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ArtistShare is an example of what we call rewards-based crowdfunding. U.S. – based Indiegogo, launched in 2008, and Kickstarter, launched a year later, are now the biggest rewards-based crowdfunding sites in the world, in terms of visitor traffic.13 In addition to the arts (including fine art, comics, dance, design, fashion, film and video, music, photography, creative writing, theater), these sites host funding campaigns for social causes (animals, community, education, environment, health, politics, religion) and entrepreneurs and small businesses (food, sports, gaming, publishing, technology).

From its launch in 2009 to September 2014, Kickstarter hosted more than 180,000 funding campaigns, of which about 40 percent were successful. The 70,923 campaigns that succeeded raised a total of $1.335 billion from more than 7.1 million backers. That's about 100 backers for each successful campaign. About 27 percent of the campaigns raised more than $10,000, and about 2 percent raised more than $100,000. The business category with the most successfully funded projects on Kickstarter is – no surprise – music, followed closely by film/video, followed at a distance by art, publishing, theater, games, and nine other categories.14 Kickstarter charges a fee of 5 percent of the funds collected in a fully funded campaign.

Not all projects are funded, of course. In an all-or-nothing funding model, roughly 44 percent are fully funded based on their stated goals, while the majority walk away with nothing. All-or-nothing means that if a project does not reach its stated funding goal within a stated campaign period, the campaign fails and the funders' credit cards are not charged – and the platform earns nothing. (Indiegogo allows both all-or-nothing and keep-it-all campaigns. In the latter, the project may keep all the funds it raises even if the goal is not reached.)

Rewards for funders of Kickstarter projects, like those on ArtistShare and most other crowdfunding sites, are usually tiered according to the size of the contribution. The Chipolo campaign is a good example, although the reward schemes vary so widely that it's hard to say what's typical.

The Chipolo is a small, colorful, battery-powered Bluetooth chip that you can fasten to valuable belongings such as mobile phones, laptops, backpacks, cameras, car keys, or even a pet collar, so that you can locate them if lost. The Slovenian-American inventors call it a “virtual leash.” The chip connects wirelessly to a smartphone via the Chipolo app (for iPhone and Android), which you can use to locate the item with a beep within 60 meters, or on a GPS-based map anywhere. In fact, anyone with the app, not just the owner of the item, can use it (with the owner's consent) to find the lost item on behalf of its owner – making it a “crowdfinding” device. The Chipolo team established a goal of raising $15,000 in 25 days on Kickstarter, starting October 21, 2013, so they could manufacture and market a pilot production run. The team promised to reward backers as follows (not a complete list):15

• Those who contributed $19 or more would receive a first-run Chipolo (estimated retail price $35), free shipping worldwide, with a projected delivery date in December 2013. This slot was limited to 200 backers, and indeed 200 people pledged $19 or more within two days.

• Those who pledged $34 or more would receive a Chipolo chip and T-shirt.

• Those who pledged $99 or more would receive four Chipolos in their choice of colors, with their names imprinted on them.

• Those who pledged $2,999 or more would receive nine Chipolos with their names imprinted and nine Chipolo T-shirts, personally delivered by one of the Chipolo team members to any major city in the world.

It is important to note that more than 20 backers pledged amounts less than $19, which means they did not receive a tangible reward – they simply wanted to support the Chipolo team and its product. To run a successful crowdfunding campaign, said another entrepreneur who did just that, “You don't want to merely sell people a product, you want to sell them a dream.”16

A week after the Chipolo Kickstarter campaign began, the pledges already amounted to $100,000, which is more than six times their goal (“6x” in the vernacular of venture capital) – although nobody had yet signed up for personalized delivery. Backers suggested additional applications for the chip, some of which the team incorporated into the design.

Campaigners whose contributions exceed their goals get to keep it all (minus Kickstarter's 5 percent), under the assumption that they will use those funds to keep the promises they made to their contributors.

One of the most outrageously successful, and subsequently famous, Kickstarter campaigns thus far was the Pebble watch. A group of entrepreneurs in Palo Alto, California, created a digital, customizable “smart watch” that runs downloadable sports and fitness apps and connects wirelessly to an iPhone or Android smartphone. The innovative high-tech features of this product are too numerous to mention here. The team sought $100,000 during the funding period spanning April and May 2012. With a pledge of $99 or more, backers could preorder the Pebble, the retail price of which was estimated at $150. Pledges of $220 or more were rewarded with two Pebble watches, and so on. The campaign raised a whopping $10,266,845 from 68,929 backers (average pledge $149).17

The most successful Kickstarter campaign to date has been the Coolest Cooler, which raised $13,285,000 from 62,000 backers in 2014. The company's funding goal was $50,000. Notably, that company failed in its previous Kickstarter campaign.

