Crowdfunding: Herd dynamics

The $2 billion acquisition of virtual reality headset start-up Oculus Rift by Facebook in March was not noteworthy just because of its size - it was nearly double what Facebook paid for social network Instagram - but because of the target's humble beginnings as a KickStarter project. Less than two years prior the deal, Oculus had launched a campaign on crowdfunding platform KickStarter to raise $250,000 in donations from fans and developers who liked the project.

In order to attract contributions, the start-up announced that backers who pledged $300 or more would receive a developer kit version of the Oculus Rift, while those committing in excess of $275 would receive one of 100 unassembled prototype kits that would ship a month earlier. The response beat all expectations, with the business raising more than $2.5 million from 10,000 backers. A total of 7,500 kits eventually had to be shipped.

Oculus Rift is not the only success story. Other examples include US smart watch maker Pebble, which raised over $10 million on Kickstarter before receiving a $15 million Series A round of funding from Charles River Ventures in March last year; and Android-based gaming console Ouya, which closed a $15 million Series A round led by Kleiner Perkins around the same time, having previously raised $8.5 million from crowd backers.

The opportunities presented by crowdfunding are compelling and inevitably the concept is catching on in Asia, with platforms set up in several countries. The phenomenon is still very much at a nascent stage - the region yet to see its own version of Oculus - but already early entrants are starting to make their mark, and the VC community is paying close attention.

"It increases the range of choices available to people," says Hugh Mason, co-founder of Singapore-based start-up accelerator JFDI.Asia. "And we are seeing more people start to think of crowdfunding as an alternative to professional investors."

Tapping the crowd

By far the most prolific model for crowdfunding - established by the likes of Kickstarter and Indigogo in the US - is a rewards-based system.

The premise is simple: projects, campaigns and small businesses in need of capital advertise their proposals on the platforms and individuals who like the idea, and want to see it come to fruition, can make a small contribution. In return, investors get the satisfaction of having supported the project or business and in some cases they may also receive a small reward, the size of which depends on their contribution. As in the case of Oculus, it may come in a form of a prototype, a discount on a finished product or other some kind of merchandise, such as t-shirt.

The first obvious benefit of crowdfunding is that it offers a source of capital to start-ups and projects at the earliest stage of development that would otherwise be unable to access funding. Meanwhile, there is the added benefit that they do not have to give up equity in the company. But the benefits go beyond that.

"It really is leading to the democratization of venture capital, which has always been the preserve of the very wealthy and well-connected," says Tim Heasley, a partner with Australia-based Artesian Capital Management and director of affiliated equity-based crowd platform VentureCrowd. "I think that is a good thing."

Another advantage is that if the company is funded, it already has a customer base in the form of its earliest backers - hence start-ups are potentially able to gain traction quicker once their product is launched. And then for later-stage investors, crowdfunding platforms can provide a source of potential targets that have already demonstrated some success.

Typically, such platforms exist as stand-alone entities intended to help projects find backers while generating revenue for the operator through a share of the capital raised. However, corporates are also starting to see the benefit of crowdfunding as a means of accessing innovation and adding to their own ecosystems. This was Singapore telecom company StarHub's motivation for launching Crowdtivate, which is co-managed by independent platform Crowdonomic Media.

"It is an extension of open innovation; it is basically a way for a company to build a bridge to innovation and invention from the external environment," says Leo Shimada, co-founder and managing director at Crowdonomic. "Start-ups also appreciate corporate involvement just because of the difference in mentoring ecosystem a large corporation can bring."

Quality control

The reward model, while it has clear advantages, has also thrown up several issues. Firstly, there is the fact that many platforms do not always thoroughly vet which projects get to apply for funding, which heightens the risk of projects failing to deliver on the rewards promised to backers or just failing to get off the ground. On the other hand, anyone can invest, so projects do not always get backed based on merit. Funded projects can often be irreverent or whimsical in nature; a classic example would be the man who recently raised $10,000 on Kickstarter to make a potato salad.

"The great thing about it is you get a lot of energy, enthusiasm and feedback from the public," says JFDI's Mason. "But the difficulty is that many first-time entrepreneurs - particularly in hardware - can be victims of their own success once they get a lot of interest, as they often have no experience in scaling-up whatsoever."

To certain extent, corporate-backed platforms might be able to iron out some of these issues. For its part, Crowdtivate is not a completely open platform; start-ups are approved before they go online. Meanwhile, those companies that are successful have the benefit of support from StarHub's own network.

"The difference with us is that we are an operator-backed platform, so we have the potential to support projects further and put them through an acceleration process," says Stephen Lee, head of innovation, investment and incubation at StarHub. "We wanted to do this is primarily because we found that Asian crowdfunding is still at its infancy stage. We wanted to see how a telecom company like ourselves could drive the ecosystem."

But perhaps the biggest issue with the reward-based model is when a business is unexpectedly successful and goes on to raise a large funding round or is the subject of an acquisition. For example, had early backers of Oculus Rift asked for equity instead of a reward, they would have potentially earned a very handsome return on their original investment.

"It is interesting because it is effectively the donation-based funding rubbing up against traditional venture capital," says VentureCrowd's Heasley. "We would say equity-based crowdfunding fixes that problem, but from the start-up's point of view a rewards-based platform is still the cheapest form of funding. All you need to do is ship a prototype or sometimes even less."

He adds that while there will always be reward-based platforms in the ecosystem, as investors see more founders making lucrative exits further down the road, they are inevitably going to become more demanding.

Gray areas

The US has already seen a number of platforms emerge that allow for investors who insist on getting equity. They include the likes of AngelList, Fundable and Early Shares. However, in most cases these platforms are not open to all and are currently limited to accredited investors, broadly defined as any individual with over $1 million in assets or an annual income in excess of $200,000.

