How to crowdfund without losing your shirt

Campaign supporters fork over millions of dollars on rewards-based crowdfunding sites in exchange for goodwill, a trivial reward like a T-shirt or, some say, nothing more than an empty promise.

The crowdfunding sector grew to $2.7 billion in 2012—financing more than 1 million campaigns globally, according to an annual report on crowdfunding from Massolution. That figure is expected to rise 81 percent to $5.1 billion in 2013.

Are crowdfunding scams set to rise at the same rate?

Barbara Roper, who oversees investor protection for the Consumer Federation of America, said it's troubling when people donate large sums to crowdfunded projects for the sole purpose of receiving a reward, because there's a good chance that the venture will fold. "The potential for confusion, misunderstanding and resentment is significant in this space," she said.

Oculus VR, the virtual reality company and wildly successful Kickstarter campaign acquired by Facebook, is a case in point—not of a scam, but of how even a project with honest intentions and clearly stated rewards can end up leading to confusion and a backlash.

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Oculus delivered rewards, as promised, but its backers didn't think that was fair compensation once it was acquired by Facebook for $2 billion. Oculus employees received death threats after the deal, according to comments posted by Oculus founder Palmer Luckey on Reddit in April.

"Everybody was going to the company and asking, 'Where is my cut of the Facebook deal?' It got really ugly," said Stephen Ma, a partner with Early Sullivan Wright Gizer & McRae who has worked with various start-ups and in securities litigation. Many of the problems he has witnessed are with rewards-based projects and result from individuals who lack basic crowdfunding literacy. "If people don't understand what they're getting into, it starts to get problematic," Ma said.

Oculus owed its backers nothing more than its stated reward—that's the distinction between reward-based projects and equity crowdfunding. Excluding equity crowdfunding—where users fund projects in exchange for an equity stake—there are three main categories of crowdfunding: donation, rewards and preorder of a product to be manufactured.

There is limited research on abuse of crowdfunding platforms. Ethan Mollick, a professor at The Wharton School, found in a recent study that more than 75 percent of non-equity campaigns are late delivering on their promises, but less than 0.1 percent of crowdfunded campaigns have been intentional frauds.

"The danger of fraud is pretty low, but there's a good chance that your products will be delivered late and potentially in a slightly different form than you originally intended," Mollick said.

The distinction between a legitimate delay and potentially fraudulent project isn't well understood in these early days of crowdfunding. That's a key distinction, though, because failure is not the same as fraud, and many more projects fail than set out to intentionally defraud, Mollick said.

Kickscammed, a site devoted to exposing cases of alleged crowdfunding scams on Kickstarter, said it has tracked more than $2 million in Kickstarter scams since it launched in March. Kickscammed founder Justin Mitchell said the actual figure is probably higher.

Mitchell investigates each user report on a potential crowdfunding scam submitted to Kickscammed. While some projects are deemed to be honest delays and are not added to the total tracked by the site, Mitchell said there are also projects that have not been reported which would likely send the total figure for alleged scams higher. Mitchell pointed to Geode, a 2012 "digital wallet appcessory" for the iPhone that raised $352,000 but has yet to deliver: The company's website states it is currently under construction. "That's $350,000 right there," Mitchell said.

Among the 36 Kickstarter projects Mitchell has personally backed, he said five have failed to deliver promised rewards and three have "totally disappeared," he said.

"I got fed up with losing money on Kickstarter and wanted to build something to simply bring attention to the issue," Mitchell said. "I think a lot of backers see that they lost $10 and don't care, but don't really see that the creator ran off with $250,000. I wanted to basically show Kickstarter that if this goes left untouched, their site will become a free-for-all for scammers." He added, "Kickstarter is not doing anything. They have refused to do anything. So the biggest thing you can do right now is prevention."

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A Kickstarter spokesman declined to comment on the Geode project, specifically, but said Kickscammed figures are false and misleading. He declined to provide internal figures for frauds that it has uncovered, or to suggest any other source of data on projects beyond the Wharton study. The Kickstarter spokesman said that several staffers work on its "trust and safety and moderation teams" and they use complex algorithms and automated tools to identify and investigate suspicious activity, but he declined to quantify how many projects it has suspended after internal investigations.

"While Kickstarter's not a store, after five years and 150,000 projects, creators on Kickstarter have an incredible track record bringing new and untested ideas to life," the spokesman said. Kickstarter allows users to report projects for violations of its terms of use, as well as trademark and copyright violations. It also offers a basic overview of what project backers can expect.

Doug Ellenoff, a partner at Ellenoff Grossman & Schole who worked with the SEC and FINRA to guide the implementation of investment crowdfunding in the JOBS Act (Jumpstart Our Business Startups Act) and whose firm represents the Crowdfunding Intermediary Regulatory Advocates, said, "Yes, it's a possibility that someone could just take the money and run, but by and large it hasn't been the case." Ellenoff said the larger platforms "are the ones who have already seen [fraud] and have implemented the best antifraud techniques."

