Andrew Duff: Crowdfunding risks can outweigh the benefits

Experienced investors help the entrepreneur to understand risks, manage them and help turn around or pivot their business when things don't go as planned. Photo / Thinkstock

Crowd-sourced funding is about to hit New Zealand in a serious way with the imminent arrival of United States website Kickstarter.

What initially drove the idea of crowd-funding was a fantastic goal and for some business propositions - particularly ideas that want to or can get to market quickly - one can see the attraction.

It's a cheap way to raise capital very quickly and it overcomes sometimes long negotiations over investment terms. There's no due diligence and no requirement to offer board positions.

But while it's one way of dealing with the cash crunch that many Kiwi start-ups face, it needs to come with a public health warning for those entrepreneurs serious about developing their start-ups into seriously large companies. Unfortunately the risks often outweigh the benefits.

Crowd-sourced funding - which enables businesses to raise money through pledges from a large number of people, usually through a web-based campaign - results in a large number of unsophisticated investors investing very small amounts because they really like an idea.

This creates very fragmented share registers which, for a number of reasons, leave the business un-investible by subsequent professional investors.

We are already starting to see the first casualties being rejected from serious investment consideration by venture capital funds through the sheer number of small investors on the share register.

While crowd-funding delivers dollars, it can make it more difficult for the entrepreneur to get the business off the ground as there are no knowledgeable lead investors and their support networks at the table.

In contrast, one of the benefits that angel investors - usually experienced business people and serial entrepreneurs - bring is the mentoring and advisory role that they play for a new business.

Experienced investors help the entrepreneur to understand risks, manage them and help turn around or pivot their business when things don't go as planned.

For the investor, crowd-funded deals offer few or no investor protections afforded by standard New Zealand early stage investment terms, no intellectual property protection, no investor representation and a lack of due diligence by an experienced investment team.

Investing in early stage companies is very high-risk and is best done via co-investment with a professional early stage investor or angel group.

Membership of an angel group or investment in a diversified early stage seed programme - such as the Global from Day One seed funding programme - can increase the chances of success for both investors and entrepreneurs.

The biggest curb on crowd-funding may ultimately be the disappointment of those who have contributed funds.

Building a successful international growth business requires balance in the potential upside for both investors and entrepreneurs. Entrepreneurs should look not just at their immediate funding needs, but plan forward to the next few funding rounds and determine which kinds of investors their business needs.

Kickstarter's launch will remind entrepreneurs that while crowd-funding can provide some much needed dollars, a good investor comes to the table with not only funds, but also networks, skills and experience. The last three are often much more valuable than the money.

Andrew Duff is the chairman and co-founder of Sparkbox Ventures, an early stage investor.