Crowdfunding: Overview of the industry, regulation and role of crowdfunding in the venture startup
©2015
Textbook
104 Pages
Summary
This book aims to take stock and systemize existing knowledge on crowdfunding while providing overview of the industry, its regulatory environment and advancing the insight into the role of crowdfunding in the startup lifecycle.<br><br>It is adopting an exploratory and phenomenon-based approach which is deemed appropriate when investigating rather new phenomena. Furthermore, the research combines survey and interview methodologies to assess the opinion and real-world behavior of different stakeholders in crowdfunding marketplace and identify gaps requiring further academic consideration.<br><br>Empirical data was gathered using multiple interactive web-based questionnaires distributed to different stakeholders and “informed general public” mainly through the social networks (Linkedin, Facebook and Twitter) and direct solicitation of entrepreneurial associations, networks and online communities. The study conducted relies on both qualitative and quantitative analysis in attempt to find data patterns useful in future research and establish some managerial and policymaker recommendations based on limited evidence collected.<br><br>The work adds value to this field through a 3-fold contribution: Taking a look at crowdfunding through the prism of SWOT analysis of the practice itself and Porter’s 5 forces analysis of crowdfunding platforms industry. Providing evidence in favor of implementing various degrees of regulation based on different crowdfunding categories, using the Italian case of equity-based crowdfunding regulation as a model. Finally, it yields some interesting findings on relevance of crowdfunding in the venture startup while pointing out key motivators which make entrepreneurs consider this fundraising option. In addition, related policymaker/managerial implications are exposed and academic literature updated with reference to contemporary developments in this dynamic field.
Excerpt
Table Of Contents
Index
Structured Abstract... 1
Index ... 3
Introduction ... 11
Part I ... 13
What is crowdfunding? ... 13
Position of crowdfunding inside the entrepreneurial equity "food" chain and how
crowdfunding differs from angel/VC funding ... 14
Main actors in crowdfunding space... 15
Crowdfunding taxonomy and crowdfund investing ecosystem ... 17
Literature review and principal research streams ... 20
General exploratory research ... 21
Who gets crowdfunded? ... 21
Regulation and policy ... 23
Dynamics of the crowdfunding process ... 25
The geography of crowdfunding ... 27
Common points and research gaps ... 28
Five forces that shape the crowdfunding industry ... 29
Market overview and SWOT analysis of crowdfunding ... 35
Part II ... 41
USA ... 41
Criticism ... 43
Italy ... 44
Is the Italian approach truly in line with expectations of market participants and the
general public? ... 45
Other European countries and the future of Paneuropean regulation ... 48
Policymaker suggestions on crowdfunding issues ... 48
Part III ... 50
Theoretical framework and grounding ... 50
Research questions ... 51
Research method and design ... 52
Data collection and empirical setting ... 55
Quantitative Findings ... 57
Descriptive results ... 58
Empirical patterns and relationships ... 61
Evidence in consensus analysis... 66
Qualitative findings ... 68
Qualitative findings obtained from questionnaires ... 68
Expert interviews ... 70
Business angels and equity crowdfunding (cases) ... 72
Conclusions ... 73
Managerial and policymaker implications ... 74
Limitations and suggestions for future research ... 74
References ... 76
Appendices ... 85
Appendix 1: Matrix of key provisions of SEC regulations promulgated or proposed
... 86
Appendix 2: Cases of crowdfunding platforms supported by business angels ... 88
Appendix 3: Survey 1 ... 90
Appendix 4: Survey 2 ... 91
Appendix 5: Cross-tabulation between the fear factors (i.e. disadvantages) of
crowdfunding and funding sources employed so far during the seed/startup stage
(Survey 2) ... 98
Appendix 6: Cross-tabulation between funding sources used in the past and those
projected to be used in the future (Survey 2) ... 100
Appendix 7: Variable dictionary for Survey 2 dataset ... 102
Appendix 8: Correlation matrix related to Survey 2 dataset ... 105
Appendix 9: Regression analysis models (Survey 2) ... 106
11
Introduction
The last few decades have been filled with technological advances and persistent
innovation. Advent of new communications channels, such as Internet, has
revolutionized the way how people interact and conduct business. Naturally, some
sectors of the economy have seen more change than others. Private equity and
business lending institutions remained mostly unchanged during this period, resisting
any significant adjustments in their business models. However, their role might soon
be complemented, if not even challenged, by potentially disruptive advancements in
the Web space populated by globalized collaborative communities.
