Lots of hyped articles about crowdfunding can be found online. Is everything they describe nonsense? No, definitely not but they do need some backup for their claims and that’s what this article provides: an approach on crowdfunding motivations from a scholarly perspective. So what are exactly the reasons for online equity investments or alternatively, ordering the product via perks- crowdfunding (or reward based crowdfunding)?
Scenarios of Mass Effect
Crowdfunding can be seen as a mass collection of funds from people with similar interests in the idea being funded. Nowadays its main feature is that it can be carried out online, thus expanding the scope of collection potentially to everyone with an internet connection.
This creates scenarios of mass effect that deserve to be better investigated. The drivers that make people share a common interest are far from straightforward and can be simply summarised as “preferences”.With regard to crowdfunding for instance, according to Belflemme, Lambert and Schwienbacher (2012a) two different forms of crowdfunding are identified. First, the rewards-based option lets “pledgers” or “backers” pre-order the product or service, creating cash flow that can be reversed if the entrepreneur does not deliver the products. Second, equity crowdfunding lets investors share the entrepreneurial risk and the profits of the shares that are bought by investors.Belflemme, Lambert and Schwienbacher claim that both options create grants that are beneficial to their backers or investors while creating additional utility to which I’ll refer as preferences. These preferences refer to consumption benefits or investment benefits. The first is highly heterogeneous since it relies on the perceived need and quality of the product or service. Investment-based utility is homogeneous and it additionally grants a perceived privilege of being part of those who contributed to the existence of the product/service itself (Belflemme, Lambert and Schwienbacher, 2012a). In the case of investment-based crowdfunding, all the participants enjoy the same increase in their utility in terms or capital, regardless of their consumption preferences.
Attractiveness of the Offer
The forms of crowdfunding, although stemming from similar background, are conceptually very far from each other. Consumption-based seems to be riskier form the point of view of the entrepreneur while investment-based form seems to offer better chances of success since it simply relies on objective criteria. As stressed by Belflemme, Lambert and Schwienbacher (2012a) it remains up to the entrepreneur to set the investment in such a way that it is attractive to individuals.
Attractiveness is also determined by the willingness to buy the end product/service. The authors claim that entrepreneurs can choose to set the investment terms in such a way that can exclude or include interested future consumers, thus leveraging its crowdfunders-base. However this is also what potentially determines the pitfall in investment-based crowdfunding.
Investment-based crowdfunding has appeared later on the scene than to consumption-based, although it has been argued that investment-based crowdfunding is potentially more rewarding. Consumption-based crowdfunding already has a track record of success while investment-based crowdfunding has only recently begun to create traction and is developing increased appeal. Additionally, investment-based crowdfunding faces the issues of its (il) legality and the underdeveloped legal framework slows down its growth, blocking an increase in usage of investment-based crowdfunding.
What is defined by Belflemme, Lambert and Schwienbacher (2012a) as “attractive terms of investment” may help to pinpoint the reasons behind an initial gap between the two forms. The ex-ante perception of the business model by the crowdfunders obviously plays a major role in their decision of investment. The underlying idea is simple: crowdfunders determine their willingness of investment according to their perceived product/service appeal as consumer. Differently put, (small) crowdfunders act as consumers, not as investors. The attractiveness of the idea must be adjusted with this in mind. What I argue is that such adjustments are potentially inexistent or not possible to pursue since too much penalizing for the entrepreneur.
However, this positive relation between the willingness to buy the end product and that of investing via profit-sharing crowdfunding only partially explain a failure of the market and is by itself not sufficient.
Seen from another perspective, the failure to set attractive terms of investments can depend on the entrepreneurs’ side – that is, they are unable to establish appealing terms for some reasons. Belflemme, Lambert and Schwienbacher (2012a) leads me to hypothesize that entrepreneurs assume the audience crowdfunders to be also interested future consumers, thus setting the investment target as if they share his same beliefs.
