With the increasing relevance of crowdfunding as a means for people to raise money, a relevant question to ask is just how safe crowdfunding really is? Safety has many connotations and there are many risks to consider.
Overall, crowdfunding is extremely safe for both backers and campaign creators. Major platforms are PCI compliant. Furthermore, donors have legal options that protect the money they contribute. Campaign creators can rest assured that they will be safe as long as they deliver their promises.
Despite the high degree of safety, there are many risks to crowdfunding. These range from the risk of losing your investment to outright fraud.
Here are 15 things donors and campaign creators should always be aware of in order to best protect themselves. (Make sure you read the 15th and most important tip!)
#1- You Might Not Raise Enough
Every campaign creator wants to raise a certain amount of money but crowdfunding isn't a guaranteed way of raising the money you need.
Statistics show that just 22% of campaigns are successful with different platforms reporting different success rates.
What makes crowdfunding even riskier is that platforms such as Kickstarter and Indiegogo follow all or nothing campaign policies. This means if your campaign doesn't hit its target, the creator gets nothing.
If you're designing a product or offering a service, crowdfunding should not be your only source of raising funds, despite the many advantages it offers. Successful crowdfunding campaigns rely on campaign creators mobilizing their audience.
If you don't have an existing audience, your chances of successfully raising enough money are close to zero.
Furthermore, even if you do have an audience, you need to ensure that your pitch is well written and that your campaign video is on point and is of an ideal length. Update your backers constantly and engage them.
You'll find that your chances of being fully funded will skyrocket!
#2- Misunderstanding The Types of Campaigns
You want to raise crowdfunded money for your local animal shelter. You need to head over to Kickstarter and create a campaign right? Offer perks and everything?
Before you even think about raising money you need to educate yourself about the types of campaigns that you can run. If you're someone who wants to contribute to a campaign, this is even more crucial for you to understand.
After all, the type of crowdfunding campaign dictates what you will receive in return. Briefly, here are the different types of campaigns that are out there:
Each of these campaign types offers a different reward for your contribution. Donation based campaigns typically don't offer anything, unless the campaign creator happens to be a large charitable organization. Even in this case, nothing is guaranteed.
Rewards based campaigns offer perks that you should carefully read before donating. Equity based campaigns give you shares in the company you're investing in.
Debt based campaigns , like the ones you'll find on P2P lending platforms, will offer you a certain interest payment for your investment.
Campaign creators need to carefully consider which type of campaign will be best suited for them. If you're a small business that is looking to create a new product, are you better off raising debt or equity?
Or should you launch a rewards based campaign and offer perks in the form of pre-orders? Consider all of your options carefully and understand that each type of campaign has its advantages and disadvantages.
#3- You Might Not Receive What Was Promised
Crowdfunding platforms host a wide variety of campaigns and these days there are almost no fraudulent campaigns. However, every once in a while this does happen.
Even if a campaign isn't fraudulent, the chances of you receiving what was promised in the campaign isn't too high.
There aren't many credible studies that have been carried out however, anecdotal evidence does suggest that many campaigns fail to satisfy their backers' expectations.
Kickstarter published a study conducted by the University of Pennsylvania which indicated the just nine percent of their projects failed to deliver.
Keep in mind that projects that experienced massive delays but still managed to deliver their rewards were not considered failures.
The fact is that most companies that seek crowdfunding tend to use it as their last option.
This is because they might not be at a stage to receive venture capital or angel investing or they simply don't wish to take the risk of launching a new product on the open market.
Therefore, there are built in inefficiencies in such projects and the real risk, from the backers' perspective, begins after the funding goal is reached.
Once this happens, the crowdfunding platform is out of the picture and the backer has to monitor the campaign themselves. All in all, crowdfunding is risky in this regard and you should be careful with the amount you choose to invest in a project.
#4- The Company Goes Bust
Equity and debt crowdfunders face this particular problem. You might invest you money in shares of a company, or in its debt and find that the company goes bust after a few months!
Startups and small businesses are the ones who seek to raise funds through equity crowdfunding and these businesses are risky. What's more, the type of deal that is offered to the investor might be risky as well.
For example, convertible notes are one type of instrument offered to investors. These are debt instruments where the investor is paid a certain interest rate for a while. Once the company's valuation reaches a certain point, this debt is converted into shares.
(If you didn't understand a word of what you just read, then you should not be going anywhere near equity crowdfunding. It's too risky for you!)
A startup faces an uphill task no matter how great the founding team is or how many big names it has on its board. Its product might sound great on paper but when it actually launches, they might find that it is less than exciting.
What's more, funding is typically provided on the basis of working prototypes. Producing a prototype is no guarantee that mass production will be possible. The various features that a product promises might not be feasible to produce.
The list of risks goes on and on. Guess who bears all of it?
The backers do!
When participating in equity crowdfunding campaigns, another risk that backers run into is the fact that the shares of the companies they're purchasing are highly illiquid.