Significantly, all rewards-based crowdfunding campaigners retain their intellectual property (IP) rights: patents, trademarks, copyrights. In other words, Kickstarter (based in New York City) is not a producer or publisher or marketer but a sophisticated intermediary that connects campaigners with backers and enables backers to communicate among themselves in order to assess the merits and prospects of the campaign.

New rewards-based crowdfunding sites are emerging that focus on a narrow product category or niche market. Experiment (originally Microryza), for example, is a crowdfunding site for hard-science research projects; funders are rewarded with “insight behind the science.” Teespring is a Kickstarter-inspired site for designers of custom T-shirts.

An entrepreneur who wants to raise money does not have to use an established platform like ArtistShare, Kickstarter, or GoFundMe to mount a crowdfunding campaign. Anyone with a WordPress-based website, in fact, can use a crowdfunding plug-in to host a campaign on his or her own website. (Self-hosting will not work in the equity crowdfunding world, as we will see.)

Backers assume risks. Even when projects are fully funded, there is no guarantee that the entrepreneurs will fulfill their promises to backers, or do so on time (at least two studies found that most projects miss their delivery deadlines18). In that sense, contributing money to a project is risky, but the promised reward is perceived as sufficient to justify the risk. One Seattle company, ZionEyez (which later changed its name to Zeyez), raised $343,400 from more than 2,100 backers in June and July 2011 to produce eyeglasses with built-in high-definition video cameras. The company ran into production problems and as yet has neither shipped a product to backers nor offered them refunds.19 Kickstarter does not mediate or intervene when funded companies fail to keep their promises.

Wisdom and Madness of the Crowd

You might expect that giving hundreds of thousands of dollars to a bunch of startups in exchange for promises of products that haven't yet been marketed would result in a high occurrence of fraud. The fraud rate appears to be quite low, however. Ethan Mollick, assistant professor of management at the Wharton School, University of Pennsylvania, concluded in a 2013 study of 48,500 Kickstarter projects that “less than 1 percent of the funds in crowdfunding projects in technology and product design go to projects that seem to have little intention of delivering their results.”20 Mollick believes that the low rate of fraud (at least this particular type of fraud) is a result of “the influence of the community,” by which he means the ability of backers and prospective backers to interact with each other, and with the campaigner, via comments and responses on the crowdfunding campaign's Web page. In other words, the continuous presence of the crowd and its highly social nature serve as a kind of screen or deterrent against possible abuses. The reason for the low rate of fraud on Kickstarter, for example,

is the persistent community built around Kickstarter projects, which allow many individuals (with verifiable real-world identities) to weigh in on projects, discussing the merits and probability of success of each project. 21

Such discussions are similar to those that “take place on other social media sites, blogs, and forums [as well as] Wikipedia and open-source software development,” writes Mollick, whose main areas of study at Wharton are innovation and early-stage entrepreneurship. “These communities play several important roles in improving offerings, preventing fraud, and making crowdfunding successful. In the case of Kickstarter, communities have successfully detected fraudulent projects.” The kind of fraud that Mollick addresses in his 2013 study is what we colloquially call “take the money and run.” To be sure, there are other kinds of fraud in the context of crowdfunding that Professor Mollick does not address in his 2013 study. For example, Sara Hanks, CEO of CrowdCheck (a due diligence service provider in the Washington, D.C., area), points out that intentional or negligent misstatement in a rewards-based crowdfunding campaign could form the basis for liability, and there have been a number of campaigns where such misstatements have been alleged. But Mollick clearly believes in the wisdom of crowds, in the context of both rewards-based and equity-based crowdfunding. Unfortunately, Charles Mackay wrote his book Extraordinary Popular Delusions and the Madness of Crowds 270 years before Kickstarter.

Oculus Rift Highlights the Difference between Rewards and Equity Crowdfunding

The distinction between rewards- and equity-based crowdfunding zoomed into widespread consciousness in March 2014, when Facebook acquired Oculus VR for more than $2 billion. Oculus had two years earlier run a successful Kickstarter campaign, where it raised more than $2.4 million.

