With the sour taste that venture capitalists and investment bankers have left in the mouth of many aspiring entrepreneurs, it's no surprise a new way of investors directly funding businesses is taking off...and every investor should know about it, writes Doug Hornig of Casey Research.

Back in the 1960s, a clever but financially disadvantaged fellow placed a small ad in a national magazine that read something like: "Money needed. Please send $1 to the address below. Do it today!"

No specific need was given, and nothing was promised in return, so that fraud could not later be charged. Yet within a few months, thousands of dollars arrived in his mailbox, a considerable sum in those days. Or so the urban legend goes.

P2P Money
A half-century later, many things have changed, but one thing remains unchanged: People still need money, and they have not ceased to innovate ways in which to get it.

We have written extensively in this space about many of the P2P Internet connections that are transforming the planet... in commerce, in education, in the job market, and with business and social networking. The list of possibilities is truly endless.

For yet another example, the world of money has been given a Red Bull jolt by a fast-growing phenomenon known as "crowdfunding."

Previously, if you had a grand scheme for a new product or service and you needed seed money to get your project off the ground, you had to save it yourself, borrow from friends and relatives, or go with begging bowl to your local bank, which was unlikely to see you as the next Steve Jobs. If it was a big enough idea, you might even attract the attention of a venture capital (VC) company, but there you had to be prepared to offer many pounds of flesh in return.

And still, those ideas that didn't meet with bank criteria (there's no collateral for a software startup), yet weren't large enough for the VC crowd often fell into a no man's land, scraping out some funding from unorganized, so-called "angel" investors, or never getting funded at all.

More recently, we've seen the rise of for-profit Internet alternatives to traditional lending, such as Prosper, Zopa, and the market leader, LendingClub. These P2P companies specialize in small loans—LendingClub's limit is $35,000.

They don't originate loans—they facilitate them, cutting out the banks and creating a situation that allows individuals with spare cash directly to invest in other people's dreams, while the dreamers can borrow based on the public responses to their particular (hopefully compelling) stories. For each loan, there is a multitude of lenders, not just one.

It's a win-win proposition. Borrowers receive below-market rates with less hassle than is usually encountered at a traditional financial institution. Investors get an excellent rate of return, and can attenuate risk by building a portfolio spread across multiple loans. And LendingClub prospers by taking a cut.

The site claims a very low default rate of less than 3% since its inception in 2007, and it has been a monster success. To date, LendingClub has negotiated nearly $1 billion in loans, a meteoric ascent from about $175 million just two years ago.

Other, more philanthropically oriented organizations either are or function a little more like nonprofits. They solicit donations in order to make very small micro-loans to budding entrepreneurs, primarily in the developing world. Donors either simply get their money back, or the principal plus a small amount of interest.

Those that work this way include Kiva, Zidisha, Fundable, PayPal's MicroPlace, GlobalGiving, FirstGiving, CreateaFund, Calvert Foundation's Community Impact Investing, and the Grameen Foundation, which received tremendous worldwide publicity when its partner organization Grameen Bank shared the Nobel Peace Prize with founder Muhammad Yunus in 2006.

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At the other extreme—if you're an upscale investor looking outside of the traditional markets for greater risk-reward potential—there are alternatives for you as well, in the form of secondary markets. Sites such as SharesPost and SecondMarket provide access to participation in private placements and the purchase of already existing, pre-IPO shares in privately held companies.

These opportunities are generally only open to accredited investors, i.e., those who can verify that they are high-net-worth individuals and attest that they're comfortable with assuming a high degree of risk.

No quite so well-heeled? You can still play the game. MicroVentures was the first Internet broker-dealer to help startups in the US raise capital in exchange for equity. Companies can apply for up to $500,000, and individuals can buy in with an investment as low as $1,000.

There's also MediaShares, which offers companies the opportunity to crowdfund IPOs, and investors the chance to buy as little as a single share of stock. The stock can be sold online, with or without an underwriter.