Web 2.0 made it possible for internet users to be more than just passive recipients of
the content; it enabled active participation and interaction, thus laying foundation for
the emergence of many recent phenomena, such as social media, crowdsourcing
and crowdfunding. The role of Web 2.0 as a marketing, communicational and
educational tool has been analyzed and extensively explained (Jones and Iredale,
2009), however little less is known about how Web 2.0 facilitates formation of new
ventures by assisting in pooling ideas and overcoming difficulties in acquiring
sufficient funding. In this work we will focus on the role of crowdfunding in a venture
startup, always having in mind that Web 2.0 is a critical ingredient which actually
facilitates the access to the "crowd" (Belleflamme et al., 2010).
Through crowdfunding an entrepreneur rises external financing by leveraging a large
group of people (hereafter referred to as simply the "crowd"), where each individual
provides a relatively small amount of money (Belleflamme et al., 2013). This is done
as an alternative to soliciting one or more sophisticated investors and the internet is
almost exclusively being used as a channel of communication instead of face-to-face
presentations or "pitches". Crowdfunding derives from a broader concept of
crowdsourcing, which is simply pooling ideas or solutions from the crowd in order to
meet some private or corporate need (Belleflamme et al., 2013).
After the financial crises of 2007-08, acquiring traditional funding, such as startup
loans, angel or venture capital (VC) became increasingly harder for young firms.
Crowdfunding emerged, roughly at that time, as an answer to difficulties faced by
early stage entrepreneurs. In the last 6 years this new form of capital origination
gained traction in most developed economies (Netherlands, UK, USA, Italy and
Australia among others). Shiller (2008) views crowdfunding as an important financial
innovation which essentially democratizes finance and brings in light the "knowledge
dispersed over millions of people". So crowdfunding can be viewed as more than just
a form of financing; it is an important point of reference when estimating the market
for future products or services, a source of collective wisdom and feedback during
venture development and a foundation for future community of lead users. The
phenomenon is increasingly attracting attention in developing economies as well,
where according to The World Bank (2013) it should play a major role in support of
innovation, jobs and growth in the future.
12
Crowdfunding takes many forms (Hemer, 2011) which will be discussed in more
depth in subsequent chapters and caters to many different projects, especially those
in creative industries, charity and entrepreneurial startups. This work will focus
mostly on startups and the role of crowdfunding in promoting, nurturing and
sustaining entrepreneurial activities as an engine of economic growth. The research
conducted here is mostly of exploratory and descriptive nature, seeking to help
understand better this new phenomenon and fill some of the gaps in a rather scarce
academic knowledge on this topic. Additionally, it should contribute to the debate on
whether crowdfunding is suitable as an addition to or as substitution of more
traditional funding channels, such as business angels or VCs. Analysis of recent
policy actions by governments and further recommendations provided in this work
shall also have significant managerial implications, guiding entrepreneurs about how
to set up and manage their crowdfunding campaigns.
This manuscript is organized in a following way: In the first part I offer a more
extensive definition of crowdfunding, its place in equity "food" chain and an overview
of the key elements of the crowdfunding ecosystem. Various models of crowdfunding
are presented in detail together with a comprehensive literature review on existing
academic work in this field. Intermediaries such as crowdfunding portals are briefly
analyzed together with preliminary observations on biases, conflicts of interest and
liability issues. Furthermore, I provide some recent data on the size of crowdfunding
market and its major players accompanied by a SWOT and Porter analysis of the
industry. Second part discusses the risks of crowdfunding and current regulatory
framework in major economies, such as USA, EEA and Italy. The aim is to critically
analyze current legislation and come up with conclusions which will serve as a
foundation for policymaker recommendations presented in Part III. The third part
opens with some general observations about the VC industry and traditional sources
of funding while putting crowdfunding in this perspective and arguing how and why
crowdfunding can be either complementary or substitute for more traditional
investors. Main research question, whether crowdfunding can serve as a pillar in
venture startup, is introduced together with the description and reasoning behind the
methodologies used. Case studies are presented together with the results of a
custom-made survey and expert interviews. Results are then discussed together with
policymaker suggestions and managerial implications which emerged during the
research. The manuscript concludes with some ideas for further work and a list of
appendices and resources discussed in the text.
