Crowdfunding

Small businesses, entrepreneurs, and independent developers often face
difficulties in finding the requisite funds to put towards their projects.
Traditionally, these upstart business would seek help from investors, such as
venture capital firms, or put their own money towards these projects.

Specifically, in the video game industry, developers often rely on the capital
investment of their publishing partners. In turn, the publishers exercise a
certain degree of control over the content and overall direction of the upcoming
video game.

Developers who work independently of any current or prior publishing deals may
have the freedom to follow their own path with regard to video game development,
but they often do not have the capital to do so. The concept of crowdfunding
these upstart projects has made the prospect of independent video game
development more viable, but has also brought with it new risks and challenges.

Crowdfunding is the practice of financing a project through large numbers of
investors giving small investment amounts. [1] For example, if a project requires
$10,000, the crowdfunding technique would seek 1,000 consumers to give $10 each.
The traditional investment model would be to find one or two investors to provide
the $10,000 figure. So, rather than having large investment amounts from a small
number of investors, crowdfunding inverts that by acquiring investment capital
directly from the target market.

Often, this funding method uses the Internet as the means of directly reaching
the target market for the project. Crowdfunding is most often facilitated through
the use of a “Crowdfunding Intermediary”, which are regulated by the Jumpstart
Our Business Startups (JOBS) Act. [2] These intermediaries must register with the
Securities and Exchange Commission and follow certain regulations. There are two
forms in which a crowdfunding intermediary can be established: either as a broker
or as a funding portal. Both forms have different obligations under the law. For
example, a funding portal cannot provide investment advice or directly handle
investment funds. They merely function as a facilitator of investment. A broker
is not restricted in this regard.

But crowdfunding platforms that utilize the broker model are restricted by the
fact that only accredited investors may participate. This restriction lowers the
effectiveness of campaigns on these platforms. Some states, such as Texas, have
tried to exempt crowdfunding intermediaries from being subject to the traditional
securities regulations in order to attract small business investment and
entrepreneurship to their states. [3]

One of the major crowdfunding platforms today is “Kickstarter”, which operates on
what is known as a “donation-based model”. [3] Backers, or those who contribute
funding to projects on Kickstarter, receive no interest in return for their
donations and assume the risk that the project my fail to materialize.
Kickstarter does not guarantee the completion of products, thus the consumers are
on the hook when a project fails and can only seek legal action against the
developer, not the crowdfunding platform.

For example, sci-fi author Neal Stephenson ran a funding campaign on Kickstarter
to create a sword fighting game named “Clang” with ultra-realistic physics and
combat. [7] The Clang campaign successfully raised over $500,000. However, the
development of Clang was not as successful as the campaign. After two years in
development, the team spent all the money and Clang failed to materialize. The
vast majority of backers did not receive a refund or any material compensation
for the failure of the project. In fact, of the $500,000 that were spent in
development, a total of only $700 were refunded. Among those that contributed to
the project, at least 8 individuals donated $10,000 or more.

Other Kickstarter campaigns have failed in similar fashion. Yogscast, a popular
YouTube channel with over 7 million subscribers, partnered with indie developers
Winterkewl Games to develop an original game using the Yogscast brand. [5]
“Yogventures” would feature open-world gameplay and highly customizable gameplay.
In 2012, they launched a campaign to fund Yogventures on Kickstarter and garnered
over $500,000 from almost 14,000 backers. Two years later, Winterkewl had spent
all the money and had no game to release for that investment.

The Yogscast people proceeded to send an email to the Kickstarter backers,
notifying them of the failure of the project and offering to provide them access
to other similar games. They also distanced themselves from the project saying
that it was Winterkewl’s project and that were ultimately under no obligation
whatsoever to compensate backers of the failed project. That, of course, is
debatable but the simple fact is that backing a project on Kickstarter does not
guarantee success or compensation for failure. Over 200 people backed Yogventures
at $300 or more and 5 people backed the project at $10,000 or more. [6] There is
no indication that they will receive refunds or be compensated for those large
investments.

According to the Kickstarter “Terms of Use”, “the creator [of the project] is
solely responsible for fulfilling the promises made in their project. [4] If
they’re unable to satisfy the terms of this agreement, they may be subject to
legal action by backers.” Kickstarter does not oversee the performance of
projects or mediate disputes. There are no internal measures to guarantee final
completion or quality of the project, so any backers interested in taking legal
action would need to do so on their on time and on their own dime.

But while these Kickstarter campaigns are notable in how they fell short of their
lofty goals, other campaigns have seen success that probably would not have been
possible without this crowdfunding model. Games such as Shovel Knight, Volgarr
the Viking, and Mighty No. 9 exceeded their expectations, sometimes receiving
double, triple, or quadruple support in the campaign. Many of these games have
been funded and successfully released to critical acclaim, while others are soon
to be released.

