Why investors are pouring millions into crowdfunding

April 17, 2014, 10:47 PM UTC

FORTUNE — There is no shortage of evidence testifying to the value of crowdfunding for those seeking to finance a new product idea, company, or even personal need. Just this month, Kickstarter-born Oculus VR was snatched up by Facebook for $2 billion. Smartwatch-maker Pebble sold more than 400,000 of its crowdfunded smartwatches last year. And in March, Kickstarter surpassed $1 billion in pledges made.

In all, crowdfunding platforms have raised some $2.7 billion and successfully funded more than a million campaigns in 2012, according to a Massolution report, with an 81% increase to $5.1 billion expected for 2013. By 2025, the global crowdfunding market could reach between $90 billion and $96 billion — roughly 1.8 times the size of the global venture capital industry today, according to a 2013 study commissioned by the World Bank.

At the same time, there’s another level of funding going on: for the crowdfunding platforms themselves. Indiegogo, Crowdtilt, Patreon — to name just a few — may seem like grassroots efforts, but they’re doing remarkably well at drawing investments of their own. Indiegogo raised $40 million in a Series B round in January. Not long before, Crowdtilt garnered $23 million in its own Series B. Arts-focused Patreon pulled in $2.1 million in a seed round last summer. And the list goes on.

Investors are enthusiastically getting behind crowdfunding platforms. Why?

Assisting entrepreneurs and NGOs

One reason is that investors see potential for these platforms to reach untapped markets. It’s not unlike the impact wrought by Muhammad Yunus, who brought capital deployment to the un-banked through microcredit funding, Michael Berolzheimer, managing partner at Bee Partners, told Fortune. “We see similar transformations taking place within crowdfunding,” Berolzheimer said. Bee Partners participated in Indiegogo’s $15 million Series A round in 2012.

“There’s a need to facilitate transactions amongst campaigners and their investors [or] benefactors, and so there’s absolutely money to be made in crowdfunding via commissions,” Berolzheimer added.

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Crowdfunding platforms are also useful for organizations that don’t need the same transactional infrastructure that a large enterprise might need, according to Wayne Kimmel, managing partner at SeventySix Capital, which also invested in Indiegogo.

“I believe that the democratization of fundraising through crowdfunding is an incredible breakthrough for entrepreneurs and nonprofits,” Kimmel said.

Expanding early-stage financing

There is also potential in equity- and debt-based crowdfunding. Sherwood Neiss, principal with Crowdfund Capital Advisors and co-author of Crowdfund Investing for Dummies, believes that it is “going to transform the early-stage financing industry in much the same way that Facebook transformed the social network industry. People investing in these crowdfunding platforms see the potential not only in these companies, but in the early-stage financing industry as well.”

Consider: Investor Peter Thiel “was able to get into Facebook early on at a $5 million valuation, [but] the public wasn’t able to get in until the IPO at a $104 billion valuation,” Neiss said. “These early investors in crowdfunding platforms are betting on who will be the next Facebook of the crowdfunding industry and hoping for that same ROI. These platforms will be processing billions of dollars shortly, and investors want to be behind the winning ones.”

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Jules Maltz, a general partner with Institutional Venture Partners, believes that crowdfunding platforms “have the potential to be massive businesses in the future.” Maltz said IVP invested in Indiegogo because “we believe in the company’s mission to democratize funding” — but equally because Indiegogo shares in the success of the campaigns it hosts, thus “building a large marketplace business with strong financial metrics.”

“[Marketplaces] often have winner-take-all dynamics, with the best campaign owners and contributors going to the largest platform,” Maltz said. “We believe Indiegogo is positioned to win in the market because of its strong team, open and flexible model, and differentiated technology.”

Shades of social media

Some investors see similarities between the rise of social media, which helped connect millions of people to each other, and crowdfunding platforms.

“At CRV, we often invest in emergent behaviors that may seem niche or ‘grassroots’ at the time, but we believe can go mainstream,” said Charles River Ventures‘ Annie Kadavy. “Twitter is a good example of that — we were the first VC investor and, at the time, it was an obscure niche community. Social networking more broadly started out the same way and, just as Facebook was not the first-and-only social platform to reach scale, we don’t think Kickstarter will be the first-and-only crowdfunding platform to go mainstream either.”