The growth of crowdfunding platforms in the US has been made possible by the Jumpstart Our Business Startups (JOBS) Act, a piece of legislation intended to encourage the funding of small business in the US by easing various securities regulations. Among the provisions of the act is an exemption under the securities law allowing equity stakes to be sold through a crowdfunding structure.

A start-up can raise a maximum of $1 million through crowdfunding offerings in a 12-month period. Investors, meanwhile, are permitted to invest up to $2,000 or 5% percent of their annual income or net worth, whichever is greater. Asia has inevitably started to follow suit with a number of similar equity-based platforms being set up.

However, in the absence of clear regulations covering crowd-sourced equity funding (CSEF), most platforms have only come into existence by taking advantage of legislative loopholes or avoiding potential issues by targeting investors over a certain net-worth threshold and capping the amount that can be raised.

China has no special exemptions but existing rules state that offerings made to less than 200 accredited investors do not need to fulfill public equity requirements. Accordingly, a handful of platforms have emerged, including Beijing-based AngelCrunch - set up in 2012 - and the more recently established Fundator in Shanghai. The latter has taken the unique approach of offering both reward-based funding and a soon-to-be-launched equity-based funding.

But the future of these funds will likely depend on what the regulators do next. As of May, the China Securities Regulatory Commission (CRSC) said it was still considering the adoption of CSEF regulations, adding that it was in the process of developing a framework. It is not the only developing country where authorities are playing catch-up. India is going through a similar process, with the Securities and Exchange Board of India (SEBI) issuing a consultation paper on crowdfunding in June. Existing domestic rules mean the country is restricted to rewards-based platforms only.

"When we set out on this journey a year-and-a-half ago, there were only one or two jurisdictions talking about equity-based crowdfunding," says Crowdonomic's Shimada. "As of today, every major market is now taking various steps towards introducing equity-based crowdfunding."

For its part, Crowdonimics is poised to move into equity-based funding in Singapore once the rules are clearer. In the meantime it is working with the Monetary Authority of Singapore (MAS) as it looks to bring reforms that cater to crowdfunding.

Asia's developed economies have arguably made the most progress, and New Zealand perhaps more so than others. It became the first country in the region to enact CSEF legislation in the form of the Financial Markets Conduit Act, which was enacted in April and allows start-ups to raise up to NZ$2 million ($1.6 million)a year from 20 retail investors. Japan has also made bold step. In May, regulators altered the definition of financial instruments business operators (FIBO) to include equity crowd-funding platforms, and start-ups can now raise up to JPY100 million ($1 million) with a JPY50,000 cap per investor.

However, not all developed economies have the progress as well as some in the industry would like. "Australia is still behind the rest of the world whereas New Zealand, Canada, the US and the UK have all implemented changes to equity-based crowd funding," says VentureCrowd's Heasley.

He explains that Australian start-ups can currently raise up to A$20 million through platforms like VentureCrowd but only from a pool of up to 20 wholesale investors - defined as those with net assets of more than A$2.5 million. Heasley would like to see the regulations relaxed to allow for smaller investments from a broader public, noting there are only 207,000 wholesale investors in the country and most Australians are excluded.

Recommendations to allow for smaller retail investor participation were included in a report by the Corporation and Market Advisory Committee (CAMAC) in September but progress has stalled since the committee was disbanded earlier this year.

Regardless of regulatory ambiguity across the whole region many companies are still trying to establish platforms in the region. "As with any area of business you will have a lot of people who go rushing in without realizing the complexities involved," says JFDI's Mason. "One of the issues is it's a lot harder think people think to find decent projects."

Accordingly, Mason expects many early movers to fail - not unlike the first wave of start-up accelerators in Asia. "Some fail to realize this isn't a tech business," he adds. "Though it is a done through the internet, it is still a financial services product and people have expectations. You only have to get burnt once, because trust is the true currency of a crowdfunding platform, not the technology or the transactions."

Positive vibes

However, there is still a general bullishness about the long-term prospects of crowdfunding in Asia, despite slow progress in countries like China, India and Australia. The expectation is that regulatory wrinkles will be ironed out, more capital will come into the market and the supply of start-ups will grow to meet investor demand. As a result, valuations should come down.

Heasley adds that more investors are likely to want to use crowdfunding platforms for the efficiency and transparency they offer. He points out that in traditional early-stage investing angel backers rarely have insight into what discussions start-ups are having with other investors. "With crowdfunding, all these conversations are happening online so everyone has line of sight with regards to due diligence," he says. "Also, since you are looking at multiple opportunities at the same time, it is easier for an angel investor take more of a portfolio approach instead of making one bet at a time."

In the future, though, crowdfunding may not be limited to very early-stage investment. Artesian is currently in the process of leading a A$7 million Series A round of funding for an undisclosed target. VentureCrowd will contribute A$1 million to the round. It is predicted that in time 20-30% of these institutional rounds will be fulfilled through crowdfunding platforms.

Crowdonomics' Shimada is equally upbeat. "Because so many people are involved in the process the appeal is that you are dissipating the risk," he explains. "Although the industry is young we are seeing some encouraging signs. The business survival rates among crowdfunded start-ups are close to 80%, which is much higher than for traditional VC-backed start-ups because so many people are involved in the process, which means more high-quality businesses are being funded."

On this basis, with increasing amounts of capital raised from larger groups of small investors, companies like Oculus Rift could become the norm rather than the exception - in Asia and other markets.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Fundraising
• Venture
• Greater China
• Australasia
• Southeast Asia
• South Asia
• North Asia
• Early-stage
• Asia
• Crowdfunding
• Fundraising
• Venture
• JFDI.Asia