Since the model is one based on donations and not traditional investement,
backers do not receive any additional compensation if a project exceeds
expectations. As pointed out by Kabir Chibber at Quartz, backers do not receive
additional or ongoing compensation for contributing to the success of an upstart
project. [7]

For example, Oculus Rift, an upcoming virtual reality device, launched a campaign
on Kickstarter to raise $250,000. However, the prospect of this product brought
in about $2.5 million from eager Kickstarter backers. A few months ago, social
media giant Facebook purchased Oculus VR for $2 billion. Backers will not receive
any additional compensation or stock in the company for their initial investment.
They will receive what they were promised in their reward tier and nothing more.

In a traditional investment scenario, investors would receive more return on
their investment if the project performed above expectations. Under the
crowdfunding model of websites like Kickstarter, backers are not investors in the
technical sense of a having a stake in the company or project. That means many
small businesses may find it more beneficial to have backers instead of
traditional investors in that they maintain more control and profit from their
work. However, this also means that serious investors may not see crowdfunding as
the optimal use for their capital.

Kickstarter also does not take responsibility for copyright violations. [4]
Specifically, Section 9 of the Terms of Use prohibits creating campaigns for
projects that contain copyrighted material for which the creator does not have
permission to use. The policing of this issue is up to the holder of the
copyright. For example, recently there was a dispute over two different modding games, one named Garry’s Mod and the other named Gmod. [8] This dispute was not dealt with internally at Kickstarter and any action regarding the use of the “Gmod” trademark needed to be handled externally. As such, Kickstarter may not be the ideal platform for modders to seek funding for their work due to the complex legal issues concerning fair use and derivative works. Modders could expose themselves to liability both from the copyright holder and from Kickstarter themselves for violating the Terms of Use.

Crowdfunding is an exciting, new business prospect that brings with it unique benefits and challenges. Backers as well as developers ought to be aware of the risks as well as the benefits of this platform when deciding whether to participate.

Sources:

[1]

http://www.forbes.com/sites/tanyaprive/2012/11/27/what-is-crowdfunding-and-how-does-it-benefit-the-economy/

[2]

https://www.sec.gov/divisions/marketreg/tmjobsact-crowdfundingintermediariesfaq.htm

[3]
http://www.strasburger.com/wp-content/uploads/2013/10/Texas_Crowdfunding.pdf

[4]
https://www.kickstarter.com/terms-of-use?ref=blog

[5]
http://www.polygon.com/2014/7/17/5912245/yogscast-kickstarter-failure-crowdfunding-risks

[6]
http://www.eurogamer.net/articles/2014-07-17-kickstarter-funded-yogventures-canned-backers-given-steam-key-for-another-game-instead

[7]
http://qz.com/268852/neal-stephensons-failed-500000-video-game-and-the-perils-of-using-kickstarter/

[8]

http://www.reddit.com/r/Games/comments/1dupnt/garrys_mod_creator_responds_to_gmod_kickstarter/

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~ by alanufl14 on October 5, 2014.

4 Responses to “Crowdfunding”

  1. Great post Alan. I’m intrigued by the Garry’s Mod situation, but it appears that this fight went in reverse – the GMod project, the latecomer to the “gmod” trademark, was the one attempting to sue the creator of Garry’s Mod. However, that’s a trademark law issue for another day.

    The interesting debate here is whether Kickstarter backers do – or should – have some sort of cause of action against the creator of the project. Kickstarter backers contribute money as a donation. I think that at most, they can reasonably expect their donation incentive, but I don’t think that they’re entitled to a completed project.

    They can expect the donation incentive because there is an actual promise there. “If you donate $25, I’ll send you a shirt and a digital copy of the game when it’s released.” On the other hand, there is no similar promise that the project will be completed. “Please support my development of this video game.” It’s a request, and people donate to support the developer. As poor of an analogy as this may be, if you give a homeless man $10 and tell him to go buy food, and he buys cigarettes instead, you don’t have any cause of action against him.

    Moreover, would it even be a good idea to create such a cause of action? Let’s assume that the developer met its one million dollar donation goal for the project and, in good faith, squandered all of that money on one legitimate copy of Photoshop. That developer may be in financial ruin now. Things happen. We shouldn’t be able to sue because the project failed. After all, in some sense, you’re not donating for a completed project – you’re donating to support the project. If that project fails, well, it needed more support in some form or another.

    As one final point – suppose there were no donation incentives and the project failed. What would you have felt entitled to in the first place? The opportunity to buy the game? What the Clang developer did was a nice public relations move, but they were under no obligation to refund anything.

  2. I agree Allen. Kickstarter has been of momentous achievements. I have personally benefited a great deal from kickstarter projects. I personally backed multiple projects including Divinity: Original Sin and Oculus Rift. In my opinion, it has been the single most influential website for the development of independent projects in our lifetime. Clearly, in my opinion, the risks are worth the rewards.

