Crowdfunding is an umbrella term covering four distinct sub-categories of group financing based on the nature of the return to investors: donation-based, rewards-based, equity-based, and debt-based. While a relatively small portion of individuals seeking crowdfunding are traditional entrepreneurs, different types of crowdfunding can be beneficial for different types of entrepreneurs, different types of businesses, and different stages of business growth.
It is important to note that the body of academic research is growing contemporaneously with the crowdfunding phenomenon. The result is often bifurcation and confusion. The reasons are twofold. First, some crowdfunding studies explore the dynamics underlying reward-based platforms, while others investigate peer-to-peer lending (P2P). As we will see below, each platform is associated with distinct financing mechanisms, project types, and participant profiles. It is imperative that future work clearly identifies platform characteristics; it will enable better understanding of each category and will highlight the boundary conditions and contingencies associated with each approach. Second, the crowdfunding industry is still in its infancy. Dozens of new platforms are started every month, each with its own unique business model, funding mechanisms, and participant base. A handful of dominant designs are beginning to emerge, yet it is too early to discuss performance implications before the industry undergoes substantial shakeout period.
A recent study highlights the rapid proliferation of crowdfunding phenomenon. Specifically, Dushnitsky, Guerini, Piva, and Rossi-Lamastra (2016) documents more than 500 crowdfunding platforms across 15 European countries from 2008 to 2014. A closer investigation of the data points to a number of notable trends. First, it highlights the uneven distribution of platforms across Europe. For an Internet-based activity it is surprisingly noticeable that the emergence of crowdfunding is associated with country size and population density. Second, if further underscores specialization in crowdfunding models (see explanation of each model in the next paragraph). Some counties exhibit equal fraction of Donation, Reward, Lending, and Equity platforms, while other countries experience a surge in one or two specific models. Finally, crowdfunding is not solely a start-up game. Increasingly incumbent organisations take an active part in the crowdfunding space.
To facilitate rigorous investigation of crowdfunding, it is helpful to map out the four main sub-categories:
- Donation-based or philanthropic crowdfunding refers to platforms where contributions are given in the form of a donation. Here, investors (usually referred to as 'donors') are motivated by social or intrinsic goals. Their payoff is mostly in the form of intangible, non-pecuniary benefits.
Examples: Razoo, which offers a dedicated platform for causes; Kiva, which employs a hybrid model of donations based on peer-to-peer lending; and DonorsChoose, which focuses on U.S. public schools. In this area, the presidential campaign of Barack Obama in 2008 was a landmark crowdfunding example.
- Rewards-based crowdfunding contributions are in the form of a pre-purchase of a product or a service. The investors (referred to as 'backers') are motivated by the rewards as well as social goals. Their payoff comes in the form of a reward or a payment.
Examples: Kickstarter and Indiegogo are the biggest platforms, with more than $1 billion raised by tens of thousands of entrepreneurs. Notable campaigns include Pebble Watch (Kickstarter) and Ubuntu Edge (Indiegogo).
- Equity-based platforms, as the name suggests, raise contributions in return for an equity stake. Investors (known as 'investors') are motivated by a balance of financial returns as well as intrinsic and social goals. As shareholders, they enjoy financial returns on investment, if successful.
Examples: Seedrs, CrowdCube, FundersClub, and AngelList. A notable campaign was CrowdCube's self-run funding campaign.
- Debt-based or peer-to-peer lending's contributions are loans. The investors (known as 'lenders') are motivated by a mix of financial considerations and intrinsic goals. As lenders, they expect to receive repayment of the principle plus a pre-agreed interest. Some P2P platforms appeal to socially motivated lenders, and accordingly, those loans are repaid without interest.
Examples: Prosper, Lending Club, Zopa.
The aforementioned categories share three common traits. First, these are all online marketplaces. That is, each crowdfunding platform runs its own dedicated webpage. Second, the platforms serve as two-sided markets. Namely, a platform is a meeting place where individuals or companies that need capital to develop their offerings are reviewed and funded by crowds. Third, funding is provided by aggregating the crowds. As the previous point suggests, the necessary capital is collected through aggregation of small contributions from multiple individuals (i.e., the crowd).