13
Part I
What is crowdfunding?
Crowdfunding (also known as crowdfinance) is a term used to describe a form of
fundraising, usually conducted over the internet, in which a large number of people
pool relatively small individual contributions in order to support a specific goal (Ahlers
et al., 2012). Review of a rather modest literature on the topic uncovers a number of
nuances in how crowdfunding is defined; confirming that substantial academic
knowledge in this field is yet to be developed in order for consensus to emerge.
Definition by Schwienbacher and Larralde (2010) explicitly states that crowdfunding
is financing of a project or a venture by a group of individuals instead of professional
investors such as business angels, VCs or banks. This definition stresses the point
that there is no intermediary, since entrepreneurs raise money directly from
individuals. In theory, majority of individuals already invest albeit indirectly through
their savings which are being managed by intermediary institutions such as banks or
mutual funds, so crowdfunding implies some sort of more direct interaction between
funders and entrepreneurs. Definition by Rubinton (2011) acknowledges "parties"
exchanging contributions in exchange for a form of value, without specifying who or
what a "party" might be.
Belleflamme et al. (2013) extended upon the definition of a more general concept of
crowdsourcing provided by Kleemann et al. (2008) in order to define crowdfunding
as "an open call, essentially through the Internet, for the provision of financial
resources either in form of donation or in exchange for a form of reward and/or
voting rights in order to support initiatives for specific purposes". Mollick (2014) and
Bradford (2012) acknowledge that crowdfunding essentially draws inspiration from
concepts like microfinance and crowdsourcing, but still represents a unique category
of fundraising enabled by the proliferation of internet sites dedicated to the concept.
The former also acknowledges a state of "evolutionary flux" in this domain, pointing
out that even an expansive definition such as that of Belleflamme et al. (2013) leaves
out examples such as peer-to-peer lending and fundraising initiatives by music or
movie fans, among others. However, one might argue that crowdfunding is still
fundamentally different from microfinance or social lending given that both funding
objectives and targets are different, so it would be justifiable to treat it as a separate
class in contemporary private capital markets.
Some authors labeled it as "community funding" (Kleverlaan, 2013), stressing out the
potential of crowdfunding "community" to fill smaller investment gaps (< 1 million)
routinely faced by SMEs (small and medium enterprises) in their earliest stages.
Since in this work the focus is on the role of crowdfunding in a venture startup, the
most appropriate working definition seems that of Mollick (2013):
"Crowdfunding refers to a variety of different efforts by entrepreneurs cultural,
social and for profit to fund their efforts by drawing on relatively small contributions
14
from a relatively large number of individuals using the internet, without standard
financial intermediaries"
It is interesting to notice that virtually all definitions mention internet as a necessary
medium to facilitate crowdfunding. Though some might argue that the concept has
been around for a long time in different forms during history, internet indeed has
made it a much easier, more scalable, and cost-efficient endeavor. Crowdfunding
heavily exploits the capabilities of Web 2.0, such as social marketing and viral
networking. However, the body of academic knowledge in this field is yet to be
extended in order to further develop crowdfunding as a new form of finance and help
shape its best practices. In addition to academic relevance, the crowdfunding
research is interesting also from a managerial perspective, given that financing
business growth during different stages of venture development is a task routinely
faced by SMEs' managers.
Position of crowdfunding inside the entrepreneurial equity "food" chain
and how crowdfunding differs from angel/VC funding
Obtaining financing is perhaps the most critical step in the entrepreneurial process.
In the early stages (Janssen, 2013) the financing mostly comes in form of equity
rather than debt, since banks routinely loan money only to companies who can
demonstrate sufficient collateral or cash flows (Smith et al., 2011). Primary sources
of capital for SMEs are thus limited to 4Fs (friends, family, fools and foundations),
angel investors and VCs.
