy

Steffan,

You make some great points that apply to crowdfunding in general, but just to clarify: the issues in my post above apply specifically to entrepreneurs who will want to consider selling equity in their companies to the public under legislation that may pass in the United States in the near future.

With services like Kickstarter, securities are not being sold and thus the legal and other ramifications of funding a project are much different (and less significant).

over 4 years ago

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Dina Akhmetzhanova

What I don't understand is what is the difference between the traditional investment banks like Goldman Sachs and new platforms like Funding circle or Slim Cats. Essentially they do the same thing trying to raise money from individuals to invest into selected businesses or funds in the hope that that will add value to the said business or fund (pool of businesses) and give a healthy return for everyone involved. The only difference I see is in how it is done. Established financial organisations use combination of communication channels (offline, online and personal selling) means of attracting potential investors the new breed of crowdsourcing finance use mostly online channel. There also seems to be more transparency and user control with crowdsourcing platforms. What I don't get how cheaply (compare to the banks) the crowdsourcing platforms mange to do it. Is it even profitable? Does anyone know? Usually if you buy into some investment portfolio with a high street bank you would end up paying up to 5% of your investment on management fees and admin costs. Investment bank would take even bigger cut up to 10-15% and they would expect at least 5 digit investment sum. How do these new guys manage to keep their costs down? Are they too good to be truth? And why are the banks not copying them? Are they so stupid?

over 4 years ago

Ashley Friedlein

Ashley Friedlein, Founder, Econsultancy & President, Centaur Marketing at Econsultancy, Centaur MarketingStaff

I think crowdfunding is a great idea, made possibly largely by the internet. However, the points you raise are absolutely valid. In my experience, the fewer shareholders you (can) have the better and the easier it is to get future funding.

over 4 years ago

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Kevin Evans

@Steffan, customer-funding is a very interesting concept. Hotel Chocolat issued 'chocolate bonds' to their customers I think back in 2010. http://www.retailinsider.com/2012/03/innovative-retailers-hotel-chocolat.html

Obviously if you are a start-up then part of your funds are probably for customer aquisition, so raising customer-finance could be tricky, but I do think it's viable for businesses with existing customer bases.

over 4 years ago

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