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Entrepreneurs tap into virtual world to fund startups

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This article appears in the October edition of the Financial Post Magazine.

Christine Dobby | Oct 16, 2012 7:59 PM ET | Last Updated: Oct 17, 2012 8:27 AM ET
More from Christine Dobby | @christinedobby

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Pranav Sood poses for a photo at a factory in Bolton, Ontario earlier this year. Sood is looking beyond TV financiers and directly at potential customers with a campaign on fundraising website Indiegogo.

Pranav Sood has already appeared on CBC’s Dragons’ Den and BNN’s The Pitch trying to land some funding for his smartphone casing business. The $50,000 deal he reached with Dragon Robert Herjavec didn’t make it past the due diligence process and though the recent business school graduate impressed the investors on BNN, he walked away without a firm commitment. Now he’s looking beyond TV financiers and directly at potential customers with a campaign on fundraising website Indiegogo.

Courting “the crowd” for backing has become a popular means of getting a product to market, spurred in part by the success story of Pebble Technology, which raised more than US$10 million in May during a wild run on U.S. crowdfunding site Kickstarter. No longer must entrepreneurs rely solely on their ability to wrangle up a term sheet from a lone venture capitalist. Social networks — both online and offline — can bring them together with swarms of investors, whether it’s through crowdfunding, Internet-assisted angel investing or increasingly ubiquitous accelerator programs.

 Thirty years ago your primary source of early stage investment would really be your close friends and family

“Thirty years ago your primary source of early stage investment would really be your close friends and family and this really close network,” says Robert Mitchell, an assistant professor of entrepreneurship at the Richard Ivey School of Business in London, Ont. “With the rise of social networks and your Facebook friends and Twitter followers and these other acquaintances, these other ties in the network, in essence the breadth of access to resources increases.”

Sood, the CEO of Toronto-based Smart Casing Inc., has fairly modest expectations for his company’s Indiegogo campaign. He’s hoping to raise $50,000 in about 50 days, enough to turn a bit of a profit and pay for the equipment he needs to produce the Emblm, his proprietary process to customize smartphone casing with designs or corporate logos embedded directly into phone parts. Raising the money would also prove his idea has legs because people who pledge their support also get their hands on a personalized cover.

The rapid validation of technology ideas — which seems to work particularly well with physical products because the Kickstarter/Indiegogo model is often based on pre-ordering — is one of the major benefits touted by fans of crowdfunding campaigns. Early backers of a product often become early customers in the process. The Pebble campaign — launched after University of Waterloo grad Eric Migicovsky couldn’t find traditional investors — attracted almost 70,000 backers, a pretty nice instant fan base for his smartphone-connected watches.

There are more than 450 crowdfunding platforms active in the world, according to an April report by research and advisory firm Massolution, which tracked a variety of initiatives including donation, rewards-based and pre-ordering campaigns as well as equity-based funding. It projected total crowdfunding will grow to US$2.8 billion this year, almost double last year’s US$1.5 billion.

The reason crowdfunding is popular with entrepreneurs is simple: It lets business owners tap into networks of people difficult to reach in the past and it sidesteps the complexities of raising money by issuing securities, something detractors of equity crowdfunding — which will soon be legal in the United States as part of the Jumpstart Our Business Startups (JOBS) Act passed in April — warn about. The U.S. Securities and Exchange Commission is in the midst of a 270-day rule-making and review period before the new legislation permitting companies to raise up to US$1 million from non-accredited investors comes into force, likely in early 2013.

While most observers agree that platforms such as Kickstarter and Indiegogo are a good way for startups to raise money, there is still plenty of debate about whether equity crowdfunding will be a similar boon for entrepreneurs. “The crowdfunding jewel is fool’s gold,” wrote U.S. entrepreneurship instructor Daniel Isenberg on the Harvard Business Review Blog Network in April. He warned purchasing stock in an early stage company is too complex to standardize and conducting due diligence will render the whole enterprise too expensive. Isenberg also questioned the presumption that crowds are innately wise, declaring them “stupid as often as not” and said the pooling of ignorance can produce unhappy results.

Money is money, but crowdfunding does not provide you with relationships and networks. They won’t get someone who works full-time on your business

Alan Hall, an investor and founder of Utah-based entrepreneurship organization Grow America, responded with his own article on the Harvard blog in May, acknowledging that crowd mentality can lead to foolish investing decisions, but he insisted crowdfunding can be an important means of filling a growing gap in early stage capital without forcing entrepreneurs to turn to credit cards or mortgage their homes. “Education is critical. Meaningful SEC guidelines are a must,” Hall wrote, reflecting the position of many equity crowdfunding supporters that investor protection can be achieved with adequate rules around governance in place.

But while the SEC wrestles with such guidelines, pre-public Canadian companies are unlikely to be able to sell shares to non-accredited investors (those whose incomes or net worths don’t meet minimum amounts set by regulators) any time soon.

The Canadian Securities Administrators, the umbrella group for the provincial and territorial regulators, is currently conducting a review on exemptions that allow a private company to sell securities without issuing a prospectus. The review could result in changes to securities legislation, with various provinces either tightening or loosening up the rules around the so-called “exempt market.” But it is not specifically looking at adding provisions to allow for equity crowdfunding. The chair of the CSA has indicated Canadian regulators are likely to take a wait-and-see approach while keeping an eye on how events unfold in the U.S.