Fig. 1 shows where crowdfunding might fit in the equity "food" chain, considering the
investment size and the stage of development of the firm.
Fig. 1 Equity "food" chain in a startup lifecycle
Source: Kleverlaan (2013)
15
At the earliest stage of venture development an entrepreneur almost always puts his
own "skin in the game", i.e. the business is self-funded by the entrepreneur's own
savings or personal lines of credit. As prototype is developed, friends and family
might step in to support the venture and help transition it to a commercial business.
At this stage angels and syndicates of angels might be a viable source of additional
growth capital until the venture reaches further milestones and qualifies for a VC
investment or debt capital (Smith et al., 2011). Crowdfunding targets the earliest
stages in a business lifecycle (pre-seed to start-up), aiming to increase availability
and reduce cost of capital while also increasing venture's visibility among angels and
VCs. Recently some companies started experimenting with crowdfunding even in
growth or subsequent stages, though in such cases the principal motivators tend to
be less of a financial nature and more related to product marketing or pre-selling,
which will be expatiated on later.
Funding entrepreneurial ventures by crowdfunding in many aspects differs
substantially from the VC or angel funding (Mollick, 2013). First, crowdfunding is
more democratic (Kim and Hann, 2014); anyone can participate even with very small
amounts of capital. On the contrary, sophisticated investors are usually clustered in
smaller groups and barriers to enter in terms of capital and industry connections are
much higher. Crowdfunding backers are weakly organized and one usually does not
have to be a part of some form of community in order to invest. Communication
channels are open (public) in crowdfunding, while traditional VCs or angels rely more
on confidentiality and proprietary information. Lastly, in most cases crowdfunding
backers have little further influence over firms they backed, while financing by VCs
by default means giving up a part of ownership and many other caveats attached.
However, the last point might over time get different shapes in different legislations,
given that regulation on so called "equity-crowdfunding" is still pending in many
countries.
Main actors in crowdfunding space
Crowdfunding process involves different actors with distinct roles and responsibilities
depending on the model being used (full taxonomy of crowdfunding models will be
subsequently introduced). In this manuscript we will be focusing on equity-based
crowdfunding as the most relevant for our research, though the general flow of
operation can be easily extended to all models. Inside so called "indirect
crowdfunding" (Belleflamme, 2013), which implies an intermediary is present, we can
distinguish between the crowd, campaign initiators, platforms, consultancy firms and
regulators.
The crowd represents a large, usually anonymous, group of people addressed by an
open call for the provision of funds. Entrepreneurs' friends and family can also be
considered part of the crowd as long as they invest through the intermediary (i.e.
crowdfunding platform). A fine distinction is made between crowd as a group of all
potential contributors and campaign supporters who actually pledge money toward a
16
pitched project. Agrawal et al. (2010) consider all crowdfunders as investors without
distinction between different models, though more commonly term "crowd investor" is
used to describe a contributor who invests directly in exchange for equity. Hence
some experts prefer the use of term crowdinvesting, as opposed to crowdfunding,
when it is necessary to stress that funding is provided in exchange for equity.
According to Hemer (2011), equity capital provision has the highest process
complexity, especially when a large number of backers and micro-transactions have
to be managed. In addition, it also represents a highly regulated activity.
The platforms act as intermediaries who facilitate transactions by channeling
financial resources from contributors to campaign initiators. Virtually all platforms
operate by the same underlying principle of pooling relatively modest contributions
from a large number of crowd participants in order to finance a big ticket project.
Platforms make money by charging a percentage-based commission on the amount
raised or sometimes they might also charge fixed fees. Often platforms may also
play the role of gatekeeper, actively filtering out which kind of campaigns should be
promoted on a particular site (Lawton and Marom, 2013). Many platforms as well
provide additional value-added services, such as certification, due diligence or
valuation. The regulator in a particular legislation may limit certain activities or
impose additional duties and responsibilities that a platform has to carry out. As per
Agrawal et al. (2010) crowdfunding platforms are intended to overcome distance-
related frictions and the majority of them have some properties in common. First,
they enable campaign creator to present his entrepreneurial project in a
comprehensive way. Second, they enable participation by managing small scale
financial transactions between crowd investors and project initiator. And lastly, they
provide some basic investment information such as fundraising statistics as well as a
communication interface for crowd investors. Platforms have been recently putting a
lot of effort in attempt to distinguish themselves, build credibility and capture a share
of growing crowdfunding market. This is per se a good development which should
help the proper function of this new market (Hemer, 2011).