We begin with a brief review of the four types of crowdfunding.
Donation-Based or Philanthropic
First, some crowdfunding efforts, such as art or humanitarian projects, follow a patronage model that places funders in the position of philanthropists who expect no direct return for their donations. There is still significant work to be done here.
We know a bit more about the second approach, commonly called reward-based crowdfunding, which is currently the most prevalent form of crowdfunding. In this approach, funders receive a reward for backing a project. This can include being credited in a movie, having creative input into a product under development, or being given an opportunity to meet the creators of a project. Alternately, reward-based crowdfunding treats funders as early customers, allowing them access to the products produced by funded projects at an earlier date, better price, or with some other special benefit. The "pre-selling" of products to early customers is a common feature of those crowdfunding projects that more traditionally resemble entrepreneurial ventures, such as projects producing novel software, hardware, or consumer products.
Studies using reward-based crowdfunding are not common, but the number is growing. The most noteworthy is a paper by Mollick (2013), which also serves as a good primer for those who interested in this market because of its rich details. Additionally, Agrawal, Catalini, and Goldfarb (2011) study a music crowdfunding site, and Burtch, Ghose, and Wattal (2013) study crowdfunding in a journalism setting. Despite the fact that this remains an emerging field, we are aware that in some sectors, crowdfunding is on equal footing with traditional financing alternatives. Consider the film industry for example. From 2009-2013, rewards-based platform Kickstarter funneled more than $160 million to some 25,000 film projects, of which 19 films were official Sundance 2013 selections (10 percent of the festival's slate), with 5 award winners and 11 distributed in 2013.
In May 2016, equity crowdfunding in its true sense (allowing non-accredited investors to buy equity shares) was officially implemented after the U.S. Securities and Exchange Commission’s rule-making regarding Title III of the USA JOBS Act (2012). Prior to that, many states had passed laws to allow intrastate equity crowdfunding (i.e., non-accredited investors could buy equity shares of in-state businesses). Outside of the United States, the United Kingdom implemented equity crowdfunding in 2012, and several other countries including Australia and Germany also implemented equity crowdfunding sooner than the U.S.
Equity crowdfunding is subject to high levels of regulation (Heminway and Hoffman 2011), and the eventual adoption of this approach relative to other forms of crowdfunding is uncertain. Even with the absence of equity crowdfunding, investor model crowdfunding can take other forms. For example, funders might receive shares of future profits or royalties, a portion of returns for a future planned public offering or acquisition, or a share of a real estate investment, among other options.
Despite regulatory uncertainty surrounding this category, we know quite confidently that there is significant interest in equity-based crowdfunding. The concept of democratizing access to capital for entrepreneurs and the ability for everyday investors to have a stake in the Googles and Facebooks of the future is undoubtedly appealing.
Debt-Based or Peer-to-Peer Lending (P2P)
A fourth model, the lending model, is one in which funds are offered as a loan, with the expectation of some rate of return on capital invested. In the case of microfinanced loans, the lender may be more interested in the social good promoted by the venture than any return generated by the loan, thus including patronage model elements as well.
We know debt-based crowdfunding much better than other types. Debt-based crowdfunding resembles traditional debt financing in many ways, including the use of personal credit information, credit evaluation methods, and so on. Many aspects of this market are easily quantifiable, such as credit scores or other hard credit information. We know that it can work, as demonstrated by the growth of two major players in this arena, Prosper and Lending Club, as well as sustained venture capital interests in them.
There has been little published research that specifically focuses on debt-based funding for business loans. Lin, Prabhala, and Viswanathan (2013) report some auxiliary results related to business-purpose loan requests on Prosper. They find that compared to other types of loans, loans that have a business purpose are less likely to be funded; if they are funded, they will be funded at a higher interest rate; and they are also less likely to be repaid. Even though these results may sound discouraging, it should be noted that there are still many business loans funded through this new channel, and there have been many anecdotes where entrepreneurs put the funds to good use. More generally, in debt crowdfunding, depending on the nature of the ties, friendship networks can help mitigate asymmetric information in the sense of helping borrowers signal to potential lenders and helping lenders screen borrowers.
