To Crowd or Not to Crowd

Like many hot startup subjects, crowdfunding is an oft-misunderstood one. At the Hardware Club we have more than 20 startups that broke $1M on Kickstarter or Indiegogo. In our portfolio companies along we have 3. We consider ourselves knowing the art of crowdfunding better than most average investors.

However, I constantly run into hardware founders that have very distorted views on crowdfunding. This article is to share my opinions on this subject as an investor. 

 

What crowdfunding is NOT

Make no mistakes, for hardware startups crowdfunding is not about fundraising. It’s pre-order sales, period.

Getting this wrong could lead to several potential problems. 

Cash-flow-wise $400k successfully raised on Kickstarter might not look that different from $400k Seed money raised from VCs (excluding the fees charged by the crowdfunding websites). However, with the $400k crowdfunding money you have an obligation to deliver the products to the consumers, while the $400k seed money raised in exchange for equities means entrepreneurial duty to shareholders with no fixed claims.

Ironically the usually useless accounting reasoning actually renders this clear this time: the $400k pre-order sales you received from crowdfunding campaign, if properly booked, should be counted as Unearned Revenues. It is booked as a Liability on the Balance Sheet rather than a Revenue on the Income Statement.

Essentially this $400k is an obligation for you to deliver the products or services that you promised the consumers.

The problem is, in most cases $400k would hardly cover all the fixed costs in manufacturing such as tooling and engineering NREs. This revenue, therefore, is impossible to realize, at least accounting-wise.

“Who cares about accounting?” you might say. In most cases, indeed, accounting is not that critical in a startup’s life. However, in this case it puts you into context: if you could not deliver the products or services you promised with $400k, would you still take the money without a proper strategy to get more VC funding as well?

If your answer is yes, you’re basically committing a fraud and you automatically disqualify as an entrepreneur – or even immediately qualify as a criminal.

While failing to deliver the crowdfunding products on time is one problem – and one that is less and less tolerated by the crowdfunding backers – failing to deliver them at all is disastrous for your startup. Raising it knowing very well that you won’t be able to do production is an outright crime. If the later two cases happen, you pretty much lose all credibility to your current and future consumers – if you can’t even keep your promise for the most loyal and passionate among them (the crowdfunding backers), how would a normal consumer trust you?

In light of this, raising that $400k in VC seed capital (and giving up certain shares) is actually more benign than crowdfunding, as long as you use it in running the company.

Some of you might want to bring up the possibility of equity crowdfunding. This is a much more complicated subject than it is on the surface. We’ll dedicate an entire section at the end of this chapter to it.

To summarize: crowdfunding is pre-order sales, not fundraising. Ideally you should raise enough, e.g. more than $1M, for you to complete the manufacturing. If you could not, you should have started a VC fundraising plan to complement your crowdfunding and make sure that you are able to deliver the products to the hands of your backers.

 

What crowdfunding is really about

For a hardware startup, crowdfunding brings several benefits. Some are more important than others. In any case if you decide to do crowdfunding, these should be the real reasons for you to do it.

Testing for Product-Market Fit

The most important benefit is testing for PMF (product-market fit). 

As in any startup, PMF is the most important factor at an early stage. For hardware startups it’s even more crucial. While lean startups could iterate and improve on their MVP (minimun-viable product) to search of PMF, once a hardware product is shipped, there’s little way you could modify and improve the form factors, physical interfaces and electronics performances. This means that testing for PMF before shipping any hardware product is an even more live-or-let-die question than in the case of lean software products.

Before the age of crowdfunding, companies relied on traditional marketing tools such as market surveys and focus groups to get a feel about potential PMF. This is very costly and almost only the large corporates could afford to do it. This is one of the main reasons why in the old days we had almost no success stories in consumer electronics startups.

Even large corporates fail to hit PMF more often than not. HP, for all its experiences and prowess, was forced to discount heavily its WebOS TouchPad product, merely 49 days after it was launched in the United States. Both Facebook and Amazon tried to do their own smartphones and both flopped. This tells you how difficult it is to test for PMF in consumer electronics.

Difficult, but not impossible. Especially for startups, crowdfunding is a great way to test for that ever illusive PMF. It is true that the passionate backers on crowdfunding platforms are no way close to a true representative of consumers as a whole, but it’s already a blessing that hardware startups have access to it. 

Kickstarter alone claimed to have raised more than $1.8 billions till 2015 with more than 2.7 million repeated backers and close to 9 million total backers. This is by far the largest consumer focus group we have ever witnessed! If a startup can successfully sell a video demonstration of its working prototype and convince backers to pay in advance for a product to be delivered in 1 year or longer periods, it’s a good PMF validation and it is done relatively cheaply. 

If there’s any single reason you should be doing a crowdfunding, testing for PMF should be the one.

 

Pricing test

Marketing is key to the success of consumer electronics. Pricing strategy is the center of marketing. The importance of pricing could never be under-estimated in today’s hardware startups. 

Unlike software, web-based or mobile-based startups that can test the pricing relatively easily by adjusting the prices at will from the server end, hardware products, once out on the market, either face the fate of overprice (selling out too quickly) or underprice (huge inventory). The later would have to resort to the dreaded discount sales, or worse, inventory write-off. The former us a better problem to have but it still implies money left on the table and usually one do not have the luxury – no puns intended! – to adjust the price back up after having found the product underpriced. 

On crowdfunding platforms, however, by skillfully structuring the different packages offered to backers and assigning different availabilities to each package, when the campaign launches one can monitor the rate at which each package goes out. The combination of price and volume information gives a startup a first indication whether the product is currently priced properly in backers’ perception. It can then adjust the price to a better point afterward when it hits traditional sales channels.