A campaign initiator is anyone who has an entrepreneurial idea but lacks adequate
capital to bring it into practice and thus decides to pitch the idea to a wider audience
in hope of receiving financial support for the realization of the venture. It is a
common belief that entrepreneurs resort to this method of fundraising since they are
unable to secure funding in any other way, be it from angels, VCs, banks or through
government grants and foundations. However, recently conducted research (Gerber
et al., 2012; Lawton and Marom, 2013; Niederer, 2013) suggests many
entrepreneurs resort to crowdfunding (especially reward-based crowdfunding) also
for other reasons, such as marketing, validation of project concepts or formation of
user communities. Sometimes these can even take precedence to financial goals.
Another benefit of crowdfunding is that founders are supposed to spend less time
fundraising and retain more control over their business which should have a strong
positive impact on business development overall. Yet still, there are researchers (Hui
17
et al., 2012) who point out that time and effort required for a successful crowdfunding
campaign are considerable and that the overall process might even prove to be
slower than traditional fundraising.
Campaign initiators use a platform to pitch their venture to the public, offering perks,
rewards or in case of equity-based model equity in the firm. Fig. 2 illustrates main
actors in the crowdfunding space and the way how they interact. Crowdfunding
platform channels multiple contributions from participating crowd and passes them
on to campaign initiators, after deducing for commissions and fees. Regulator sets
the rules on who can participate in this process, what kind of disclosure is necessary
and what are the limitations imposed regarding number of investors and capital
committed. Role of the regulator differs from one country to another and will be
further discussed in Part II.
Fig. 2 Main actors in the crowdfunding space
Source: own interpretation
Crowdfunding taxonomy and crowdfund investing ecosystem
Scholars have long attempted to provide taxonomy for the diverse crowdfunding
forms (Giudici, 2012). Kappel (2009) distinguished between ex post (e.g. when a
product is offered after financing has been provided) and ex ante crowdfunding (e.g.
financial support for political activities or similar). Belleflamme et al. (2010)
differentiated between active and passive investments. Active investments imply also
an active involvement in the decision making process inside the company, while
passive investments receive only a compensation resulting from the financed
18
activity. In this sense crowdfunding blurs the line between the role of customer and
the investor.
Hemer (2011) focused on project substance when providing taxonomy for
crowdfunding. According to commercial objectives and background of the initiative,
he differentiates between non-profit, for profit and intermediate crowdfunding.
Intermediate crowdfunding is in this sense a catch-all term describing projects which
start without a clear commercial goal but over time develop into a for-profit business
(for example, social networks or music festivals). Another line of differentiation is
according to place of origination of the idea and its eventual affiliation to an
organization. In this sense, we can differentiate between completely independent
one-off initiatives, embedded projects (initiated and managed by a private or public
organization) or startups which naturally lead to a foundation of a company.
Lambert and Schwienbacher (2010) classified crowdfunding typologies according to
the nature of the reward for funders. Over time different crowdfunding models
emerged and majority of platforms (explained in more detail infra) do specialize in
providing services related to the model(s) they advocate. Up to date, most widely
used and most frequently researched (Giudici, 2012; Hemer, 2011) capital provision
forms are:
1) Reward-based: funders receive non-monetary benefits in exchange for their
contribution. Some examples include receiving a product once it is finished,
complementary gifts such as T-shirts or accessories, credit in artistic work (such as
movies or music), opportunity to spend time with the founders and "shadow" them,
etc.
2) Donation-based: funders contribute for altruistic reasons through a sponsorship or
charity donations. No compensation of any kind is received.