According to this hypothesis, unsuccessful investment-based campaigns stem from a too narrow audience of people sharing the same entrepreneur consumption preferences. This not only totally eliminates the substantial advantage of the investment-based form but it also adds further limitations to the crowdfunding practice that actually prevents the market to exist. Indeed, the shared-investment model does not necessarily include the consumption and especially it does not grant any rights on the final output of the enterprise rather than financial proceeds. The base of attracted crowdfunders is then further narrowed down since those of them interested in being simple consumer are excluded from the equation.
This might explain why the investment-based form is taking more time to take off despite its conceptual advantage. This hypothetical scenario determines that the investment-based crowdfunding is degraded to being a subsample of the consumption-based form, where the profit-sharing benefit is not really perceived as such. As a consequence, the consumption-based model is preferred by the majority of the entrepreneurs looking for financing, especially if the enterprise is aimed at the production of goods rather than services. This may well explain the success of platforms based on pre-order such as Kickstarter.
There are, however, some other aspects that deserves to be investigated from the investors’ side. As a matter of fact, there might be some inherent specifics in the two crowdfunding models that make one preferable to the other and vice versa given the nature of investors themselves. Starting from a microeconomic perspective, the consumption-based model is current consumption (C0) while the investment-based in actually comparable to save and therefore post-pone the consumption to time 1 (C1). Although C1 is nominally much larger given to return on investment effects (it is assumed that the savings are invested at least at the risk free rate), most people might still prefer C0 over C1. There are several reasons to justify such behaviour and one of them is risk adverseness.
Although invested at risk free rate, the postponing of purchasing power to later stage is something that might scare people since they lack the knowledge to understand such concept. This topic goes way too much in behavioural finance theory, but it might at least partially explain why consumption-based form has received positive response while the other model is vacillating.
Risk adverseness of the crowdfunders hardly plays a major role alone, though. Indeed if the risk is compensated accordingly, then the model is by no mean inferior to pre-order crowdfunding. As found out by Belflemme, Lambert and Schwienbacher (2012a) in the conclusion of their work, also the amount of capital initially required has a major influence. They found that consumption-based is preferred for relatively small capital needs and investment-based for relatively big sums. This same concept has been confirmed by a research conducted by Crowdsourcing.org.
Extending their conclusions, it may thus be that consumption based is more successfully simply because it attracts lower-capital projects that are much easier to finance quickly. On the other hand, larger amounts may constitute an hurdle that prevents most of the interested crowdfunders to participate the campaign, especially if none of them makes the first step. As shown by Ward and Ramachandran (2010), crowdfunders are influenced both by the success or failure of related projects as well as by the actions of other crowdfunders as a source of information in their funding decisions. As consequence, the stock market pattern called herding behavior is also present in crowdfunding. Projects that are unable to create the initial “buzz” around them are destined to failure, according to this theory.
Finally, what most seems likely to negatively affect the appeal of crowdfunding is information asymmetry that turns into the adverse selection phenomenon. However the point I am raising contrasts with existing literature. As a matter of fact, Belflemme, Lambert and Schwienbacher (2012a) claim that the advantage of online platforms is to facilitate the learning of business case quality through the possible direct interaction between crowdfunders and entrepreneur as well as the simple observation of such interaction. This again relates to the peer effect suggested by Ward and Ramachandran (2010) and outlined before.
You can read more about the information asymmetry in crowdfunding in my blog post here.
Therefore online crowdfunding should increase the chances of success per se and I totally agree that theoretically it has the potential to do so. However this comes on condition that entrepreneurs engage in information disclosure, and this may not necessarily be the case. Entrepreneurs might be reluctant to disclose what they consider confidential to an impersonal party such as the crowd is or, on the other hand, they may lack the knowledge to do so (e.g. disclosure of correct financial information). As a consequence, the research by the aforementioned authors leads to the conclusion that platforms should provide entrepreneurs with the right means to offset such information asymmetry in order to avoid adverse selection on their portal and preventing the market for high-quality startups to exist.
Running a crowdfunding campaign? Take a look at our post on how to stand out from the crowd.