A new US law (HR1070) has been passed by Congress that will allow for advertising the sale of stock to the general public and selling to non-accredited investors. This is expected to greatly expand these types of online offerings. Crowdcube, Grow VC, and Symbid also finance business startups. SeedUps specializes in tech.

Clearly there are a lot of new and imaginative ways of moving money around that vie for our attention. Many of them would be considered crowdfunding (derived from the general term "crowdsourcing," which has traditionally referred to works like Wikipedia driven by large numbers of amateur contributors), since the definition of this term still tends to be on the loose side. It can be applied very widely, as Wikipedia does, calling it any "collective effort of individuals who network and pool their resources, usually via the Internet, to support efforts initiated by other people or organizations."

Crowdfunding, if thought of merely as the pooling of resources for a common cause, is as old as human groupings. Neighbors pitching in to help someone who's had a house fire, supporting the local rescue squad, sending truckloads of canned goods to disaster areas—all of these cooperative efforts represent crowdfunding of a sort.

But that isn't the way it's thought of nowadays. In fact, the very term "crowdfunding" is just six years old, with Word Spy attributing its first official appearance in print to blogger Michael Sullivan on his fundavlog of August 12, 2006. And the first book on the subject—Kevin Lawton and Dan Marom's The Crowdfunding Revolution—wasn't published until October 2010.

In contemporary usage, "crowdfunding" is generally defined as an ongoing money-raising effort organized through the Internet. As such, it is intimately related to and initiated by online communities and social networks.

However, while a given crowd might pre-exist as a community, it can also arise completely spontaneously, from disparate groups around the world which happen to share an interest in funding a person, project, or whatever. And it can be brought together by a Web site whose purpose is just that. These are the characteristics that distinguish crowdfunding from traditional co-ops.

Kick It into Gear
Then there is the current king of the hill, Kickstarter. Launched in April 2009, the site has been a massive success.

At the moment, Kickstarter says that over $350 million has been pledged by more than 2.5 million people, successfully funding more than 31,000 creative projects "in the worlds of Art, Comics, Dance, Design, Fashion, Film, Food, Games, Music, Photography, Publishing, Technology, and Theater."

The bulk of Kickstarter-funded projects, 68%, were in the $1,000 to $10,000 range. But 300 raised between $100,000 and $1 million, and 13 raised in excess of $1 million. Of those that are posted, about 45% fully meet their goals, and about 12% end without having received any pledges. 82% of those that reach 20% of their goal go on to attain full funding.

Kickstarter is an "all or nothing" proposition. Project creators make their pitch, set a funding goal, and a deadline by which the full amount must be raised. If they succeed, donors' credit cards are charged at that time; if they don't make it, no one is charged anything.

Kickstarter takes a 5% cut of successful fundraisers, and payment processing fees can claim another 3% to 5%. Outside of that, creators keep 100% of the money and retain all rights to their projects.

Backers receive no equity or financial payback, but are promised "rewards," depending on one's pledge level. Mostly, people participate in good faith, contributing to something they believe in. Kickstarter's "Terms of Use require creators to fulfill all rewards of their project or refund any backer whose reward they do not or cannot fulfill." But there are no legal guarantees.

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If a Kickstarter project really tickles people's fancies, the results can be stunning. For instance, a modest project currently listed on its start page began with a goal of $5,000, and with the deadline still two weeks away, has pulled in almost $110,000.

