Kick-start a radical new funding model

The future of venture capital?

pebble watch 665Last year, Eric Migicovsky was scrounging for funding to mass-produce a smart watch. The 26-year-old Canadian and his small company had already built a watch that synced with the BlackBerry, but he was looking to produce a more advanced version to connect with iPhone and Android smartphones. Called Pebble, the smart watch would be able to display call, text and e-mail notifications, and allow the users to control music on their phones. Migicovsky, who relocated to Palo Alto, Calif., after graduating from the University of Waterloo, tried and failed to drum up funding from venture capitalists. Then he turned to Kickstarter, the crowd-funding website.

On Kickstarter, anyone can donate money to entrepreneurs, artists and other creative types seeking to raise funds for their projects. In exchange, backers could receive a finished product (as Migicovsky promised backers of Pebble) or a token of gratitude, such as T-shirts or tote bags. Migicovsky set a goal to raise US$100,000, which he figured would be enough to produce a thousand smart watches, and launched his fundraising drive on April 11, 2012. Within two hours, Migicovsky had already met his goal. By the next day, he hit $1 million. “Right from the day that we launched, it kind of exploded,” Migicovsky recalls. When the fundraising period closed a month later, nearly 69,000 people had donated a combined total of $10,266,845. (There are no funding limits on Kickstarter, which takes a percentage of the cash raised. Massively oversubscribed projects also make for good publicity, and many Kickstarter users anticipate that possibility by offering different rewards for various levels of funding.)

Pebble instantly became the highest-profile Kickstarter project since the website launched in 2009. Along with other crowd-funding websites, such as Indiegogo, Kickstarter has been a boon for musicians, filmmakers and video-game designers. But whether actual businesses can be built and sustained through crowd funding remains an open question.

The viability of crowd funding has taken on added importance as governments have begun promoting a new model, one that doesn’t depend on donations. Instead, upstart companies could sell equity shares in their ventures online to anyone, even unsophisticated investors. Entrepreneurs would gain easier access to funding, and the public would be able to share in their success. Donation-based crowd funding tends to be geared toward entrepreneurs selling a consumer product, whereas “equity crowd funding” potentially could allow a wider variety of startups to raise money online. The U.S. government passed legislation last year to allow equity crowd funding, and instructed the Securities and Exchange Commission to develop regulations around the concept. Various Canadian provinces are looking at it, too. The Ontario Securities Commission published a discussion paper in December to solicit feedback. While the concept isn’t explicitly prohibited in Canada, current securities regulations render equity crowd funding too expensive and cumbersome to be feasible, and so the OSC is examining what kinds of exemptions might be necessary.

The idea makes a lot of people nervous. Allowing startups to sell equity online to amateur investors under a light regulatory regime seems like a recipe for fraud. Columbia Law School professor John Coffee called equity crowd-funding legislation in the U.S. the “boiler-room legalization act.” But the startup community points to the already tough climate for funding, and argues the need to find a workable model for equity crowd funding is urgent in Canada, as the U.S. is already moving ahead. If we drag our feet, Canadian entrepreneurs will have even more incentive to head south.

As for Migicovsky, he knew that first day in April his plans had to change. His 11-person company, Pebble Technology, had already been working with a consulting firm to assist with manufacturing, and he immediately called to inform them that instead of producing Pebbles locally, as originally intended, they had to manufacture them in China. It didn’t take long to realize that given the volume of orders, and the complexity involved in co-ordinating the shipment of components, that the company would not be able to ship by September, as it had promised Kickstarter backers. Migicovsky disclosed the news in a blog update in July, almost as an aside. At first, the project’s backers were supportive, but as the weeks ticked by, they grew indignant. Some demanded their money back. The turning of some Pebble backers didn’t faze Migicovsky. “I’m a pretty focused guy,” he says. “We dealt with it by building the product,” he says.

In January, the company finally announced it was ready to start shipping, and Pebble smart watches have begun to find their way to their owners. Reviews have been lukewarm. Walt Mossberg from The Wall Street Journal found the product “generally helpful,” but “ran into a bunch of annoying bugs and limitations.” Migicovsky still has to release a software-developer kit to allow outside programmers to build on Pebble’s features. But many of its backers are satisfied, and the comments section on Pebble’s Kickstarter page are brimming with enthusiasm.

“It was certainly delayed,” says Ethan Mollick, a professor of innovation and entrepreneurship at the Wharton School, and a Pebble backer. “But it was a bit of a minor miracle that a bunch of people who have never done this before were able to arrange wholesale manufacturing for a new device and get it shipped from China.” Pebble’s future beyond fulfilling existing orders is anything but certain, of course, but its success thus far lends credibility to the notion that successful, lasting businesses can arise through crowd funding.