 

PR

Today almost all hugely successful Kickstarter/Indiegogo campaigns receive repeated coverage by relevant media such as TechCrunch, VentureBeat, etc. Since crowdfunding campaigns come with live-updating dollar amounts, the news articles covering them get shared and re-shared on Facebook as well as tweeted and re-tweeted on Twitter, creating waves of free PRs for the resource-constraint startups. 

For example, Pebble, the smart watch maker that had a successful campaign of more than $10M in 2012, earlier this year returned to Kickstarter to pre-sell their second product Pebble Time. The campaign cleared the $1M bar in a mere 34 minutes after launch, $7M in 14 hours and eventually closed at more than $20M. When interviewed by TechCruch, Pebbel CEO Eric Migicovsky admitted that the choice to return to Kickstarter is “a bit of a spectacle, a little bit of an event” – in other word, a PR stunt. And it proved to be hugely successful as the news articles kept coming up as the number rose and related info get re-shared and re-tweeted over and over again.

Note that PR is a two-sided sword. A badly managed campaign could also be a disaster. And with Kickstarter and Indiegogo, all the comments will remain there on the websites, completely public to potential investors and future customers.

Overall, if PR is the main reason for you to do crowdfunding, I would suggest that you think twice.

 

Working Capital

One of the most capital inefficient part of investing in a hardware startups – both from the VC and founders point of views – is working capital. A startup has to pay the suppliers such as component makers, contract manufacturers, logistic partners and in some cases even retailers in advance to be able to get the product into the hands of its consumers to collect revenues. With pre-order sales on crowdfunding platforms, however, one gets paid in advance to go into manufacturing. This helps enormously on working capital issue and in some cases where several millions were raised, might even completely resolve it, enabling the startup to delay an entire round of VC fundraising.

 

Kickstarter, Indiegogo or private crowdfunding pages?

The success of a crowdfunding campaign hinges mainly on the ability to build a community that’s large enough and passionate about your product proposition. 

Most of the time the community is best managed via emails: 

  • Consumers motivated enough by the product proposition leave their email addresses at the landing page of the startup.
  • The startup continues clear and proper communication about the project progress with their followers.
  • The startup launches its well-timed crowdfunding campaign with all followers being led to the crowdfunding page.
  • At a certain conversion rate, the followers place pre-orders on the crowdfunding page.
  • This initial momentum (in both backers and amount of sales) generates more buzz and sharing that bring more traffic to the crowdfunding page and more conversion.

It’s getting rarer and rarer that a campaign would be hugely successful by itself without building such a community first. In other words, we are seeing fewer and fewer campaigns go viral by themselves without managing.

Consequently, if a startup succeeds in building a large and active community, its crowdfunding campaign will be successful wherever it’s carried out: on Kickstarter, on Indiegogo or even on a private crowdfunding page, as is the case in the eye-popping $34 million pre-order campaign of Lily, the drone that automatically follows you around taking video.

On the other hand, if a startup fails to build such a community, it could have the most beautiful campaign video and the most well thought-out campaign and have launched on Kickstarter or Indiegogo, its campaign will still most likely fail.

In short, it’s not about the platform that you choose to launch your campaign. It’s the community that you manage to build.

 

Equity crowdfunding

Equity crowdfunding became a buzzword in 2014. Part of the momentum came from the highly successful investment exit of Oculus VR, sold to Facebook for $2B barely 2 years into the company’s existence. Some early backers felt that they contributed to the “fundraising” but didn’t get a cut in the exit. Equity crowdfunding is supposed to address this imperfection and allow passionate backers to invest in the startups that they are passionate about.

Is equity crowdfunding a good thing for a startup?

In general, no. In practice, if a startup has raised money via equity crowdfunding, it could pretty much kiss goodbye the chance to get funded by real venture capital investors.

Note that VCs are very sensitive to existing shareholders, co-investors and even future investors. Ask any experienced angel investor and he or she will surely be able to recount a horror story where he or she was almost forced out (to sell the shares) by a subsequent VC investor in the Seed of Series A rounds.

This is not VCs being evil financiers, but simply because non-professional investors represent a risk to the startup on its odyssey to a successful exit. Especially in the great entrepreneurial wonderland of the United States, as a startup grows and raises more and more money over the rounds toward IPO, it’s not uncommon for a random early investor to decide to sue the company for some stupid reasons related to his or her shares. This is unavoidable however perfect the investment contract was created in the first place – and it’s usually not perfect in the early stage.

To have 3 or 4 amateur angel investors, each contributing $20k or $50k, sitting on cap tables is at best a nuisance for the the follow-on VC investors. To have 200 investors, each contributing $1k, sitting on cap tables would be a mental disaster for the follow-on VC investors.

And forget about the contractual delegation agreement between the equity-crowdfunding platforms and their investors. Human beings with little at stake seldoms follow the book. VCs could easily imagine the scenario where on the eve of the IPO those two hundred $1k investors launch a class action suing the company for wrongdoing with whatever reason, completely disrupting the IPO process. If it had been professional angels who had written $20k or $50k checks, this would be against their interest. But the $1k investors would stand to gain more by blackmailing the company and/or the subsequent large-ticket investors. It’s a $1k bet that anyone will take any day.

No VC will want to deal with this kind of potential trouble, unless the startup really posses something very very unique that the VCs are willing to take the risk to sit on the cap table with other equity crowdfunding investors. Most of the time that’s not the case.

To summarize it: crowdfunding is not fundraising. Equity crowdfunding is dumb capital that comes with great risks. If you can’t raise angel or VC capital, your product or idea are probably not good enough for the venture startup world. It’s better to call it a quit and spend your time on something else or something new. Raising equity crowdfunding might not give you the much-needed breathing room but rather it might completely eliminate any hope that you’ll get venture backing in the future.

Founder ownership and capital efficiency

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