Sarah Dvorak was desperate. The former retail executive had depleted her savings accounts, borrowed from family members, and secured a microloan from a local development group to launch Mission Cheese, a San Francisco café that would specialize in domestic products like Minnesota-made Camembert and a silky sheep’s-milk cheese from Northern California. But three weeks before opening day last spring, she still didn’t have refrigerated cases to store and display her fare. Despite having cobbled together $225,000 to start her business, she had come up $12,000 short. So she turned to Indiegogo, a San Francisco-based site that allowed her to appeal directly to the public for money. “Within one month, I had the funding I needed,” Dvorak says. “I was in tears.”
Welcome to the new world of fundraising, in which so-called crowdfunding websites like Indiegogo and Kickstarter let just about anyone with an idea try his or her hand at bankrolling a dream. Proponents of crowdfunding believe it has the potential to upend traditional financing models, such as loans and venture capital, and unleash a tidal wave of capital for entrepreneurs, creative types, and, yes, cheesemongers. Reliable estimates of the industry’s size are hard to come by, but one research outlet, Massolution, predicts some $5 billion will be raised through crowdfunding this year, up from $2.7 billion in 2012.
This thoroughly modern, highly democratized approach to finance still has a Wild West feel to it, and many crowdfunding pioneers hope it stays that way. They want people to be able to use the web to fund virtually anything, from fertility treatments to puppetry-school tuition (for real). But as more for-profit enterprises seek to raise money, regulators are stepping in to make sure small investors are protected — and rewarded — for their risk taking, just as in traditional finance.
The two largest crowdfunding sites, Indiegogo and Kickstarter, offer very different glimpses at the future of the nascent industry. Indiegogo, founded in 2008 by a former securities analyst and others, supports a new law that would enable equity crowdfunding, or the ability of nonaccredited investors to actually own a piece of the fledgling companies found on this type of site. Until now, the only returns given to individual backers were perks like shoutouts and signed copies of products (or, in Dvorak’s case, gift cards and Mission Cheese T-shirts).
Equity crowdfunding “offers promise that future successes can get off the ground, when in the past they wouldn’t have had that opportunity or would have had to limp along as they bootstrap themselves,” says Harvard Business School professor and innovation guru Clayton Christensen. “For entrepreneurs in underserved niches, it will make a world of difference.”
Indeed, when Danae Ringelmann started Indiegogo, she hoped to help founders whose products were too focused or obscure to attract venture capital or even angel money or bank loans. “In the past, it was dependent on who you knew — friends and country clubs and going to the Hamptons,” says Ringelmann, who spent six years as an entertainment industry analyst at J.P. Morgan and Cowen & Co. Originally focused on small film projects, Indiegogo has now helped fund more than 100,000 initiatives around the world, from sex-toy inventors to a London-based café that caters to human patrons and their feline friends. Last year the first “crowdfunded baby” was born, after a couple from Florida launched an Indiegogo campaign to raise money for fertility treatments.
Indiegogo gets a 9% fee on any money raised through its site, though it takes a smaller cut (4%) from campaigns that manage to reach their fundraising goal. True to its mission, it has become the Android of crowdfunding sites — an open platform that lets just about anyone try to fund anything. There’s no waiting time for applications to be approved, and the only banned projects are ones that are against the law. In the spirit of giving more open access to capital to all entrepreneurs, Indiegogo plans to let people exchange equity for funding when the practice becomes legal. Ringelmann is not quite sure how it will work because the exact rules have yet to be published by the Securities and Exchange Commission, which would help regulate and monitor equity crowdfunding. But she says opening the doors to small investors is a natural fit with Indiegogo’s democratic ethos. “Finance has a bias toward mainstream, in order to make the numbers work,” says Ringelmann. “But if there’s a niche audience that wants to fund something, then they should have every right to do so.”
Kickstarter also positions itself as an alternative to mainstream finance, but it isn’t interested in opening its site to investors in search of a monetary return on investment — it sees that as a contortion of its original vision. “We aim to be as open as possible while protecting the health and creative spirit of Kickstarter for the long term,” the company says on its website. CEO and co-founder Perry Chen declined to comment.
The site, which was launched a year after Indiegogo, does provide something of a safety net to the individuals who decide to back Kickstarter projects. Pledged money is collected only if entrepreneurs or artists meet their fundraising goals. (Kickstarter’s cut is 5%.) And Kickstarter serves as a curator, rejecting applicants who don’t meet its guidelines. The company has positioned itself as a site for “creative projects,” and about 25% of Kickstarter proposals don’t make it onto the site: Cosmetics, sunglasses, and weapon accessories aren’t allowed, nor are “causes.” Mission Cheese’s Dvorak, for example, was rejected by Kickstarter because at the time she applied, the site didn’t accept efforts in progress. If Indiegogo is an open platform, Kickstarter is like Apple’s iOS.
Gadgetmakers in particular have had a tough time on the site because of new and more restrictive guidelines, as have some of their backers, who have been disappointed with occasional lengthy waits for hardware products that are their rewards for funding a project. “There’s a misunderstanding, as many people think it’s some kind of store and they’re in line for a product,” says Kitae Kwon, a Silicon Valley-based entrepreneur who was almost a year late shipping his docking station for MacBook Air laptops to backers on Kickstarter. “When they don’t get it [immediately], they get upset.” Nevertheless, Kickstarter has given birth to some high-profile hits, most notably the Pebble smartwatch, which raised more than $10 million on the site. The star and writer of the discontinued television series Veronica Mars turned to Kickstarter to raise money for a movie based on the show.
While Indiegogo and some other sites believe crowdfunding not only can help entrepreneurs become profitable but reward investors too, Kickstarter isn’t promoting its projects as moneymakers for investors. (Of course Kickstarter itself is a for-profit company that raised a reported $10 million in venture capital funding in 2009.) “Kickstarter has a good thing going, and it makes sense that they wouldn’t want to change,” says Jason Best, co-founder of Crowdfund Capital Advisors, a consulting and advisory firm that has pushed for equity crowdfunding.
The prospect of equity crowdfunding has prompted concerns about online fraud and bad investment decisions by inexperienced investors. (A major critic of the new measures: the North American Securities Association.)
The web has long been a place where consumers need to tread carefully, and crowdfunding (equity or otherwise) is no exception. Surely there are people who experience remorse after donating money to send a stranger to puppetry school.
But for those who want to join the crowdfunding party, there are a growing number of ways to find just the right person or project to back. A new wave of specialty sites includes CrowdSupply, a site that specializes in design and distribution of crowdfunded products, and Microryza, which focuses on scientific projects. There’s even a new website, Teespring, that bills itself as a “Kickstarter for T-shirts.” Perhaps a crowdfunding site for artisanal cheese ventures is not far off.
This story is from the May 20, 2013 issue of Fortune.