3) Equity-based: funders claim a share of future income generated by the project or
the company. A share that each crowdfunder receives is most likely proportional to
the amount contributed.
4) Lending-based: funders receive back the amount they lent out together with any
eventual interest as contractually agreed.
5) Royalty-based: a sub-form of equity crowdfunding targeted mostly to media
content creators. Funders should receive royalties from copyright, proportionally to
their contribution, for a certain period of time, without actually being stockholders in a
company.
Castrataro (2012) proposed extending further this classification to sub-models
according to specificities of how each model is being implemented on a particular
platform. Consequently reward-based model could be further split into `all or nothing'
model, where the funding goal of the campaign must be reached in full and in due
time in order for any financial transaction to be generated, versus `keep it all' model
19
where any funding collected is paid immediately to the project owner regardless of
whether the initial goal of the campaign is met or not. Equity-based model can be
implemented as `the club' model, where each member of the crowd is treated as a
member of closed investment club, thus circumventing limitations on public offerings
or as a `cooperative' model where a cooperative vehicle is used to pool the funds of
individual contributors into a single legal entity which further invests in single
businesses. Lastly, lending-based model is realized as either `microfinance' model
where the money of the lenders is being managed by an intermediary reassembling
a bank for low-income clientele or as a `peer-to-peer' lending where transactions
happen directly between the lender and the borrower without any intermediation.
Active experimentation with different combinations of crowdfunding models is
increasingly gaining traction in practice, suggesting that there still might be a lot of
spur and innovation in the field before stable paradigms emerge. Various studies
have shown that not all investment decisions are economically motivated, which
might explain the existence and relative success of donation-based crowdfunding so
far. Probably the most prominent example is the US President Barack Obama who
rose over $137 million dollars for his 2008 election campaign using a donation-based
crowdfunding platform. In Columbia a skyscraper ("BD Bacata") was entirely
crowdfunded by locals, proving that the concept works also for real estate. How
different investment drivers in the crowdfunding space will evolve in the future and
which models will be the most successful, remains an interesting question for both
academia and practitioners.
The World Bank (2013) proposed a universal model of crowdfund ecosystem
containing four basic elements: community engagement, technology, entrepreneurial
culture and economic regulation. Fig. 3 outlines key enablers in the model on which
policymakers have to focus in order to promote crowdfund investing.
Fig. 3 Key enablers in the crowdfunding ecosystem
Source: The World Bank, 2013
20
Although the research by The World Bank (2013) focuses on these enablers only in
terms in which they relate to government policies, it is possible to extend upon that
reasoning and argue that the factors presented actually constitute a part of a more
universal model describing crowdfunding ecosystem in a holistic way. Community
engagement campaigns may be used by the governments in order to strengthen the
entrepreneurial culture and encourage future startups to participate in events such
as startup weekends, meet-ups and business plan competitions sponsored by
government. However, community engagement is also needed in a broader sense in
order for the "crowd" to participate. Subsequent research has shown that masses
participate in crowdfunding for different reasons, many of them not under direct
control or influence by governments (Hemer, 2011; Schwienbacher and Larralde,
2010). People who belong to a certain community are more likely to invest in projects
related to that community, the most prominent example being probably computer
games fans or movie fans who routinely participate in reward-based crowdfunding on
platforms such as Kickstarter. Still the government policies address directly only a
small subset of `community engagement' activities, leaving most of them to market
forces, creative leadership and personal preferences. Technology is understandably
an essential part of the crowdfund ecosystem since it facilitates oversight of the
businesses and helps governments derive more accurate numbers for profits, hiring
and taxes. But technology is also an enabler in a wider sense, given the internet and
technologies facilitating online pitching, communication, transactions and
securitization are a necessary requisite for the crowdfunding to happen.
Entrepreneurial culture is another important factor in crowdfunding, extensively
shaped by the regulatory bodies which directly promote or hinder formation of new
ventures through policies affecting "ease of doing business" (The World Bank, 2012).