Some platforms do talk about starting a secondary market, like the NASDAQ Private Market, where investors can transact in there shares.
However, the practicality of such a market appearing in the near term seems remote. A big reason for this is crowdfunded companies are privately held and any sale of shares needs to be approved by them.
This means crowdfunded equity lies in between public equity and fully private equity. There isn't much legislation covering this area at the moment and fraud can arise. The best way to prevent it for now is to simply make the sale of such equity inconvenient.
So how does an equity crowdfunding backer earn a return if they buy shares? The only way to earn one is if the company goes public (which is a remote chance) or if it gets acquired by a bigger company (far more likely.)
Both of these options take time and valuations in the meantime are subjective. There is no active market for shares so it is the management and new investors who ultimately decide the valuation ballpark.
As a shareholder, you're simply along for the ride without much of a say in anything.
While equity crowdfunding has its risks, what about crowdfunded real estate? Well things are even murkier here, despite it being heralded as the next big thing.
The fact is that real estate investors have always had access to cash flow from properties even if they haven't had money for a down payment.
Real Estate Investment Trusts (REITs) have traded in the public stock markets for a long time now so there's nothing inherently special about a crowdfunded real estate deal. A lot of it is fancy marketing.
What's more there are some unique risks to these kinds of deals as I'll detail shortly. For now, understand that crowdfunded REITs (eREITs) are illiquid as well. You'll be selling them back to either the deal's principals or to other investors on the crowdfunding platform.
This means your chances of getting out of a bad investment at a fair price is pretty low. While they're not as illiquid as crowdfunded equity, eREITs are hardly a safe investment.
#6- Platform Risk
You might find a great campaign, conduct research with regards to the product, its market fit and every other variable you can think of.
You've even figured out how much you need to invest exactly so that your risk is covered. Everything's great so far!
Except, you've neglected one tiny detail. The platform itself could go bust and your donation/contribution could go up in smoke.
Traffic is the lifeblood of any crowdfunding platform and without it, their chances of survival are remote.
Many backers invest in P2P lending sites (which facilitate debt based crowdfunding) and expect to earn steady returns. While it's easy to think of platforms as being just facilitators, the fact is that they need to evaluate themselves like any lender would.
They need to facilitate easy access to cash for debtors and offer creditors a good level of investment return. Thus, not only so they have to worry about the people that borrow money, they need be act as an investment manager for those that lend it as well.
This need to manage dual expectations is not easy to pull off. In June 2019, one of Europe's largest P2P crowdfunding platforms Lendy collapsed.
This platform guaranteed lenders (backers) ridiculous 1% per month returns with some of its loans. It was a tactic to generate more traffic and activity on its platform.
While traffic and growth did increase, performance could not keep up and it duly went bust. As the company entered administration, it had close to 97 million pounds in defaulted debt.
As a backer or as a campaign creator, stick to the bigger platforms that have huge traffic numbers. Avoid smaller platforms that do not disclose relationships to its investors and stay away from seemingly ludicrous offers that some platforms make.
#7- Security and Compliance Risk
Something that crowdfunding participants ignore when it comes to evaluating platforms is the technological security that is in place.
You'll be entering your credit card information (if you're contributing money) or will be providing a lot of personal information and data to the platform (if you're a creator.) It stands to reason that you need to be doubly sure that all of this will be securely handled.
While there haven't been any instances of data breaches with the bigger crowdfunding platforms, this is mostly because all of them adhere to PCI (Payment Card Industry) compliance norms.
PCI compliance requires web hosting companies to satisfy a variety of technological guidelines to ensure all data transmitted is secure. There is no straightforward way of figuring this out since the formal process is lengthy.
However, the least you can do is examine the payment pages on the site for SSL presence.
This is indicated by a little lock appearing in the left hand corner of the address bar when you're on the payment page.
In addition to this, also look for the 'https' lettering in the address.
Generally speaking, you don't have much to worry about if you're using one of the larger crowdfunding platforms. The trouble arises when you use one of the smaller platforms that just don't have much traffic or web presence.
#8- Beware Conflicts of Interest
Trust is a major issue when it comes to crowdfunding and creators who are serious about raising funds for their campaigns do their best to address the issue.
However, there are issues of trust even with platforms. The funeral industry is one such example. People who raise money for funerals are emotionally vulnerable and face rip offs at the best of times.
The rise of crowdfunding has led to people turning to it to raise money. This has led to funeral directors getting in on the action as well with a few funeral crowdfunding platforms being backed by them.
This is a massive conflict of interest since not only is the client charged a service fee but the funeral director raises money from the donations as well. Platform fees typically work out between three to five percent.
Compare this to the zero charges that GoFundMe imposes on memorial fundraising!
Often such relationships are not disclosed to the customer and this is a highly unethical practice, even if it is fully legal.
