Abstract
This paper examines how different sources of risk in reward-based crowdfunding campaigns influence the entrepreneur’s choice of targeted crowdfunding goal. This form of crowdfunding helps entrepreneurs to obtain feedback on market demand (next to raising money), since the pre-purchase decision of the crowd generates useful public information about product demand. However, it may also lead to project discontinuation if not enough money is raised during the campaign. We therefore derive conditions under which the entrepreneur sets a higher target. At other times, this leads entrepreneurs to raise sometimes even more money than necessary when there is a risk that the idea is quickly replicated by others, leading to even larger campaigns but also to fewer projects offered on platforms. Conversely, the increased presence of professional investors (business angels, venture capitalists) on platforms reduces the entrepreneurs’ incentives in their crowdfunding campaign, which leads to more but on average smaller crowdfunding campaigns.
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Notes
On Kickstarter, over $2.7 billion have already been pledged to projects, generating more than 115,000 successfully funded projects and a success rate of 36% (Source: https://www.kickstarter.com/help/stats; accessed on November 23, 2016). On IndieGoGo, over 47,000 projects have been posted from 2008 to October 2013, with 18% of the projects having achieved their goal (Cumming, Leboeuf and Schwienbacher, 2016).
Throughout the study, we use the terms “reward-based” and “pre-purchase” crowdfunding interchangeably, although they are not exactly the same.
As a result of concerns raised by crowdfunders, Kickstarter published a note on accountability in the event that entrepreneurs are not able to deliver the promised products (for more details, see: http://www.kickstarter.com/blog/accountability-on-kickstarter; last viewed on August 24, 2017). Among other things, it says: “It’s not uncommon for things to take longer than expected. Sometimes the execution of the project proves more difficult than the creator had anticipated. If a creator is making a good faith effort to complete their project and is transparent about it, backers should do their best to be patient and understanding while demanding continued accountability from the creator. If the problems are severe enough that the creator can’t fulfill their project, creators need to find a resolution. Steps could include offering refunds, detailing exactly how funds were used, and other actions to satisfy backers.”
The market potential of the product can also be assessed through a market survey. However, there are at least two important differences with crowdfunding: first, a market survey is costly; and second, survey participants are asked for their opinion but not to commit to buy the product.
Kickstarter, the largest reward-based platform worldwide, operates on a “all-or-nothing” basis. A noticeable exception is IndieGoGo that offers the entrepreneur the option to choose between “all-or-nothing” and a more flexible form (the “keep-it-all” model) in which the entrepreneur receives the pledged money even if the set threshold is not achieved. As shown in Cumming et al. (2016b), the crowd bears more risk under the keep-it-all model, since the entrepreneur collects the money even if the project is underfunded. In contrast, the all-or-nothing model ensures this is less likely.
Given the structure of the model, it is possible to impose a weaker condition for Assumption 1, which is that L < μI + (1 − μ)i. However, the same results are obtained.
Under “informative” I mean that the information collected in the course of the crowdfunding campaign is useful to decide on whether to continue the project or stop. Another case where the outcome of the crowdfunding campaign would be “uninformative” is when demand during the campaign and in the aftermarket is uncorrelated, which is not the case here since both demands are related through the values H and L.
Most entrepreneurial finance studies, especially those studying venture capital finance, consider a different source of effort than what we consider here. These studies consider entrepreneurial effort during the R&D phase, where the investor’s involvement is often crucial. Thus, they often highlight moral hazard problems. In this study, we assume the entrepreneur already has a product, but now seeks capital to finance commercialization. Thus, effort here is limited to preparing the crowdfunding campaign and not the development of the product.
This quadratic cost function is common in the agency literature. Our results are not limited by this particular specification, which could also include fixed or minimum effort costs. The quadratic function offers easy and tractable solutions and complies to the first-order conditions of unique equilibrium in our model.
We rule out the possibility that the entrepreneur runs a second crowdfunding campaign, for instance as a way to raise the extra amount (I − i). This limitation is consistent with the empirical evidence that the success of any campaign lies in the entrepreneur’s capacity to mobilize her personal network, which can only be mobilized once.
The case where I is raised even if demand is L (i.e., effort level I/L) is ruled out by assumption 1, which makes it unprofitable. Similarly, assumption 1 eliminates the case of targeting an amount i under low demand (i.e., effort level i/L).
Setting the goal to i also leads to risk-taking by the crowd, since the latter loses its consumption utility if the project is not undertaken.
This model can be extended in several ways. One is to add an extra agency problem at the production stage. To make it meaningful for my analysis, it would have to be related to the amount raised. Since here the upside potential and costs of the project are known before production take place, such agency problem would largely be a separate issue. Another interesting extension is the introduction of donors with pro-social behavior (Allison et al. 2015; Cholakova and Clarysse 2015), which further provide funding without requesting any compensation. This group of individuals then provides no information on market demand but instead cheap money, which reduces the need of the ENT to exert as much effort during the campaign. The main tradeoff examined here would however remain qualitatively unaffected as long as this pool of money is limited (compared to the uncertainty on production costs).
