To Kickstart or Ask Grandpa for the Dough?

by G.N. Jacobs

Entrepreneurs all over the civilized world anxiously await the results of an ongoing discussion at the SEC about the future of crowdfunding sites like www.kickstarter.com and www.indiegogo.com. Coming on the heels of the small handful of Kickstarter projects that have gone bad and a legal requirement related to the 2012 JOBS Act, the Securities Exchange Commission (SEC) has delayed writing new rules to govern how crowdfunding sites will operate.

Going back to the beginning (about 2003), there have been many different flavors of crowdfunding sites. A common feature: the site connects people with a little bit of extra money with people who have projects that need funding. The first I heard about www.kiva.com was that they act as a middleman for zero-interest development loans to the Third World. After a few years, sites like Kickstarter and Indiegogo developed where the plan was to connect artistic entrepreneurs with people with small amounts of money to invest in creative projects. In essence, a creative entrepreneur posts a plea for cash and the funders pledge money, or not.

All good ideas can be misused or simply driven into the ground. Kickstarter and its general ilk were initially intended more to allow filmmakers, musicians, writers and other flavors of artists to find the funding to get them in game with the large corporate media producers. Need seed money for your splashy low-budget horror film that will get you in the door with the Hollywood agent? Post a video plea on Kickstarter or any of the similar sites and see what happens.

Ain’t It Cool News Kickstarter project that’s currently active.

However, small entrepreneurs intending to get funding for operations that make and sell physical products also discovered Kickstarter. Therein lies the first problem for crowdfunding as a business model. Inventors have different needs than a filmmaker needing to make a movie, or a comic book writer that can’t actually draw needing to pay an artist to give the book real street cred. That inventor with the new oil spout needs to find a factory (probably in China, sadly) to make it, which can include negotiating with suppliers of the plastic. And they have to set production schedules so the investor/donor can have real verifiable signposts of progress.

But, the SEC’s concern is more basic than whether inventors misuse a site intended for artists. The concern is whether or not the whole practice of crowdfunding violates pre-existing securities law, some of which goes all the way back to the Great Depression. The argument articulated in 2011 by C. Steven Bradford of the University of Nebraska-Lincoln College of Law in a paper available on the SEC website posits two problems—does a crowdfunding site sell securities as defined by the Securities Act of 1933? Are the crowdfunding sites legally a broker of those securities?

A comic book publisher who hasn’t agreed to go on record in support of Kickstarter commented, saying, “I think it’s a good idea. Kickstarter, crowd-sources a creator’s pre-sales so that he or she can get their project into the marketplace in return for a few copies. I think part of the problem may be that the entrepreneur says ‘donate to my project’ when they mean ‘get in on the ground floor with my early pre-sales.’”

IndieGoGo Project by actor James Franco

Luckily for the majority of creative entrepreneurs on Kickstarter and IndieGoGo that use a reward/pre-sale model where the investor/donor will only get some sort of tchotchke or a first edition/DVD of the project being created, Professor Bradford argues that by not offering profits or company equity the entrepreneur and/or the crowdfunding sites using this model should be completely exempt from regulation. But, if the SEC ignores this finding then Kickstarter might be in big trouble because registering with the SEC is expensive and fraught with so much red tape that only the serious players need apply.

The reason for these rules is to keep the fly-by-night operators out of financial markets. If Kickstarter is judged to be selling securities it would be because of the occasional campaign that is out-and-out fraud, or more charitably a well-intentioned mess created by someone with a good idea, but no idea how to go from the drawing board to the completion stage. Which brings us back to the question should product inventors use the same crowdfunding sites as creative entrepreneurs?

In 2011, a product designer named Seth Quest came up with an iPad rest and started a campaign. In a train wreck described as “more stupidity than fraud,” Mr. Quest and a partner collected some $35,000 to start making the Hanfree iPad rests. Only he’d never previously started any companies, or actually made any prototypes, all things that an inventor going through the traditional venture capital process would be forced to address.

HanFree Kickstarter project

The short story version of the disaster: when the investors didn’t get their first off-the-line iPad rests in a timely fashion they sued. Because Mr. Quest hadn’t incorporated, or created an LLC, he went bankrupt and couldn’t get another job in design.

“When you fail on Kickstarter, it’s a very public failure,” Mr. Quest told Inc. Magazine. “It definitely derailed my career substantially. Your backers can give you massive support, but they can also tear you down if you fail.”

The investor leading the suit, Neil Singh, had originally thought Kickstarter was some kind of mall. This led the principals of Kickstarter to post on their blog “Kickstarter is Not a Store.” They changed how product campaigns operate adding a Risks and Challenges section to the campaign listing where the entrepreneur has to detail what may go wrong with the project and how they are suited to deal with them. Additionally, product- based campaigns can’t post anything but pictures of the product as it is now, which presumably keep them from being overhyped.

Another Kickstarter for a video game called Code Hero may have been a classic case of taking the money and running. As of December 2012, no one had delivered any games and the creators had been largely silent, except for sporadic updates providing vague information. If this is a case of fraud, the bad guys got away with approximately $170,000.

When dealing with disputes and potential fraud, generally the crowdfunding site has passed the responsibility for keeping an eye on the posting entrepreneur to the backers. In many cases, the backers simply wrote off the small amount of money. It is in this environment of the occasional fraud and the more common problem of slipping delivery dates that may cause the SEC to lump “reward/pre-sale” crowdfunding sites like Kickstarter and IndieGoGo in with the sites that actually have already registered to sell securities, despite prevailing legal opinion to the contrary. Sometimes the Government can be goaded into throwing out the baby by spouting buzzwords like protecting children, protecting against fraud, or protecting against terrorists.

Code Hero Kickstarter Project

Over the past several years, pressure to include new regulatory language for all types of crowdfunding resulted in language promoting what may be middle-of-the-road rules for crowdfunding that sells securities into the JOBS Act enacted in May 2012. Essentially, the people trying to raise small amounts of money wouldn’t have to register to the same degree as large brokerage firms working Wall Street, which in theory would help provide funding for projects that provide jobs (ostensibly the point of a JOBS Act). The problem and worry is that the legislation required the SEC to make the new rules by December 31, 2012. But, one look on the SEC’s website shows that they are still taking comment messages asking them to do their jobs and make new crowdfunding rules ASAP; the last message was accepted July 4, 2013. I can only state that rulemaking that’s seven months late leads to frustration.

Now, it’s just possible that the “Reward/Pre-Sale” model that is specifically used by Kickstarter, IndieGoGo and others will continue to prevail, because you get to do X cool things and all I get is a lousy T-shirt (to steal from a T-shirt slogan) then it isn’t a security I’m buying, but the satisfaction of helping someone with a project. If this is the case, then this analysis is all hot air and unrealized fears. If not, we won’t know until the SEC finishes deciding the shape of the table and does their job. If things go wrong for Kickstarter… well, some of us still have rich grandfathers.

However, if more fraudsters crawl out of the woodwork on Kickstarter, the Government will feel the temptation to regulate. Tipper Gore freaked out over rap lyrics and the record industry started voluntarily labeling CD’s. There are suggestions floating about the Internet that Kickstarter may have to alter their terms of service to state that they will take more responsibility for fraud and delays in completing projects. In some ways, the Terms of Service already reflect this, but depending on how many campaigns go bad there may be a need for more proactive rules. As always, to steal from Heroditus, “We shall see at the end of the year, if the horse will sing.”