Even if your funeral director isn't backing a platform, they can earn affiliate commissions from these websites. This in turn causes people to try to raise more than is strictly necessary.
As I mentioned earlier, trust is an ever present issue when it comes to crowdfunding. You don't know the person behind the campaign and it is impractical to try to get to know them completely before contributing money.
The earlier days of crowdfunding witnessed some spectacularly fraudulent activity with the Kreyos smartwatch being the poster child of such behavior.
These days, you won't find frauds of such size operating in this space. However, smaller levels of fraud do occur. The funeral crowdfunding space sometimes witnesses campaigns that raise more than is really needed for services, for example.
The good news is that crowdfunding platforms have stepped up and have made it easier for backers to sue creators in case of a campaign failing.
While the legal process is lengthy, the mere presence of it deters many fraudulent campaigns from appearing.
As a backer, you should educate yourself about what your options are and how you can spot the tell tale signs of fraudulent campaigns.
Read the last three sections in this article to understand how you can protect yourself against fraudulent activity.
#10- Lack of Properly Defined Regulation
Crowdfunding is just beginning to witness increased levels of governmental regulation. As you just learned, legal procedures that allow backers to sue campaign creators are still relatively new.
There are a number of issues that need to be sorted out in this space. Equity crowdfunding is perhaps the one with the most number of issues.
The lack of liquidity of shares means that investors are locked in for a long time in their investment whether they like it or not.
Over and above this, the risks that debt crowdfunding backers and campaigners face in case of a platform's failure are still high and there isn't enough regulation that protects them.
Currently, regulation in the United States is carried out by the Securities and Exchange Commission, and the Federal Trade Commission.
While the regulation that does exist is stringent, it isn't nearly enough to cover a few major risks. The onus largely remains on backers and campaign creators to ensure safety.
#11- Due Diligence Limitations
This particular risk concerns the spheres of equity and real estate crowdfunding. The fact is that these deals are inherently risky to begin with.
In the case of equity crowdfunding, you'll be investing in startups and these companies by very definition don't have a track record.
When it comes to real estate crowdfunding, you're looking at deals that are spread all around the country and it's hard for an investor to be able to properly assess the deals' profitability without local market knowledge.
This puts you at the mercy of the platforms' due diligence abilities. While there haven't been any cases where investors have lost large sums of money, there simply isn't a viable reason for you to be investing in crowdfunded real estate.
This is because you can easily invest in a REIT in the stock market!
REITs have diversified portfolios with far larger assets and best of all, their liquidity is extremely high. This is not the case with a crowdfunded eREIT.
Being public companies, REITs also offer detailed financials that are open to the public. Given all of these benefits, the case for crowdfunded real estate is pretty weak.
#12- The Biggest Platforms Are Secure
Right, enough with the bad news and onto the good! It's true that crowdfunding does pose many risks but all of these can be mitigated by some intelligent decision making.
With regards to security, the biggest platforms are more secure than ever. These are now large companies that face significant risks to their reputation if they're found slacking in this area.
Therefore, stick to the big platforms that witness a lot of traffic and you'll be just fine!
#13- Invest in Engagement
This point applies to both campaign creators as well as backers. The best campaigns are the ones that provide the highest level of engagement with their backers.
These are the ones that are constantly publishing updates and are providing their backers with content related to the promises being delivered.
If you're a campaign creator, have a plan during the pre-launch phase to release relevant updates. If you're developing a product, plan on involving your backers in it.
Why not invite them over to your production facility and record a video? Given them a chance to touch and feel your creation!
Trust is a huge issue when it comes to crowdfunding. Your backers don't know you and in order to win them over and to maintain that trust, you need to let them know what's going on.
Put a human face to your efforts and show them what you're doing! They'll appreciate it and will back your next campaign as well!
From a backer's perspective, look at engagement. It shows that the campaign creator cares about what they're promising.
Before giving them money, look for hints in their pitch with regards to how well they'll stay in touch with you.
Does it seem like they have a schedule in place to provide you with updates? If so, back them wholeheartedly!
#14- Know Your Options
Every campaign has the potential to go wrong. Educate yourself as to what your options are. Creators specifically need to understand what to do if their campaign has failed.
Campaign backers need to understand what their legal choices are and prepare in case they need to sue a creator.
Prepare beforehand and don't click the launch or donate button until you fully understand what you're getting into!
#15- Invest What You Can Afford
The simplest thing to be aware of in order for you to avoid all of these risks? Invest what you can afford to lose!
This is such a simple thing to do and yet, so many backers forget this principle.
They invest large sums of money by getting carried away either by the emotional jolt the campaign pitch provides or by thinking of all the riches they'll attain once they invest.
Crowdfunding is risky! Do not be that person who throws away their hard earned money by investing it unwisely.
Do your homework and always be aware of these risks that you've just learned about. Crowdfunding is a great way to support causes you believe in or even to make money.
However, with opportunity comes risk and intelligent backers and campaign creators are always aware of them.