Several recently accepted or published papers have started addressing the issue of geography in crowdfunding. Agrawal, Catalini, and Goldfarb (2011) show that investors who are geographically close to the bands invest early, but these local investors tend to be friends or family with the band members. In contrast, Lin and Viswanathan (2016) show that on Prosper, investors are more likely to invest in borrowers who are in the same state as they are, and this pattern still holds when we exclude friends and family. Zhang and Liu (2012) show that investors exhibit rational herding in this market, in the sense that they are more likely to participate in loans that have attracted more existing funding.
Researchers have also examined other aspects in debt crowdfunding. For example, Wei and Lin (forthcoming) study the effect of funding mechanisms on participant behaviors and social welfare. Gao and Lin (2015) show that the way borrowers write their loan requests, or their linguistic features, can explain and predict their likelihood of repayment, although such information is not yet fully interpreted by investors.
General Characteristics of Crowdfunding
Crowdfunding is a new field, and there are lots of open questions. First, it may be fruitful for scholars examining more traditional forms of entrepreneurial finance to examine the decision-making process in crowdfunding to gain insight into the new venture signaling process (Busenitz, Fiet, and Moesel 2005) (Higgins, Stephan, and Thursby 2011). Further, examinations of the extent that the criteria for selection diverge between crowdfunding and other approaches to entrepreneurial finance can offer insight how the funding environment affects the diversity of projects and ideas developed by entrepreneurs (Tolbert, David, and Sine 2011). The nature of how entrepreneurs signal quality, legitimacy, and preparedness is much less defined in the virtual setting of crowdfunding than in traditional new venture settings, and future scholarship into this process may add to existing theory in this important area.
Second, crowdfunding potentially changes the nature of geography and association in new ventures. At least in part, crowdfunding reduces the importance of traditional geographic constraints, even as it potentially imposes new ones. Further, online social networks and communities increase in relevance in crowdfunding. The innovative ability of online communities has been of increasing interest to scholars (Baldwin, Hienerth, and von Hippel 2006) (David and Shapiro 2008) (von Hippel 2005), and crowdfunding represents a concrete way in which online communities can influence the creation of new ventures. Crowdfunding also suggests a path by which user innovators, who are often the sources of radical innovations, might transition to entrepreneurship (Franke and Shah 2003) (Shah and Tripsas 2007). Future research can shed light on how communities coordinate, fund, and interact with crowdfunding efforts to generate new products and services.
Third, crowdfunding creates a useful window for the study of nascent entrepreneurial ventures, as both failed and successful projects are represented. Left censoring is a frequent problem in entrepreneurial research (when we know a data value is below a certain amount but we don't know by how much), and efforts to solve the problem have involved large-scale population studies (Davidsson 2006) (Reynolds 2006). Crowdfunding provides an empirical setting where a wide range of nascent ventures are more easily compared, and thus can serve as a fruitful way of testing and extending existing theory.
Finally, for entrepreneurs who seek crowdfunding, there are some clear lessons. First, project quality is important, and entrepreneurs should look for ways to signal preparedness. Social network ties have also been found to be important in crowdfunding, both in this study and in others (Agrawal et al. 2011). Second, appropriate goals are those that allow a founder to deliver a product on time; achieving significantly more funding than requested is rare. Most importantly, careful planning is required to both set these goals and to prepare for a crowdfunding success, which will entail a need to rapidly execute a promised venture.
- Broader spectrum of platforms: Going forward, there is need for additional work based on data from a broader set of platforms. Future work should go beyond studying a single peer-to-peer platform (Prosper) and a single reward-based platform (Kickstarter). For example, we need to learn whether the Kickstarter experience applies to other reward-based platforms. We also need more analysis of donation-based and equity-based crowdfunding. Finally, there is also scarcity of studies that look across platforms, with the exception of Dushnitsky and Klueter (2010), who study 30 leading marketplaces.
