Monthly Archives: October 2014

There is No Such Thing as a Free Lunch

article source anonymous Hamburger and potato freeI have counseled a number of companies in need of early stage funding to consider Kickstarter or similar campaigns, in which individuals contribute money to a company in exchange for very little (e.g. a t-shirt or a hand-written postcard that says “thank you”).  To the extent a company creates an effective campaign, the money need not be repaid nor does the contributor receive equity in the company—it’s free money.  Except when it’s not.

Recently a clever entrepreneur that I know launched a company to develop, market and sell a new electronic consumer product.  The product (which I will not describe to protect the innocent) was a break-through device that I, and many others, were interested in obtaining.  The entrepreneur created Kickstarter campaign to pre-sell the product.  In exchange for each $100 contribution to the campaign, the company promised to ship one of the products when ready.  The entrepreneur estimated that the product would retail for around $100 (with costs of goods at $50).

The campaign was a smashing success, with over 2,000 initial products sold (raising in excess of $200,000).  The entrepreneur then raised some equity capital on the strength not only of the $200,000 “free” seed money raised through the Kickstarter campaign, but also based on the big demand for the product.  Money in hand, the entrepreneur went about creating the product and building the company.

As (always) happens, the product took longer to develop and was more complicated to build than first imagined.  By the time the first commercial version was ready, the cost of goods had ballooned to $200, with a target retail price close to $400.  With time and volume, the company expected the price to drop substantially–maybe not all the way down to the initial $50/$100 range, but hopefully under $100 for cost of goods and under $200 at retail.  Because of the extended development time and increased costs, the company was also out of money and needed to raise a new round.

When new prospective investors analyzed the company, they saw a big problem:  the company “owed” its first 2,000 production units to the initial funders on Kickstarter.  Not only did that represent a $400,000 expense on cost of goods, it also would take up several months of initial production and shipping (at an estimated cost of $250,000 between outside production costs and inside burn rate).  Thus, the first $650,000 of new investment would have to go to pay for the past:  paying the costs of the “free” money raised on Kickstarter!  Needless to say, the funding did not get done.

While this is an extreme example of what can happen, it is a good reminder of the saying “money must be fed”:  no matter how one raises funding for a company, that money expects something in return.  Entrepreneurs have to make sure that they can provide those returns if they want to build a successful company.