In this proposition, we use the term “may” since an increase in Δ also affects the values of x ' and y '. A shift to the right may lead some campaigns to have smaller effort levels; however, this occurs only at the margin.
The availability of professional capital along with running crowdfunding campaigns may generate other sources of inter-linkages, some generating beneficial ones (e.g., the monitoring and value-adding capabilities of professional investors that are likely to accelerate growth and the fact that the crowdfunding campaign can be an insightful mechanism to assess entrepreneurial capability in marketing the product later on). We discuss here one that directly relates to our tradeoff.
For a more detailed discussion, see http://time.com/39577/facebook-oculus-vr-inside-story/ (last viewed: April 20, 2015).
See: https://www.cbinsights.com/blog/crowdfunded-venture-capital-hardware/ (last viewed: April 20, 2015.)
Other factors not considered here may affect the likely participation of professional investors in crowd-funded projects. These include the size of the project’s funding goal, the presence of other external investors, alternative investment opportunities outside the crowdfunding space, and (mostly for equity and loan-based crowdfunding) the platform’s fee structure. Moreover, platforms differ in their fee structures, which in turn attracts different types of investors with different motivations for engaging in crowdfunding in the first place (Cumming and Johan 2013). Here, we consider consumption-driven crowdfunders.
In the model here, investors can infer the ENT’s effort under certain conditions due to the assumed binary structure of costs and profits. In a more general model, it would however not be possible with full certainty.
Idea-stealing by others might even generate unethical behavior by the entrepreneur herself, something not developed in this study. Indeed, the latter might sometimes be tempted to post fraudulent projects and “run away” with the money (assuming this is possible) if profits in the aftermarket are too low. Said differently, crowdfunders are better protected from fraudulent behavior by entrepreneurs if she can earn significant profits in the aftermarket, since accessing these profits requires supplying first crowdfunders. Future research may explore the possible occurrence of unethical (or even fraudulent) behavior of participants.
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Acknowledgements
The author wishes to thank participants of 5th HEC Workshop on Entrepreneurship (Paris, France), the Belgian Entrepreneurship Research Day (Vlerick Business School, Belgium), and IAE Rennes (Rennes, France) for their comments. Special thanks to Thomas Astebro, Jean-Noel Barrot, Ulrich Hege, Franck Moraux, Patrick Navatte, Silvio Vismara (the Associate Editor), and three anonymous reviewers.
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Appendix 1
Appendix 1
This Appendix presents a simple theoretical, micro-economic framework that is consistent with the simpler product market assumptions used in the paper. The product differentiation framework presented here is based on the existence of heterogeneous consumers regarding their consumption preferences so that they differ in their marginal utility): consumers’ marginal utility levels from consuming a good produced by the project are uniformly distributed within the range (0–1), with individuals consuming either one or zero goods. Note that since we consider pre-purchase crowdfunding, the crowd makes decisions to crowdfund based only on their utility gains as consumers. Recall also that we consider campaigns run under the all-or-nothing funding scheme (Cumming et al., 2016b). Under reward-based crowdfunding, the crowd does not participate in the project’s revenue. Further, let us assume that the investment made by the ENT is not sunk; i.e., the crowd receives its money back if the project is not undertaken (alternative assumptions may also be imposed and would lead to different expectation formations, since the participation of one consumer will also be based on the expectation of others to participate; see Belleflamme et al. 2014, for related discussion). This further implies that any CAPEX made initially is reversible. As mentioned above, there is uncertainty about the true population of individuals: they constitute a mass of 1 with probability (1 − δ) and a mass of N > 1 with probability δ, consistent with the way probabilities about the occurrence of H and L have been introduced above. In contrast to Belleflamme et al. (2014) however, let us set the price of the product p > 0 as given, an assumption that is equivalent to saying that a market (or substitute product) already exists (e.g., an alternative product or any other outside option available to consumers) and that the ENT is “price-taker” at same price p. However, to make consumers who are aware of the crowdfunding campaign to pre-order, the ENT needs to offer them a price that is slightly lower than p. Under the assumptions made above, this can is an epsilon lower (since it is assumed that the ENT can reimburse the crowd), leading to an equilibrium price at the pre-order stage very close to p. Under these assumptions and parameters, market outcomes are H = N/4 and L = 1/4. In what follows, I only use the terms H and L to characterize the different levels of market demand.
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Schwienbacher, A. Entrepreneurial risk-taking in crowdfunding campaigns. Small Bus Econ 51, 843–859 (2018). https://doi.org/10.1007/s11187-017-9965-4
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DOI: https://doi.org/10.1007/s11187-017-9965-4