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Charles River participated in Patreon’s seed funding round last year.

“Part of what makes many crowdfunding platforms interesting to investors are their unique P&Ls,” Kadavy added, using the acronym for profit and loss statements. “Specifically, a crowdfunding platform’s sales and marketing spend can be effectively zero, as the users of the platform do the selling/customer acquisition for them. So, aside from credit-card processing fees, crowdfunding platforms can be extremely low-cost businesses to run. If Kickstarter was a public company today, it could be worth $500 million-plus, given how profitable it could be.”

A question of scale

But it’s scale that determines just how profitable a crowdfunding platform investment would be, investors said. Though Indiegogo is the largest — 200,000 campaigns and growth of more than 1,000% over the last two years, Maltz said — others aren’t quite so successful.

Do the numbers still work out?

“If I do some quick back-of-the-envelope math using the Crowdtilt numbers quoted by Forbes last December that ‘the average project on Crowdtilt raises $1,300 from 17 people,’ they would need to do about 1.5 million campaigns to gross $100 million to the platform itself,” Kadavy said. “That is, $1,300 per campaign times the 2.5% fee paid to Crowdtilt times 1.5 million campaigns. That equals approximately $100 million revenue to Crowdtilt.

“If I go one step further to assume that approximately one-third of people contribute to more than one campaign — this is what it is on Kickstarter, according to their 2013 Annual Review — that gets me to 8 to 9 million people.”

Through Charles River has not invested in Crowdtilt, Kadavy said that using it as an example shows that “the question becomes: Is that level of scale feasible? I think so.”

‘A&R for everything’

David Hirsch, managing partner at Metamorphic Ventures — which led Indiegogo’s seed round — likens crowdfunding to what the music industry calls A&R, or artists and reptertoire. “If you look at the music industry, there was this whole layer of people who used to go out and scout bands,” Hirsch said. “It was the coolest job in the world.”

Crowdfunding is a sort of “A&R for everything,” he said, in that it helps the winning ideas rise to the top. That applies not just to content but also to products, Hirsch said. “Crowdfunding is becoming a ‘petri dish’ of user demand that commerce companies will, if they’re smart, use as a sort of old-school A&R for product development,” he said.

Metamorphic became “very excited” about Indiegogo “because of the payment opportunity,” he said. “On one end, it’s fostering innovation; on the other, money is transferring.” The business model seemed sound. Still, unlike an investment in the car hire startup Uber where “we could say, ‘if we disrupt the market X percent, an investment makes sense at this price,” it wasn’t possible to “back into a macro number” for investing in Indiegogo, Hirsch admitted. “While we believe the model works, there are still pieces that have to be sewn together.”

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Nonetheless, crowdfunding companies like Indiegogo are “a payment and crowdfunding layer that’s being put into ideas and feelings and commerce and causes,” he said. “That, for us, make this worth the risk and uncertainty of being unable to anticipate the future. We think it’s massive, with global ubiquity.”

At least in sight, anyway. “We think we have the wind to our backs as regards growth,” said John Frankel, a partner with ff Venture Capital. “Crowdfunding is a theme that is just going to become more mainstream in the way people approach raising money and putting money to work, whether it’s for equity or in order to prepurchase a product. We think it really appeals to Millennials and this new social network-based economy that we live in.”

Frankel’s firm invested in Indiegogo back in 2011, when “no one had even heard of the word ‘crowdfunding,'” Frankel said. “[But] I recently pulled out their presentation deck that we had back in 2011 for revenue projections in 2013 and 2014, and those projections were actually pretty good. They’re beating the numbers they said they would do, which is pretty rare.”

It demonstrates that a crowdfunding company with an eye on profits is an investment worth making, he said. “It attracts capital that grows the platform, and that enables it to reach further to more countries, currencies, and capabilities,” Frankel said. “I look at that and I think, ‘That’s a wonderful thing.'”

Clarification April 21, 2014: An earlier version of this article quoted CRV’s Kadavy as saying that the fee paid to Crowdtilt is 5%. It is actually 2.5%; the remaining 2.5% is a standard credit card processing fee that Crowdtilt does not keep.