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The wisdom or stupidity of the crowd(funding)

January 26, 2015

Pedro Hinojoauthor is a student in the Barcelona GSE Master in Competition and Market Regulation. Follow him on Twitter @pedrohinojo.


Crowdfunding can be defined as the peer-to-peer provision of financial resources, from the crowd to a particular project or venture. This is usually done via online platforms that forego the need of face-to-face interactions, slashing transactions costs and allowing the fundraiser to reach a wider audience.

This phenomenon started with a non-profit orientation, as donations channelled to political or development campaigns. Reward-based crowdfunding became more relevant later on, where a product is delivered to consumers who finance the project pre-development, usually at a discount or with other ‘perks’ (such as limited editions, first releases, recognition or references in the credits). Even if reward-based crowdfunding entails (economic) advantages for the fund providers, it is tagged as non-profit because these consumers value non-economic benefits (Belleflamme et al, 2013), such as the sense of belonging to a community (a reason for the funding scheme’s popularity in creative industries like films, music and videogames). Reward-based crowdfunding is rooted in the marketing concept of crowdsourcing, whereby firms take advantage of the crowd to obtain ideas, feedback, and solutions to corporate challenges (Schwienbacher and Larralde, 2010).

image source: mindwize.nl

image source: mindwize.nl

But crowdfunding has become relevant when moving towards a profit and investment orientation, be it credit-based or (notably less frequently) equity-shaped (Wilson and Testoni, 2014). In this fashion it is bound to become an alternative source of finance to the real economy when the traditional banking channel is temporarily subdued after the crisis (if not permanently due to more stringent capital requirements). Furthermore, it should benefit primarily small, nascent and innovative firms (which are among the most credit-rationed), especially when they produce unique goods whose features can be communicated easily through the internet.

Therefore, crowdfunding platforms put in contact a crowd of investors with entrepreneurs whose projects need financing. In principle, crowdfunding allows lenders to receive a (higher, although riskier) remuneration for their investment and entrepreneurs to get (cheaper) credit for their projects. Apart from these pecuniary benefits, the entrepreneurs can also promote their brand and products and engage with potential customers through crowdfunding platforms. Therefore, these platforms become essential not only to minimize intermediation costs but also to generate network externalities that attract good projects and a huge crowd of investors. Furthermore, projects appealing to crowdfunding have less geographical constraints in finding sources of finance than with traditional vehicles (Agrawal et al, 2013).

Nonetheless, crowdfunding comes at a cost for entrepreneurs (Agrawal et al, 2013). First, they lose the contact with rather professional investors, who can provide even more valuable advice than a crowd of individual consumers. Other sources of finance for these nascent or innovative firms, like venture capital or (to a lesser extent) angel investors, do provide some technical advice (beyond the funding) to assess the project’s feasibility (and help to improve it if needed).

Second, they may have to disclose some information in the online platforms, something which could be critical in nascent and creative/innovative activities. If some commercially sensitive information becomes publicly known to some extent, incumbents (less credit-constrained) can adapt these new ideas to their business, hammering potential competition from new entrants.

Crowdfunding also poses market challenges, given that imperfections which affect the financial sector are amplified. In financial markets information is far from perfect because it is both incomplete and asymmetric. Information is incomplete because agents cannot control results with their actions in an environment of risk and uncertainty. This problem is amplified in the context of crowdfunding where small, nascent and innovative firms are involved, with riskier projects (Llobet, 2014).

Moreover, information is asymmetric for borrowers and lenders, leading to moral hazard and adverse selection. Moral hazard arises because once borrowers have received the funds, they have the incentive to misbehave and refuse repayment, while the lenders find it difficult to monitor whether these eventual repayment problems are caused by misbehaviour or pure bad luck. Adverse selection happens because lenders cannot discriminate borrowers’ quality, so they charge a high cost to offset potential losses (or even ration credit), jeopardizing paradoxically the best borrowers.

Again, asymmetry of information may be amplified within the crowdfunding context. Given that lenders are now a crowd, it is very likely that each of them only holds a small part of the total investment, reducing incentives to carefully monitor with due diligence the borrowers’ ex ante quality or ex post conduct. In this case, the lack of geographic bonds enabled by crowdfunding is a hitch for lenders to track borrowers in the post-investment phase (Wilson and Testoni, 2014).

In addition, this crowd of lenders will be composed mostly of non-professional investors, so, even if they devoted time to assess the borrowers’ projects, they could lack the necessary skills. And, finally, a crowd of investors would have to face problems of collective action. Against this backdrop, the borrowers might also find less incentive to repay if they use crowdfunding platforms as a one-off bet to raise funds, without any discipline effect coming from repeated interactions or reputational issues.

Bearing in mind these market failures, there is some room for regulation. Considering some international cases (such as the US, the UK or Spain), the regulatory response usually adopts a paternalistic tone: restrictions to the investment by agents (especially individuals who are non-professional investors) and to the amount a project can raise. Crowdfunding platforms are subject to registry requirements similar to other financial intermediaries, although there may be exceptions for small projects. These exceptions can be sources of distortions if firms scale down their projects to fall below certain thresholds (Hornuf and Schwienbacher, 2014)

In order for public intervention to beat the market, regulation ought to be well targeted. Limits to the exposure of non-professional (low-income) investors are rational given their lack of skills, the risks of herd behaviour, path dependence (Agrawal et al, 2013), and the high risk-profile of these investments (Dorff, 2013). However, setting stringent caps on the maximum raisable amount for projects may squeeze the sector’s (and the whole economy’s) development.

Furthermore, the sector itself can provide some solutions to these market failures. For instance, crowdfunding platforms normally charge a fee for every successful project, (which raised the same or more funds than it had pledged). This strategy gives the platforms the right incentives (skin in the game) to monitor and screen projects, so that small (non-professional) investors are relieved of that assessment.

Besides, most crowdfunding platforms opt for an All-Or-Nothing (AON) or a ‘provision point mechanism’ model, whereby projects which do not raise the amount of funds they had pledged will not receive anything. Platforms opting for the Keep-It-All scheme (KIA, whereby projects receive all the funds they have raised even without having achieved their goal) would see higher funding costs charged to those projects (Cumming et al, 2014), given that underfunded projects (which would still receive the funds in the KIA scheme) have less likelihood to succeed.

To conclude, crowdfunding offers a promising venue to spur innovation, creativity and firm growth. The regulatory response must allow that development while ensuring that no substantial amounts are invested by those individuals lacking the skills and the resources needed to cope with the complex and risky investments (See Kay, 2014, whose contribution also served as an inspiration for the title of this post).

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