- Optimal degree of information transparency: Despite its promise, not every person who has some investable assets is a good investor, and even fewer have an interest in coaching entrepreneurs or sharing the burden when challenges arise. At the same time, very few will be willing to make an equity investment (no matter how small it is) unless the entrepreneur is transparent with his or her business ideas. To what extent equity-based crowdfunding can integrate into the landscape of entrepreneurial financing remains unclear. In fact, the need for information transparency is not unique to equity-based crowdfunding, but other types of crowdfunding as well. This is a critical issue that will affect entrepreneurs' willingness to take advantage of this channel, out of fears that their competitors, or even VCs, may take away their idea. The market may very likely only stabilize as a complementary channel of funds for entrepreneurs who are relatively well-established; not early-stage entrepreneurs who will require funds the most.
- Crowds vs. experts: A fundamental premise of crowdfunding is that, collectively, a crowd should be able to at least match the ability of "experts" to identify worthy investment opportunities at the time of funding (their ability and willingness to monitor and mentor seems hopelessly lower compared to VCs or angel investors, but that would be a different issue). While crowd-based economic activities have some success in the past (Wikipedia, open-source, etc.), the financing of business activities is much more susceptible to fraudulent activities and could result in an Akerlof (1970)-style collapse of the entire marketplace. The margin of error is a lot smaller.
To further complicate this issue, in the context of crowdfunding, "experts" could participate in the marketplace alongside the "crowd" without necessarily revealing themselves. In a recent working paper, Lin, Wei and Sias (2015) find that the mere label of being an "institutional investor" has a large, albeit not necessarily justified, influence on the behavior of retail investors. Additional research is necessary to understand the dynamics between these two major sets of players in the crowdfunding market, how to best design a market mechanism that is robust to various manipulations, and how to evaluate the actual ability of a crowd to correctly infer the quality of entrepreneurs.
- Incentive alignment of platforms: Almost all platforms in any kind of crowdfunding are designed with a short-term orientation: they obtain their revenue at the time of loan origination or the time that a project is funded. The ultimate outcome of the products (loans, start-ups, ideas, or businesses) does not directly affect them. As demonstrated in Wei and Lin (forthcoming), which analyzes the move of Prosper to switch from auctions to posted-prices, the platform has a natural incentive to increase loan origination, though all else being equal, those loans are more likely to default. This is an important area of potential market failure.
The rise in crowdfunding literature is largely due to the ease of access to relevant data. Because crowdfunding platforms are, in fact, online websites, it is easy to monitor and collect rich data on their activity. To gauge the role data availability had on the development of the crowdfunding literature, consider another entrepreneurial finance phenomenon: angel investment. The angel phenomenon exceeds crowdfunding on various dimensions; angel investors are a critical source of funding to early-stage entrepreneurs across the globe. They have played this important role for the past couple of decades. Moreover, even conservative estimates of angel investment suggest the total amount is larger than total crowdfunding contributions by order of magnitude; yet, lack of systematic data on angel investment has meant that empirical research of the phenomenon has never taken off.
Each crowdfunding paper tends to employ detailed data from a single crowdfunding platform. Two platforms in particular have received substantial attention. One of them is the peer-to-peer lending platform, Prosper, which began posting daily updates in 2006 about all the transactions it processed that day. Consequently, many of the early studies of crowdfunding have utilized Prosper data. However, in recent years Prosper has gradually reduced the amount of information it releases to the public, such as bid information on loans.
The second major platform is the popular reward-based crowdfunding site Kickstarter. The platform received substantial media attention as an example of the prospects of the USA JOBS Act. As a result, we have recently seen a large number of studies that draw on Kickstarter data.
For both platforms (and for less popular but still-utilized sites, such as Indiegogo), scholars either have private arrangements with the sites themselves, or else are "scraping" data from the public-facing portions of the websites.
Finally, there are also data from other similar sites from outside the U.S. These data, however, are less accessible to researchers based in the U.S. An additional and also important caveat here is that many legal and cultural details vary from one country to the next.
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