Currently lots of hyped articles about crowdfunding can be found online. Is everything they describe nonsense? No, definitly 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)?
By Gianluca Valentini, Financial Engineer, Owner and Blogger of Equidam.
Part1: The reasons behind equity-based crowdfunding gap
Introduction: online crowdfunding and scenarios of Mass Effect
Crowdfunding may be seen as a mass collection of funds from people with similar preferences. Nowadays its main feature is that it can be carried out online, thus expanding the scope of collection potentially to everyone with and internet connection. This creates scenarios of mass effect that deserve to be better investigated. As a matter of fact, the drivers that make people share a common vision (the financing of a business project in this case) are far from being straightforward and simply resumed as “preferences”.
With regard to crowdfunding for instance, according to Belflemme, Lambert and Schwienbacher (2012a) two different forms are identified. In the first, crowdfunders are invited to pre-order the product or service meant to be put in place thanks the funds raised through the campaign, while in the second they are invited to share the entrepreneurial risk and thus sharing the potential profits. The first form is also known as “reward-based” or “pledging” alternatively, while the second as “equity-based” crowdfunding. In this essay, I will refer to the first form as “consumption-based” and as “investment-based” for the second, following the terminology used by academic literature.
With regard to the aforementioned paper, the authors assert that either form grants to its adopters an additional utility, which has to do with what I previously referred to as “preferences”. However, on one hand it relates to consumption benefits, while on the other to investment benefits. Consumption-based utility 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 crowdfunding investment-based, 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 from the point of view of the entrepreneur, according to this initial analysis. 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 is however 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 final 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 crowdfunder-base. However this is also what potentially determines the pitfall in investment-based crowdfunding. As a matter of fact, investment-based crowdfunding has appeared later on the scene, compared to consumption-based, although theoretically superior. Famous examples of consumption-based form have already proven to have an outstanding success, while investment-based (in the form of equity-based) is only lately arisen as reality and is increasingly gaining appeal. Although the development of such form is slowed down by legal issues, it is still a fact that it has so far had a secondary role compared to consumption-based.
What 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. Indeed, the ex-ante perceive riskiness of the business model by the crowdfunders plays a major role in their decision of investment. As a matter of fact, the mentioned attractive terms must account for such aspect, as suggested in the theoretical model by the authors. In other words, set a return on investment which is high enough to offset the high uncertainties in the business growth opportunities. However, such terms are potentially inexistent or not possible to pursue since too much penalizing for the entrepreneur, determining a failure of the market for investment-based crowdfunding. For example, entrepreneurs may be compelled to give away the majority of the equity to external investors, and founders are generally reluctant. Of course, it is also possible that not even with 100% of the ownership external investors would be interested. However this is also possible in the case of consumption-based model.
Following the previous reasoning, it can be inferred that the failure to set attractive terms of investments is potentially dependent 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 their audience crowdfunders to be also interested in future consumption, 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 equity-based model does not necessarily include the future 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 crowdfuding 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 however some other aspects that deserve 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 behavior 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 behavioral finance theory, but it might at least partially explain why consumption-based form has receive a positive response while the other model is vacillating.
The capital requirement factor
Risk adverseness of the crowdfunders hardly plays a major role alone, though. Indeed if the risk is compensated accordingly, 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 a 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 seems most likely to affect negatively the appeal of crowdfunding is information asymmetry, that it turns into an 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. 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.