Where To from Here?
So, is crowdfunding the future capital source for every new venture under the sun? Well, probably not...although we can't say for sure, because it does sometimes seem that way. In no particular order, some current and projected applications include:

  • Journalism—With Spot.us and Global for me, the public provides suggestions and tips for stories. When a journalist accepts a suggestion, he creates a pitch, which is then funded by those who are interested. Whether this will gain any traction with readers accustomed to free Internet news content remains to be seen.
  • Politics—Democratic candidates can benefit from ActBlue, a crowdsourced fundraising site that allows anyone to be part of a PAC. Since 2004, ActBlue has raised over $300 million. Across the aisle, Ron Paul ran his campaign for the presidential nomination largely through crowdfunding.
  • Public projects—Want those bike lanes but your town is out of money? You can turn to CivicSponsor.
  • Fashion—Milk and Honey Shoes allows customers to design their own shoes. Several other sites that will let consumers participate in designing new fashions are currently under development.
  • Personal wants and needs—GoFundMe specializes in fundraising for individuals, for everything from weddings to funerals, and medical expenses to high-school trips. Greedy or Needy aims to fund make-a-wishes without the necessity of going through a big foundation. Kapipal teams up with PayPal to finance just about anything.
  • Science—Still in its infancy, science crowdfunding has many researchers excited about the possibilities. RocketHub's #SciFund Challenge was the first crowdfunding initiative to support science projects, while Petridish invites donors to "fund science & explore the world with renowned researchers."
  • Biotech—On October 1, biopharmaceutical antibacterial drug-discovery company Antabio, and WiSEED, the French crowdfunding platform dedicated to technologic startups, announce the successful completion of their seed round of financing. Initially funded by more than 200 small investors, Antabio was able to finance a key step in the validation of its drug-candidate molecules, bringing it to the attention of some major players in the drug-discovery arena.
  • Cars—According to Gizmag, Local Motors "is a small Phoenix, Arizona-based automotive firm that uses crowd sourcing for brainstorming, designing, refining, and developing vehicle ideas. They work with an Internet community of more than 20,000 designers, engineers, auto enthusiasts, and other passionate minds toward developing unique, customer-centric offerings." They're currently working with BMW to crowdsource the Beamers of the future.
  • DIY—Launcht claims it "empowers universities, nonprofits, startup crowdfunding portals, and others" to design and implement "their own custom white label crowdfunding and voting platforms."
  • Brewskies—BeerBankroll is your destination if you want to help fund a small brewery.

And so on.

It's difficult to overstate how fast and furious crowdfunding has grown (but it pales in comparison to the growth potential of a new technology in replication). So red-hot is the sector that a whole secondary support network has popped up out of nowhere, largely as a result of the 2012 passage of the Jumpstart Our Business Startups (JOBS) Act, which effectively lifted a previous ban against public solicitation for private companies raising funds.

Among the nascent bureaucracies, there is now a National Crowdfunding Association (NLCFA), National Crowdfunding Association of Canada, World Crowdfund Federation, Crowdfund Intermediary Regulatory Advocates, and Crowdfunding Professional Association (CfPA), all of which sprang into existence subsequent to the passage of JOBS. The CfPA offers a course in Crowdfunding 101 and sponsors a Crowdfunding Bootcamp to teach entrepreneurs how to master the process.

While crowdfunding does not yet have the Web presence of some other services, it's headed up with a bullet. Alexa, a leading Web information company, ranks some 30 million Web sites worldwide, according to the amount of traffic users of its toolbar generate. Its statistics are considered one of the most accurate yardsticks by which site popularity can be measured.

As of August 2012, crowdfunders were nowhere near challenging the Top Ten megasites like Google, Facebook, YouTube, Wikipedia, Twitter, and Amazon. But Kickstarter was in 748th place, followed by Indiegogo (#1,798).

Rounding out the ten most-visited crowdfunders were GoFundMe (10,892), ChipIn (28,394), RocketHub (47,424), GiveForward (52,383), Fundable (60,149), Crowdtilt (133,246), crowdfunder (105,447), and appbackr (125,977).

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Pros and Cons...and Cons
The pros of crowdfunding—the Internet's P2P ability to unite worthy projects with seed capital, in the absence of conventional funding sources, and bring dreams to life—are obvious. But what of the cons?