    Yet, will all that said I think you bring up a really good debate: should kickstarter the company bear the risk for failed projects. Obviously someone has to. Should it be the backers, the project creator or Kickstarter the company? There are good arguments for each. On this point, I completely agree with Trace. It is the backers who should bear the risk. Since this is a crowd funded project, it is often funded by hundreds if not thousands of people. Each backers generally stands to loose only a small amount (although there are obviously some excpetions.). Some may argue for a class action but I could see this completely ruining the Kickstarter system. In my opinion, the backers know they are taking a risk, they know the project may not be completed. It is more like a gambling than it is like a contract.

  3. Alan, nice work. The crowdfunding model is certainly a viable alternative to the typical venture capitalist route. In my opinion, the greatest downfall to securing investments through crowdfunding is the possibility of not being able to generate enough start-up revenue and facing a potential class action law suit if the project never materializes.

    Crowdfunding Intermediaries doing business as brokers, as opposed to those doing business as funding portals, face additional liability issues stemming from the fact that brokers generally owe a fiduciary duty if providing investment advice. It makes sense then for Kickstarter to shield itself from additional liability by registering as a funding portal on the JOBS form.

    Backers on Kickstarter face additional risks. As is true with many crowdfunding models, the Intermediary owes no duty to the backers supporting one of the many projects listed with the Intermediary. Backers must contribute at their own risk, and without any guarantee of project completion or return on their investment. Indeed, a true difference between the original venture capitalist model Alan referred to at the beginning of his post is that the original model permits the investors to become stakeholders. The success of the project directly impacts the success of the investors, so there is more incentive to donate more and give enough to the project to see it come to fruition. Developers using the traditional model must prove the viability of their project to investors in the same way that a small business applying for a bank loan must showcase a specific and legitimate business plan with sales projections, estimates, overhead costs, prospective lease agreements, etc.

    In contrast, developers using the crowdfunding model face less pressure. They do not need to outline as specifically the who, what, where, when, why, and how of the project in order to receive support from backers who are simply excited with the prospect of creating the program, product, game, or service. It is true that developers using Kickstarter must present some sort of business plan, but the difference is that each individual investment is small, for the most part, so those developers run less of a risk of significantly irritating their backers. Quite simply, I would rather owe 10,000 people $10 than owe 10 people $10,000.

    Our clients may face an issue with the Kickstarter policy that does not permit projects featuring (or including) derivative works, without the express grant of permission from the original developer. In our case, our clients have not provided the “open source” material, nor are they able to affirm that the material is truly open source. Therefore, using Kickstarter to fund a mod that may infringe upon the original developer’s copyrighted material may overtly subject our clients to backlash from the developer. A Kickstarter campaign gets people talking; if that buzz makes its way into the original game’s forums and the developers take note of it, our clients could face a DMCA takedown notice as well as take heat from many angry backers who pledged support to the project.

  4. Very nice post and thoughtful replies. I will add this piece to the discussion. Kickstarter recently changed its ToS, http://techcrunch.com/2014/09/19/kickstarter-updates-terms-of-use-section-related-to-failed-projects/ to tighten up requirements that the developer provide a finished product to the backers. While Kickstarter does not, at the moment, have liability if a project does not deliver, it still has its reputation AND its income stream to worry about. It wouldn’t take too many more of the huge failed projects such as the ones Alan mentioned for people to start becoming gun shy about donating to the Kickstarter projects. You can already see some of the reticence being discussed on blog sites such as Massively.com and Kotaku.

    It is also conceivable that the law could eventually develop in such a way as to hold Kickstarter responsible if it has been negligent in assessing whether a proposed project even has the possibility of being completed. That is not the law now, but in the State of Washington, prosecutors are looking closely at a failed Kickstarter project, not to assess liability against Kickstarter but to investigate what happened to the money. I see the possibilities in the same sense as when companies get hacked. There didn’t used to be liability for the company, now courts are beginning to examine whether the companies are negligent in not providing reasonable security safeguards.

    The sale of Oculus Rift to Facebook caused great consternation among the Kickstarter donor community on several levels. While it is true that the donor model doesn’t promise any equity, still the sale to Facebook violated the “spirit” of the Kickstarter community, once again causing donors to question the Kickstarter model. All that to say, the model is great, it allows players to particpate in getting games that they want to play to the market. Nonetheless, I think Kickstarter and others need to tread carefully and do all they can to encourage the developers to deliver a finished product. It is really just a question of self -preservation as far as I can see.

    As for the developing equity side of it, that is also exciting. It is clear that some from the Kickstarter community have the kind of funds that could be used to gain equity in the developing company. Ultimately, the requirements for those crowdfunding projects are going to be more stringent. How much more, we don’t know yet, certainly not as stringent as funding that requires SEC regulation and yet, the equity nature of it will surely require something more than the lack of protection Kickstarter provides. It will be very interesting to follow Texas and some of the states that have already ventured into equity crowdfunding to see what kind of legal problems pop up. So far, the projects I have backed on Kickstarter have done well. I am looking forward to trying the equity based model.

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