x Abu Dhabi, UAETuesday 25 July 2017

Crowdfunding should come from customers, not investors

Crowdfunding, while tempting, will ultimately hurt budding entrepreneurs by reinforcing bad habits. A better solution is raising capital from customers.

Customer funding is not a new idea, and it is alive and well today. Illustration by istockphoto.com
Customer funding is not a new idea, and it is alive and well today. Illustration by istockphoto.com

For budding entrepreneurs, crowdfunding appears to be the answer to all financial troubles. Some start-ups are able to raise large enough amounts to be used in the business, while investors can benefit from a potentially profitable venture by committing even a small sum.

But while crowdfunding may seem to be a win-win situation and there have been some notable crowd-funded successes, I have several concerns about the viability of this model.

First, much of the venture capital industry has a poor record in picking companies to invest in, not to mention often delivering negative returns to its investors. It is unlikely that contributors to crowd-funded projects will do any better and they may soon discover that their investments have turned to dust.

Second, the emerging early data on crowdfunding suggests that the average amount raised is in the neighbourhood of Dh6,000. Running a successful crowdfunding campaign involves lots of work and effort, which can include creating a compelling promotional video and building a prototype. Is it worth all that effort for such meagre returns? Might that effort be better spent on finding some real customers and persuading them to buy?

Third, obtaining finance, while difficult in itself, is the easy part of getting a new venture under way. Actually running the business – developing the right products, targeting the right customers and making the business viable – is much more difficult. Crowdfunding does not offer any support in that regard.

Finally, the crowd’s attention is less credible and repeatable than the attention of the customers your business actually wants to serve. Most crowd-funded money comes from the entrepreneur’s family, friends and networks. Their initial investments do not necessarily represent confidence in the business idea. Much of the time, they invest because they love you.

So, is there a better way forward than seeking crowdfunding, angel investment, or tapping the proverbial 3Fs – family, friends, and fools? As I argue in The New Business Road Test, there is. Get your initial funding from your customers, just as Michael Dell and Bill Gates did in starting Dell and Microsoft many years ago.

Customer funding is not a new idea, and it is alive and well today. Anyone who has booked a hotel room on Expedia.com, for example, might be surprised at the role they were playing in funding Expedia’s operations and growth. Not only did Expedia not pay for your hotel stay until after you arrived – despite the fact that you probably paid Expedia when you booked the room – in many cases it paid the hotel as much as six or eight weeks after your stay. What is Expedia doing with your money – their customers’ money – for all those weeks, sometimes months? Running and growing its business, of course.

Customer-funded models – there are five of them, as I uncovered in my research – provide numerous benefits to entrepreneurs and their backers alike.

First, waiting to raise capital forces entrepreneurs’ attention towards their customers, where it should be in the first place.

Second, client orders often give customers a vested interest in the venture’s success. If they are happy to buy a business’s products they will want it to stick around, whether to purchase its products again or to get already-bought products serviced. For entrepreneurs, having customers on their side is helpful. For angels or venture capital investors from whom money may be sought eventually, having customers rave about the company in which they are thinking of investing is a positive sign.

Third, making do with the probably modest amounts of cash that customers contribute enforces frugality. Having less money will make entrepreneurs smarter and force them to run their business more efficiently.

Fourth, when venture capital is raised later, after customer traction is proven, the investor’s risk is lower. This means that the terms and valuation are more favourable for company founders, making their stakes and control more substantial. For angels, investing later reduces financial risk and is likely to improve returns.

Fifth, focusing efforts to raise cash from customers who are willing and eager to buy from an unproven company is likely to mercifully put to rest a half-baked or not-quite-right idea that requires more development. This aspect of customer funding can force a necessary pivot that helps an aspiring entrepreneur hit the mark.

Finally, funding a business through customers allows more freedom and control for the founder, a factor that is usually high on entrepreneurs’ priority lists.

Whether you’re an aspiring entrepreneur lacking the start-up capital you need, an early-stage entrepreneur trying to get your cash-starved venture into take-off mode, a corporate leader seeking to grow an established company, or an angel investor, mentor or business incubator professional who supports high-potential entrepreneurial ventures, the five customer-funded models offer the most sure-footed path to starting, financing or growing your business.

John Mullins is associate professor of management practice in marketing and entrepreneurship at the London Business School