Well, there's fraud, for one. Though crowdfunding sites claim to do detailed background checking before clearing a project to be posted, in reality this is fertile new ground for scam artists. In fact, in August the Massachusetts Securities Division charged a Lowell man in a crowdfunding scam, alleging that he had bilked 20 investors—who thought they were putting money into a gaming site—out of more than $150,000.

Regulation of securities issuance is another sticky topic. Questions about crowdfunding campaigns involving unaccredited investors and private companies are being closely examined in Washington.

Complicating the matter is that due diligence can be very hard if not impossible for a prospective investor to do prior to offering startup money for a new company, and that the stock those companies are offering is often not intended to be traded on any recognized exchange. Private offerings for oil and gas drilling, which are not SEC-registered, are another area of concern.

Though the SEC has yet to set any hard-and-fast rules in place regarding equities, it is widely expected to stick some fingers into this rapidly baking pie as soon as the next few months.

Further, the North American Securities Administrators Association (NASAA) publishes an annual list of emerging threats to investors. This year, NASAA included crowdfunding on its list of worries, warning that fraudsters could use it in new scams involving such unexplored territory as precious metals, real estate, and promissory notes.

Although not overtly fraudulent, there are also going to be ideas (including possibly some great ones) for which the funding goal is unrealistic. A September Reuters article discussed a Kickstarter project called Lifx, which intends to develop a dimmable, WiFi-enabled, multicolor, energy efficient, 25-year LED light bulb that you control with your iPhone or Android...and to start shipping finished product by next March. Talk about ambitious.

So far, the bulb is a monster Kickstarter hit, and the project is oversubscribed. Backers have thought so highly of it that they've ponied up more than $1.3 million, in return for which they'll get...well, some bulbs. Once they're in production.

Unfortunately, as the Reuters piece pointed out, "Coming up with a truly worthy LED bulb is enormously complex, requiring expertise in physics, chemistry, optics, design, and manufacturing." One of the early entrants into the space, the Switch bulb, has received an eight-figure investment from one VC company alone; it was promised in October of 2011 and still hasn't arrived. And Philips, which won a $10-million government prize by marketing the first LED bulb, spent much more than that in development.

So maybe Lifx can deliver the goods for $1.3M, and good for them if they can. But investors should probably be at least a little skeptical that they'll ever be dimming the room lighting with their phones.

If instead of bulbs or other manufactured goods that may not show up, you're looking for a return on capital—i.e., investing in a startup that's offering stock—you are also likely to be disappointed, since more than half of all new small businesses fail within five years. Should you wish to make such an investment, it would seem sensible to find one in your immediate area, so you can check it out with your own boots on the ground.

Then there is intellectual-property theft. Most basement innovators probably haven't patented their ideas before presenting them to the waiting world, which means there's nothing to prevent someone with deeper pockets from stealing the idea, producing the product, and getting it to market first.

The reverse is also possible. Someone may, knowingly or unknowingly, post a project that infringes on someone else's patent or intellectual-property rights. According to a recent story in Wired, this has happened on Kickstarter at least five times since April.

On balance, though, we're optimistic. All of these potential drawbacks will eventually work themselves out in the marketplace, we're sure, provided that forthcoming government regulations don't make it too difficult for these sites to thrive.

Investment Implications
Crowdfunders may facilitate transfers of newly minted stock to investors, but they don't sell stock in themselves, so there are no opportunities here, at least for the time being.

However, there are some income-producing sites, like LendingClub, that have been very successful at returning a decent yield. Some Casey Research employees are invested in them, and they may interest readers who are willing to do their homework. By all means, check them out for purposes of portfolio diversification if you'd like to—or crowdfund your own pet project.

As promising as crowdfunding is for investors, its profit potential pales in comparison to a new technology that could change everything from people's shopping habits to the way diseases are treated. When you hear about it, it may well seem like science fiction, but it's already working on a number of fronts.

Read more from Casey Research here...

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