In the past few years, raising money on crowdfunding platforms has become a pillar of more and more start-up business plans. An alternative to courting angel investors and venture capital (VC) firms for seed funding, websites such as Crowdfunder, GoFundMe, Indiegogo, Kickstarter, RocketHub, and others ideally grant entrepreneurs an outlet to fund their dream projects with altruistic donations and without compromising their creative vision.
If the creators launch a campaign with a great idea founded on a comprehensive business plan, the crowdfunding model gives the project decent odds of hitting its fulfillment goals. Although, when it comes to hardware products, that initial crowdfunding goal is but the first step to a solvent business.
There are currently more than 500 technology projects live on Kickstarter, spanning all manner of hardware and software. Although, according to the platform's own Kickstarter Fulfillment Report conducted by the University of Pennsylvania (UPenn), nine percent of Kickstarter projects failed to deliver their backers "rewards," meaning a campaign was completely funded but those who donated never received any of the promised perks or returns. UPenn surveyed 456,751 randomly selected backers over a sample size of 65,326 successfully funded projects from April 2009 through May 2015. The nine percent figure is for all projects but the technology projects percentage was around the same.
While the report's failure rates are consistent across projects labeled as "technology," the last several years have seen many high-profile crowdfunding flops across Kickstarter and other crowdfunding platforms, particularly around hardware products. The failures span projects from a $3.5 million Zano drone and a $300,000 Smarty Ring, to smart printer projects ranging from $1.5 million down to $88,000. Regardless of how much money these companies raised, they fell into systemic traps around upfront costs, manufacturing contracts, and shipping complications, leading to an insurmountable deficit in cash flow.
A recent example is the iGuardian home Internet security system developed by a start-up called ITUS Networks. Despite a fully funded campaign, a long list of pre-orders, press coverage, and interest from both brick-and-mortar and online retail stores, ITUS Networks CEO and founder Daniel Ayoub explained that his company is in limbo—more than a year after raising nearly $175,000 (far eclipsing its funding goal of $125,000), contributed by more than 1,000 backers.
"We have eager customers, a great product, we've gotten play in the press, but we fell into this trap to keep the wheels turning," said Ayoub. "When you're manufacturing and shipping a complex hardware product that you're selling at a low price, you're going to run into unexpected issues, and then your estimates and projections are going to change. When that happens, it's not like you can go back to Kickstarter for more money."
5 Post-Funding Obstacles to a Crowdfunded Hardware Business
Ayoub left his day job as a network security engineer in April 2014 to found ITUS Networks after helping his elderly mother-in-law fix her slow, old PC. On her machine he found more than 100 Trojan viruses from her having inadvertently clicked the same malicious download links. The subscription to her antivirus software had long since expired; she hadn't realized she needed to re-subscribe to stay protected. Ayoub realized there was a gap in the endpoint security market and launched ITUS Networks and the iGuardian to fill it, giving home users an enterprise-grade firewall system they never had to manually update; they simply had to plug it in.
"Businesses dealt with this kind of Internet garbage a long time ago but less savvy users still fall for it," said Ayoub. "It's just run-of-the-mill spam that casts a wide net. I wanted to make something affordable that's continuously updated once you plug it in and that gives you the same level of security that enterprises have."
From a holistic security perspective, the product addresses what security expert Dan Geer referred to in his 2015 RSA keynote as the problem around "perimeter control." This involves firewalls using decade-old Linux kernels, while the consumer firewall market has created a false sense of security as the so-called "hack surface" has increased with new classes of Internet-connected devices. Besides consumers and retailers, Ayoub said ITUS Networks also received interest in iGuardian from businesses looking to shore up the network security of their telecommuting workforce, protecting at-home attack vectors beyond traditional virtual private network (VPN) technology.
"Hardware has thin margins and we couldn't really get investors to sit down with us since we were targeting the residential market as opposed an enterprise or B2B products," said Ayoub. Instead, ITUS Networks chose to launch a Kickstarter. Ayoub stressed that the Kickstarter funding process itself was exactly as advertised; it gave the product consumer and press exposure, confirmed the market demand, and more than met the initial funding goal. The problems all occurred after the campaign successfully concluded in September 2014. Ayoub described the main obstacles the company has faced since then.