The project certainly taught us that one of the big challenges for crowd-funded projects to overcome is the propensity for delays. Last summer, Mollick published a study of 47,000 projects and found more than 75% were late. The reasons were not surprising: entrepreneurs can be inexperienced, overwhelmed and exceedingly optimistic about their own abilities. Consistent delays can potentially taint crowd funding in the eyes of the public, Mollick says, adding that entrepreneurs need to be more realistic about their goals, and that backers need to be more patient. One new service, CrowdHut, launched last year to provide entrepreneurs with guidance on everything from manufacturing to marketing to ensure expectations are met.

What’s more surprising is that Mollick’s study found less than 1% of the projects examined were fraudulent. “That’s kind of shocking,” he says. “This should be a scammer’s dream.” There is no regulation, and there is no obligation for entrepreneurs to actually live up to their promises. They can return money to backers at their own discretion, but Kickstarter can’t compel them. Crowd-funding portals vet projects before posting them, and Mollick speculates that because communities tend to form around projects, the constant dialogue and scrutiny from backers discourages and weeds out fraud.

His findings bode well for equity crowd funding, which may in fact allow backers more recourse than those who donated via Kickstarter should an entrepreneur fail to meet expectations. “With rewards-based crowd funding, there isn’t a body of case law,” says Andrea Johnson, a partner with FMC Law in Ottawa. Those who invest through equity crowd funding are shareholders, and Canada has reams of established case law that sets out what happens when directors and executives don’t fulfil their duties.

Failures are more likely than outright frauds. “As an asset class, returns are going to be negative,” says Daniel Isenberg, a professor of entrepreneurship at Babson College in Massachusetts. “It’s just like playing the lottery.” Even professional angel investors and venture capitalists, who devote countless hours and gobs of money to due diligence, strike out most of the time. It’s unrealistic to expect that an unsophisticated investor picking startup projects on the Internet will fare any better, and downright misleading to suggest that equity crowd funding allows the masses to participate in the next Google or Facebook, as proponents have done, Isenberg argues.

The concept could face additional challenges among Canadian investors, who might not have the appetite for it. “Canadians invest in real estate and gold mines,” say Rob Chaplinsky, managing director of VC firm Bridgescale Partners in California. Chaplinsky, a Canadian, has lived and worked on both sides of the border. “California is different. The west is the wild frontier, and people are willing to invest in risky companies and deal with the repercussions.”

Still, proponents argue that even if the concept won’t completely transform the funding landscape in Canada, it is worth pursuing. Gordon points out that the country is consistently slipping in international rankings of innovation. Venture capital investment in Canada hasn’t even recovered to the $2.1 billion invested in 2007, itself not a great year. Equity crowd funding is worth trying as just one tool to help foster startups, at the very least to keep pace with the U.S. and give Canadian entrepreneurs more reason to stay here. “It’s going to do more value than hurt,” Gordon says.

Perhaps ironically, Migicovsky hasn’t been following the developments with equity crowd funding in either the U.S. or Canada very closely. He still has tens of thousands of orders to fulfil. “We’ll just keep making Pebbles until no one wants them anymore,” he says.

A smarter watch

The emerging smart-watch category is getting crowded, and both Apple and Samsung are rumoured to be developing their own versions. Just about every model on the market today has shortcomings, so there’s still plenty of room for improvement.

Sony SmartWatch US$129

Sony promises owners of this watch, compatible with Android handsets, can take phone calls and check texts, e-mails and Facebook updates while looking “cooler than anyone else.”

I’m watch: US$469

Designed in Italy and billed as the world’s first “real” smart watch, this bulky device packs many of the same features as Sony’s watch, but it’s also iPhone compatible. Reviewers complain that it’s exceedingly buggy.

Martian watch: US$249–$299

A glorified speakerphone that can also read text messages aloud, Martian watches are at least relatively inconspicuous, designed to look like classic analog timepieces, not mini–smartphones.

MetaWatch: US$179–$299

The MetaWatch can’t actually make or take phone calls, but it does notify you when someone is calling. Same goes for text messages. E-mail and Facebook notifications are still in development, however.

Apple iWatch: Not available (yet…)

Rumours are flying that Apple is working on a smart watch made of thin, curved glass. Tech pundits speculate it could come equipped with many of the iPhone’s features, such as navigation, Siri and fitness-tracking apps. The company won’t comment on the rumours.