Crowdfunding Rules: 3 Keys for Kick-Starting a Business with Web Money

Once the domain of artists and philanthropists, crowdfunding -- in which several investors put up cash for a project or business idea posted to the Web -- has become a major source of capital for start-up entrepreneurs.

According to data compiled by Crowdsourcing.org, Massolution, and more than 130 crowdfunding platforms, or CFPs, the industry is on track to raise more than $2.8 billion this year alone, up 91% from 2011 and more than triple 2010's total.

President Obama deserves at least some credit for crowdfunding's rise. Earlier this year, he signed the JOBS Act into law and in the process gave entrepreneurs the ability to raise as much as $2 million in seed capital without jumping through a bunch of oversight hoops, providing the business in question provides financial statements.

But even without said statements, it's possible under the law to raise $1 million from investors who can pitch in as much as 10% of their income, up to $10,000 each. Fewer restrictions makes obtaining capital easier, which is the point.

An Imperfect Model

Yet easy money has its drawbacks. Critics of the crowdfunding model say that cheap access to capital could create a legal and PR nightmare.

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In a recent blog post, Nick Petri of OpenView Venture Partners argues that lawsuits are all but inevitable: "If you're taking on 1,000 investors who you've never met, you're practically inviting one to sue you. Public companies don't spend millions in legal fees on their IPO for fun -- it's to bullet-proof their financials and offering docs against litigation if the investment sours."

Over at Forbes, attorneys Bryan Sullivan and Stephen Ma argue that crowdfunding is designed to appeal to "a less sophisticated investor who will invest in any project they think will be the next Facebook." Cynical? Undoubtedly, but this same view is shared by several of my colleagues, as well as the Secretary of the Commonwealth of Massachusetts.

Finally, at TechCrunch, JOBS Act contributors Jason Best and Sherwood Neiss argue that appealing to a large base of equity owners can become an investor relations nightmare for the unprepared entrepreneur.

"Could you imagine adding an extra 10 hours a week of email management to your schedule? For crowdfunded companies that do not plan and execute properly, this can become their new reality," they write.

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Order in the Court... At Least So Far

For now, complaints and lawsuits have proven scarce. But that could change quickly when (not if) a high-profile crowdfunded start-up goes bust. Under the JOBS Act, investors may sue for a refund should there be evidence of a material misstatement or omission in prepared materials.

Think about the potential lawsuits. Public market investors are almost never made whole, even in cases of outright fraud, and still there are active class action suits against Citizens Republic Bancorp (CRBC) and Facebook (FB), among others. Crowdfunded failures could bring exactly the sort of windfall in attorneys' fees that Petri envisions.

3 Pieces of Advice From a Veteran

So is crowdfunding for you, the entrepreneur? Salt Lake City start-up Xi3 took its shot and failed, but not before receiving commitments for $90,000 of the $250,000 it was seeking for producing a new line of grapefruit-sized gaming computers built as modules for easy upgrading.

Source: Xi3.

"Future introductions of I/O Boards that feature new components [and] connectors are expected to allow Xi3 Modular Computers to enjoy useful lives of 6-10 years instead of the standard 3-5 years of traditional PCs," the company said in its now-ended Kickstarter pitch.

Xi3 wasn't looking to trade equity for cash so much as goodies and high-end systems, but its try at financing a signature product via Kickstarter offers lessons for those thinking of taking advantage of the new rules put in place by the JOBS Act. CEO Jason Sullivan offered three pieces of advice in a recent interview.

1. Experiment! Sullivan says to think of crowdfunding as cheap research. In the case of Xi3's Modular Computer, the company promised early access to the machine, among other perks, in order to gauge interest.

"It's like a test market, only better. That's because the backers don't tell you they would buy -- they actually do buy through their pledge [or] backing," Sullivan says. "This means they have confirmed interest in your product, at a set price, along with your market assumptions ... all at the same time."

2. Spread your bets. Sullivan says one of his regrets is not looking beyond Kickstarter when deciding to launch the Modular Computer via a crowdfunded campaign. Indiegogo.com rates as a popular second choice, one Sullivan says might have brought benefits to Xi3 because it lacks the screening that can lead to delays in working with Kickstarter. (Two weeks in Xi3's case.)

Sullivan says, "According to Crowdfunding.org there are nearly 500 active crowdfunding services today. Is it possible that one platform will be better for a specific campaign than another? Even if the number of monthly visitors is lower -- even significantly lower -- than another platform? Perhaps so."

3. Get comfortable with discomfort. Sullivan calls crowdfunding "social creation," in that entrepreneurs and creators offer ideas, get feedback, and adjust, all before the product is delivered. Handling the inevitable back-and-forth with clients (provisional ones, at that) can be challenging.

"Crowdfunding is not for the faint of heart because it is very live and very real. So if your project is not put together well, the community will rightfully call you on it," Sullivan says.

And what of the money? How much should you try for? How many investors? Sullivan doesn't say, and maybe that's the point. Regulators may see crowdfunding as a way to diversify or increase access to capital, but for entrepreneurs like Sullivan, it's just another way to build a market.

What do you think of crowdfunding? Should investors to be turning to platforms such as Kickstarter to bet on new ideas? Make your voice heard by leaving a comment in the space below.

Motley Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. The Motley Fool owns shares of Facebook and has bought calls on Facebook. Motley Fool newsletter services have recommended buying shares of Facebook.