1. Estimates and Fees
From the moment the funding goal was met, Ayoub said money began coming off the top. Of the nearly $175,000 raised, Kickstarter first took its standard five percent fee (of approximately $8,750), followed by what Ayoub stated was another few thousand from the two to three percent in payment processing fees from Amazon.
Ayoub also designed the iGuardian CPU with a custom processor, Random Access Memory (RAM), flash, and interface specifications, a fact that, when brought to the manufacturer, resulted in dramatically higher product development costs than ITUS Networks initially projected, nearly tripling the manufacturing estimate. Thus, every iGuardian unit pre-sold on Kickstarter—for between $149-179 per device—came at a substantial loss.
2. Contract Manufacturing
Even after a successful Kickstarter campaign, finding a contract manufacturer to produce the initial order of iGuardian machines proved difficult. Ayoub said ITUS Networks found itself at a disadvantage in negotiations as an unproven company, and that the majority of manufacturers they approached required 50 percent of the order cost upfront, with anywhere up to a $100,000 minimum order.
"With the contract manufacturers there's no leeway with payment terms, especially for us where we needed custom manufacturing for a complex piece of enterprise tech," said Ayoub. To build the initial batch of compact home firewall devices with Ayoub's custom CPU design, the manufacturer with whom ITUS Networks contracted required between 12-20 weeks of lead time, adding several more months onto the period before the start-up could begin recouping costs.
3. Shipping Complications
ITUS Networks had enough capital to manufacture its first shipment but then came the matter of shipping the devices to backers all over the world. The start-up divided its domestic and international orders between FirstMile and Amazon shipping and sent the product shipment to those fulfillment companies. As the iGuardians made their way to destinations worldwide, Ayoub said a variety of unforeseen problems cropped up.
When customs forms were improperly filled out for various countries, those packages essentially went into limbo; Ayoub said it took weeks to track down where they had ended up. If the retail price of the item turned out to be wrong after exchange rates or taxes, the recipients had to pay duties upon delivery. Some—who assumed that once they had pre-ordered on Kickstarter wouldn't have to pay any additional fees—declined the shipment and the packages were sent back. All these international shipping complications led to further ballooning costs.
4. Are They Backers or Investors?
Throughout the process of re-adjusting estimates, manufacturing, and shipping the products, Ayoub said he felt constant pressure from his Kickstarter backers. The issue comes down to the ambiguity around the line between crowdfunding and traditional investment, one that's becoming ever more blurred given the U.S. Security and Exchange Commission's (SEC) newly approved Regulation A+ (RegA+) funding regulations and the hybrid crowdfunding/investment platforms emerging in the space.
"Kickstarter is an interesting phenomenon," said Ayoub. "There's a great divide between the folks that support the idea of bringing something into the world and those who see it as just a marketplace to find products. It's the difference between the backer who supports only our project and the backer who just donated to 20 different projects. I would constantly hear from 'investors' about taking our product at a loss."
5. The Vicious Cash Flow Circle
In addition to the months of manufacturing time, the brick-and-mortar and online retailers who expressed interest in ordering iGuardian units each required between 20-40 percent of the profit, and would only accept the shipment on consignment (meaning no payment until after the units are sold). Put all that lag time together and Ayoub said ITUS Networks was looking at six to eight months before any money came back in.
"After we built and shipped our first round, we didn't have money for the second," said Ayoub. "We have more demand than we can handle—backorders, pre-orders—but we don't have the capital to continuously manufacture the hardware. The only solution is significant capital for ongoing manufacturing for the product to turn over."
How to Fix the Process
While it's true the crowdfunding process doesn't build in safety nets for fully funded companies, part of the onus falls on entrepreneurs to prepare for unexpected complications that plague businesses of all shapes and sizes. Rod Turner, founder and CEO of RegA+ crowdfunding investment platform Manhattan Street Capital (and a veteran of multiple start-ups and VC firms) said the biggest reason many of these start-ups fail is because entrepreneurs aren't prepared for the sort of overnight success crowdfunding platforms enable.