In May, Washington State Attorney General Bob Ferguson filed a consumer protection suit against entrepreneur Edward Polchlopek III and the company for which he served as president, Tennessee-based Altius Management. In September and October 2012 its Kickstarter campaign to create the Asylum Playing Cards—retro-horror themed cards designed by a Serbian artist—raised more than $25,000 but to this day has not delivered goods to a single consumer who backed the project. Among the backers were 31 people living in Washington State.

"Consumers need to be aware that crowdfunding is not without risk," Ferguson said in a statement. "This lawsuit sends a clear message to people seeking the public's money: Washington State will not tolerate crowdfunding theft."

The Kickstarter spokesman said the platform "wants every backer to have an amazing experience, and we're frustrated when they don't. We hope this process brings resolution and clarity to the backers of this project."

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Commenters on the Kickstarter page of a project Mitchell personally backed have been sending complaint letters to the Texas attorney general. The project to create a printer was successfully funded in September 2012 with more than $88,000. The project creator has not logged onto his Kickstarter page since a December 2013 update that stated the first shipments were almost ready.

Mitchell recommended that Kickstarter create a rule that stipulates a time period—and time out—for a project and offer refunds: "If a creator hasn't updated their profile in X amount of months, they need to reach out and find out what's going on. ... If a project hasn't delivered in X amount of days past the delivery date, then they need to be offering refunds. ... You can update a project for seven years straight, saying, 'We're shipping next month,' and that would completely satisfy Kickstarter's terms," Mitchell said.

Mollick said a crowd may be the best safety mechanism in crowdfunding—he contends fraud mostly happens on platforms that have less "eyes on them," making it easier for fraudsters to go unnoticed.

"Its fine to fund projects listed on unknown sites … but ask them why they choose that particular platform," Mollick said, adding that projects aimed at a specific niche market tend to work well on smaller platforms.

The Geode campaign with near 1,800 backers donating $352,000 suggests there is no single, simple measure that can be relied on, while the Washington State case against a Kickstarter campaign and Kickscammed suggest that it's far from hard science to say larger platforms are safer.

Mollick said the Geode campaign is a good example of the kind of projects that fail and receive negative attention—they raise a lot of money, more than expected in many cases, and have ambitious goals. But he said that having watched the space develop in the past few years, it's the same projects that show up in negative mentions over and over again. "The impressive thing isn't the scams, it's the lack of them," he said.

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There is no science of crowdfunding due diligence. Indeed, Ma said backers should "do a gut-level check" and assess if they truly trust the project and its ability to deliver on promises. "If it sounds too good to be true, it usually is," Ma said. He added that while crowdfunding fraud cases may have legal standing, "lawsuits won't help if you've already lost your money," because of legal fees and court cost.

Jason Best, who co-authored the framework for the U.S. JOBS Act to legalize equity- and debt-based crowdfunding, said there is no substitute for due diligence. "It all starts with a basic Internet search," he said. "Type in the name of principals in the project, coupled with the word 'fraud.' ... Dig into their background."

It's best to invest in projects that relate to technologies or industries with which an individual has knowledge, but if you don't know a lot about the industry, read the comment section of the campaign to see if industry professionals support the project, Best said, adding, "Is the company responding to questions completely, quickly and in a way that's honest and fair? If they're not responding in a few hours, I think that's a red flag."

Mollick said expertise in a specific area is what often attracts people to projects, and that can also help to weed out any suspicious projects before it is too late. This was the case in a famous Kickstarter scam that has made the rounds of the press—a Kobe Beef jerky campaign, which was pulled by Kickstarter right before it reached its goal (and would have been able to collect the $120,000 it raised). The Kickstarter community ultimately "self-policed" the campaign to discover that its creators didn't have the background or appropriate knowledge in the subject area to be legitimate.

"Small companies have a very high failure rate, so there is a very big risk that most crowdfunding investors will lose some, or all, of their money," Roper said. "You're dealing with people who may not understand those risks and cannot afford the losses."

Kickscammed's Mitchell said he doesn't believe he is the right person to vet projects—in fact, the company where he works as a software engineer, NXT-ID, trades as an OTC stock and has created a digital wallet product that it is accepting preorders on its own website and states a delivery date of September 2014, similar to a crowdfunding campaign. But Mitchell said he created the site to fill a void in the crowdfunding market. "I'm absolutely not the right person [to investigate crowdfunding scams]. I don't think there is a right person. … There is little insight besides reading the comments and reading updates," he explained.

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Basing an analysis of project intentions based on user reports certainly has its limitation as far as exposing potential fraud. "People love to complain online," Mollick said.

As it stands now, consumers' financial well-being doesn't typically depend on the outcome of these transactions, but when you start using crowdfunding as a way to invest in companies, it changes what's at stake, Roper said.

Roper added that more lawsuits could arise once online equity crowdfunding enters the equation—the Securities and Exchange Commission is expected to issue rules in the foreseeable future.

Her advice to people worried about being swindled: "Don't put any money into it that you can't afford to lose." Or, she said, just stay away from crowdfunding.

—By Karma Allen, CNBC.com