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While Canadian entrepreneurs on both sides of the border may not yet be able to sell small equity stakes in their ventures to their virtual “friends,” they can use the Internet to pitch to accredited investors, whether professional or casual angel investors, anywhere in the world. For instance, Toronto entrepreneur Mark Organ, who had already built and sold one company (marketing automation software maker Eloqua Inc., which went public under new ownership in August), recently raised an eye-catching first round of financing for his new venture, Influitive, a marketing platform focused on leveraging online advocates and brand ambassadors. The funding was notable both for the amount — US$3.75 million, large for a seed/series A round — and that it came from about two dozen investors from around the world.

In addition to a dozen big-name venture capital firms, Organ says he attracted the backing of 12 angels, many of whom he connected with via AngelList, a website started in 2010 to connect potential investors with startups looking for money. It’s a U.S.-based site, but Canadian entrepreneurs often use it to link with investors and fill out a funding round. “Technologies are there to scale things like this more than was ever possible before,” Organ says. “A round like this is impossible without AngelList. You can’t possibly communicate with that many people effectively.”

Chris Fralic, a partner at U.S.-based First Round Capital, which co-led the Influitive funding round, says his firm often invests with multiple investors including angels, in what are sometimes termed “party” rounds, as long as there’s at least one engaged investor who will actively work to mentor the startup’s management. “The downside sometimes is what we would call club deals or headless deals where there are 10 logos but nobody’s in charge, nobody’s leading,” he says. “If things aren’t going well, sometimes you hear CEOs complain of phone calls not being returned… That’s the thing to be careful of.”

Mark MacLeod, a partner at Real Ventures, a Montreal-based seed-stage investment firm, shares Fralic’s concern about party rounds without a clear leader. He manages relationships with 10 of the 30-plus companies in his firm’s investment portfolio and says crowdfunding can provide a foundation for “proper institutional funding” but is not a replacement for it. “Money is money. But crowdfunding does not provide you with relationships and networks,” he says. “What they won’t get is me working full-time on their company, opening doors and facilitating fundraising, sharing war stories… they’ll just get money.”

Startups, of course, can also make friends with deep pockets in the offline world through the growing number of accelerator programs. There are more than 100 business and technology incubators in Canada, according to a list compiled by the Canadian Association of Business Incubation and updated in January 2012. Granted, only a handful of those are the classic, for-profit-style accelerators based on the model forged by U.S.-based YCombinator and TechStars, which take a small equity stake in exchange for some seed funding and a crash course in building a business. Most of the initiatives culminate in a demo day where startup founders have the chance to pitch their businesses to investors who sometimes number in the hundreds.

At their best, trusted accelerator programs can offer investors a solid crop of pre-screened and well-instructed teams with refined business plans developed over the course of the typical three-month incubation period. Sunil Sharma, managing director at Extreme Startups, an accelerator program in Toronto, says he focuses on creating quality deal flow and building a network of investors to increase the likelihood that startups attract investment.

Two of the companies in Extreme’s first batch of startups have landed backing from Valar Ventures, a fund started by original Facebook Inc. angel investor Peter Thiel. “No question, having that kind of investor as part of your syndicate gives you a lot of confidence, momentum and credibility as you grow your business,” Sharma says. “You’re able to demonstrate you’ve got a highly regarded, ultra-connected investment fund in San Francisco that’s coming all the way up to Toronto to look at early stage investments and actually making those investments.”

That type of social validation is also key when it comes to online crowdfunding, although it comes from the sheer number of investors as opposed to one big name. For instance, by the end of August, Smart Casing’s Sood had raised $2,500 from about 30 backers who had contributed to his Indiegogo campaign, which concludes Oct. 14. “It’s pretty clear that there’s a lot of noise out there on the Internet. Crowdfunding is just becoming another sort of spoke on that, so it’s difficult to capture people’s attention,” he says. He notes the Pebble smartwatch had a following prior to raising its US$10 million, momentum he believes helped propel it to become the most successful Kickstarter campaign to date.

“For the average entrepreneur or startup that’s doing a crowdfunding campaign, it’s actually very difficult to get that message out,” Sood says. A research paper on the geography of crowdfunding by Ajay Agrawal, a professor of entrepreneurship at the Rotman School of Management in Toronto, confirms this feeling. Agrawal and two co-authors specifically looked at crowdfunding pioneer Sellaband, an Amsterdam-based online platform that helps unsigned musicians raise money to make an album. Its model is similar to equity-based crowdfunding in that investors receive a share of the revenues from album sales (rather than a copy of the record or a T-shirt as they might with a Kickstarter campaign).

The study, conducted for the National Bureau of Economic Research in Cambridge, Mass., found that over the three-year period examined, most ventures did not get funded and the early money came predominantly from local investors for those that did. “The offline reputation of these people mattered a lot for getting the process started,” Agrawal says. “If you could raise $5,000, you were almost surely going to be able to raise $50,000.”

The often lauded democratization of capital may be well underway, but real-world factors such as relationships and trust still matter. “When we got into who those local investors were, friends and family played a really big role. It turned out it was just like regular venture capital where if you can’t get the people who know you best to put in money, then it’s much less likely that you’re going to be able to get other people to invest in you,” Agrawal says. “They know you better than anybody and their money sends a signal.” FP

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