"Part of the challenge is that in many cases, these young entrepreneurs with little experience didn't expect their idea to catch on this quickly, to be funded this quickly, and are faced with far faster success than they bargained for," said Turner. "They didn't have a set plan in place. It's like telling someone to get car insurance after they have an accident."
Even Ayoub, an experienced network security and information systems engineer, found himself unprepared for the entrepreneurial challenges a quickly crowdfunded start-up presents. Turner laid out four recommendations for hardware start-ups getting set to launch a crowdfunding campaign.
1. Stay a Little Cynical
Many entrepreneurs, especially the ones with a great idea, are often wild optimists, according to Turner. "Make sure there's someone on the start-up team who can think through the loopholes and help pre-emptively plan for the unexpected crisis."
2. Double the Budget
However much you're thinking of asking for in your crowdfunding campaign, double it, advises Turner. "Parts of the process are always going to cost more than you think so build in that cushion. Surplus can be re-invested into expanded features or helped to keep the business afloat later on."
3. Triple Your Manufacturing Time
Turner advises you to triple the time you think it will take to complete manufacturing because real life happens. "Manufacturing the hardware is always going to take longer and cost more, especially when it's an inexperienced entrepreneur believing the first estimate they can get, and basing their timeline on that manufacturer's projections of when it will be done."
4. Keep It Simple
"An entrepreneur should always be thinking about how to expand and improve their product—new features, a wider launch internationally, translated versions, etc., but in the early stages of manufacturing and selling your product, keep it simple," said Turner. "You will always find added complexity somewhere that didn't meet the eye, so in the first phase stay focused on success with a simpler approach. Tuck those additional feature ideas away for later."
On the other side of the equation is the opportunity for the crowdfunding platforms to begin offering wider post-funding business services. Turner said that in preparing small to midsize businesses (SMBs) for eventual RegA+ initial public offerings (IPOs), Manhattan Street Capital offers advice and mentorship throughout the process, and offers a list of resources including verified manufacturers, ranked by community ratings.
As for ITUS Networks, the start-up is still in limbo. Ayoub said the start-up's options are either to raise enough money to recoup costs, receive a large enough order to cover one or two full production runs and fulfill its back orders or to sell the company. As for how he'd revamp the funding and development process to prevent other hardware start-ups from encountering the same crowdfunding woes, Ayoub echoed Turner's point when describing how the crowdfunding platforms themselves could evolve to help facilitate business partnerships.
"One thing a Kickstarter could do is compile a list of contract manufacturers vetted and approved particularly for hardware," said Ayoub. "If we had a list of well-rated and willing manufacturers from which to choose, we wouldn't have been at such a disadvantage from a negotiating standpoint."
This sort of facilitator role is one crowdfunding platforms are in an ideal position to take ownership of. Kickstarter is already moving in the right direction, recently launching a list of verified manufacturing resources and a new forum for Kickstarter creators called Campus. The opportunity extends not just to manufacturing partnerships, though, but in more clearly defining whether backers should have an option to re-invest in a product (and whether legitimate investment is or is not a part of the future of these crowdfunding platforms), whether to offer additional financial consulting or cost estimate services or self-service tools to campaign organizers, and whether to allow organizers to revive campaigns and solicit a second round of funding.
Kickstarter has only been around since 2009; Indiegogo since 2008. Our modern conception of what crowdfunding is, the types of ventures it can support, and what the platforms facilitating it can do is still very much in flux. Businesses will rise and fall on their merits and the market, but it's a far more systemic problem when nine percent of successfully crowdfunded companies on Kickstarter flounder and fail to meet fulfillment once the platform is no longer involved.
Rod Turner is the founder and CEO of Manhattan Street Capital, the #1 Growth Capital service for mature startups and mid sized companies to raise capital using Regulation A+. Turner has played a key role in building successful companies including Symantec/Norton (SYMC), Ashton Tate, MicroPort, Knowledge Adventure and more. He is an experienced investor who has built a Venture Capital business (Irvine Ventures) and has made angel and mezzanine investments in companies such as Bloom, Amyris (AMRS), Ask Jeeves and eASIC.
Manhattan Street Capital, 5694 Mission Center Rd, Suite 602-468, San Diego, CA 92108.