On March 26, 2014, the Huffington Post posted an article with the intentionally naive title “I Backed Oculus Rift on Kickstarter and All I Got Was This Lousy T-Shirt.”

Oculus VR, based in Long Beach, California, is an “immersive virtual reality technology” developer. Its very first product was Oculus Rift, a virtual reality headset for 3D gaming, which looks like big, industrial-strength goggles that wrap around the eyes and ears. The company launched its Kickstarter campaign in the summer of 2012 with a relatively modest (in hindsight) goal of raising $250,000. Backers who pledged $25 or more would receive as a reward an Oculus VR T-shirt. Those who pledged $275 or more would receive an unassembled Oculus Rift prototype kit. Several steps up the pledge ladder, backers who pledged $5,000 or more got 10 kits (and a T-shirt, poster, and a few other things) plus a full-day visit to the Oculus lab. Seven backers went for it.

Oculus blew through its goal and raised $2,437,429 from 9,522 backers in about a month. The campaign closed on September 1, 2012. Backers eventually received their promised rewards. A consumer version of the Rift could be available in the spring of 2015. Everyone was happy.

Then venture capital firm Spark Partners and hedge fund Matrix Partners each invested $19 million in Oculus. Facebook finally bought Oculus for $300 million in cash, $1.6 billion in Facebook stock, and another few hundred million in incentives (subject to Oculus meeting certain milestones). When that happened, the value of those equity investments by Spark and Matrix grew to about $380 million each, a 20x gain in less than a year.

The Kickstarter backers had not bought equity in Oculus, but some of them posted crabby and even angry messages on the Oculus Rift Kickstarter page (and elsewhere). One backer, for example, wrote: “You selling out to Facebook is a disgrace. It damages not only your reputation, but the whole of crowdfunding. I cannot put into words how betrayed I feel.” The gist of most of the complaints was that the early backers deserved better rewards because they helped Oculus shareholders strike it rich.

Mo Koyman, a partner at Spark Capital, responded to the ruckus by explaining: “Just because people say ‘Well I want equity in this company’ doesn't mean it's available. I don't think the Kickstarter backers were backing it because they wanted a financial win… They wanted to try it, wanted to experience it, wanted to see it. They got exactly what they bargained for.”22

Business media outlets took the opportunity to explain that Kickstarter is not an equity-based platform, and the law did not allow average investors (the crowd) to buy equity on any kind of platform in the United States at that time, so backers (who received the rewards they expected) had no right to expect capital gains from their contributions. Bloomberg posted an article on the same day as the Huffington Post story, in which it distinguished between rewards-based Kickstarter and equity-based CircleUp. Bloomberg said that CircleUp “is among crowdfunding sites focused on letting individuals buy stock in startups,” and quoted CircleUp's CEO Rory Eakin, in a plug for equity-based crowdfunding: “Imagine if those early [Kickstarter] supporters were equity investors …”

Rewards as a Gateway to Equity

As the Oculus Rift campaign on Kickstarter demonstrated (see sidebar), rewards-based and equity-based crowdfunding are two very different animals in terms of what you can expect in return for the funds you provide to startups. You can't buy equity in companies listed on Kickstarter, and, beyond the specific reward you sign up for, you can't share in the upside if the startup you fund gets acquired by Facebook for billions of dollars.

Even if your aim is to be an equity crowdfunding investor, by first exploring a few rewards-based crowdfunding platforms you can learn a lot about the crowdfunding infrastructure and vernacular, the social media aspect of crowdfunding, and the collaborative nature of the crowd. It is a valuable orientation that will not cost you much. We recommend that you at least browse through the projects seeking backers, read the updated funding stats and comments posted by other visitors, and then register on the portal that you like most and spend a few tens or hundreds of dollars to experience the process. Perhaps acquire some new music or gadgets while you're at it, and maybe have more fun than you expected. See how it feels to be a member of a crowd. You can find various lists of crowdfunding sites (including “top 10” lists compiled by Forbes, Entrepreneur, GoFundMe, and others) by searching for “crowdfunding sites” on a search engine.23

We strongly recommend that before you risk thousands of dollars investing via equity-based crowdfunding, you should become familiar with the crowdfunding concept and process in a relatively risk-free environment like the rewards-based version. Rewards-based crowdfunding platforms like Kickstarter can be good training, from a navigation and social point of view, for equity-based crowdfunding portals. We will help you learn the investing aspects of equity crowdfunding in later chapters.