However, also this factor can be viewed in a much broader spectrum when we
consider other aspects such as country's history and whether being a small business
owner is generally profitable and reputable career path in a given social
environment. Economic regulations define conditions for entering into, conducting
and dissolving business operations. In this sense they should create a stimulating
environment for venture inception and growth with minimal risk. This is achieved not
just through laws directly focusing on entrepreneurship, but also through a broad set
of regulations ensuring efficient markets, free competition and reduced systemic risk.
Literature review and principal research streams
Existing scholarly knowledge in this field is relatively scarce and the research has
been just recently moving from an embryonic to a growth phase (von Krogh et al.,
2012; Giudici, 2012). Most academic work so far has been of exploratory nature due
to limited access to data, absence of widely recognized theoretical frameworks and
persistent fluidness in the domain. The aim of this section is to offer an overview and
critical evaluation of selected research papers and data points. As this book focuses
more on financial aspects of crowdfunding and its propensity to serve as a viable
source of early-stage capital, literature about equity-based crowdfunding is
21
considered more relevant. Nevertheless, research about other types of crowdfunding
has been mentioned as well when it seemed pertinent for answering the main
question. By exploring the literature, following research streams have been
identified: who gets crowdfunded, regulation and policy, dynamics in the
crowdfunding space, geography of crowdfunding and various case study analyses.
The streams are described and discussed further on, jointly with suggestions
regarding new research questions and general hypotheses to be tested, which
concludes this chapter.
General exploratory research
Schwienbacher and Larralde (2010) were among the first scholars to put
crowdfunding into perspective of entrepreneurial finance and discuss factors
affecting entrepreneurial preference for this alternative form of financing. Different
business models with respect to the structure of the crowdfunding process have
been discussed together with practical recommendations for entrepreneurs seeking
funds derived from a case study described in the paper. The authors conclude that
small ventures should leverage crowdfunding only if they are raising a reasonably
small amount, have an innovative project and are versatile and skilled in Web 2.0
technologies. Some issues are also raised, such as whether intellectual property
related risks might deter entrepreneurs from disclosing their ideas and what
incentives and remuneration scheme makes the crowdfunding most optimal. These
early exploratory findings have set a foundation for subsequent work by other
researchers as per von Krogh et al. (2012) model.
Who gets crowdfunded?
Mollick (2013) explored whether the amateurs who casually invest in crowdfunding
projects respond to same signals of quality as professional investors (VCs) and
whether they are subject to the same biases. VCs are experts in assessing quality of
ventures, constantly looking for signals such as background of the startup team,
endorsements and demonstrated preparedness in order to determine if a project is
worth funding or not. However, this process is also prone to biases which stem from
the method itself being too ignorant of some signals due to geographical or gender
constraints. For instance, most VCs prefer to fund companies in their geographical
proximity with preference generally skewed toward male founders (Chen et al., 2009;
Canning et al., 2012). Crowdfunding offers an alternative selection environment
which eliminates some of these biases, even if crowdfunding backers still look for the
same indications of venture quality as the experts (Mollick, 2013). The work
suggests that entrepreneurs who demonstrate preparedness with a high quality
product and team are more likely to be funded, since their venture is perceived as
having a higher potential. In this sense "the wisdom of the crowd", although
decentralized, exhibits similar characteristics to one of more institutional structures.
The quality signals of high-potential ventures are further magnified through a
22
Matthew Effect, multiplying the impact of project quality and increasing the draw.
However, the research does not track the future of companies who received equity-
crowdfunding and whether those reached a successful exit in the subsequent period.
It would be interesting to analyze the speed with which those ventures developed,
how did they obtain subsequent rounds of financing (either through crowdfunding or
angel/VC rounds) and whether they were lacking some of intangible assets and
competencies professional investors usually bring to the table (such as networks and
industrial know-how). Limitations mentioned by the author hint at possible need to
repeat similar research in the future in order to increase robustness of the findings,
especially in light of other researchers debating extent to which biases, such as
gender bias, are being remedied in crowdfunding space (Marom et al., 2013).
Ahlers et al. (2012) focus specifically on equity crowdfunding context, providing an
empirical study on startup signals that induce small investors to commit financial
resources to a specific venture. Previous literature extensively dealt with signaling of
startups toward VCs or business angels, however little research has been done
having small (retail) investors in mind. Advent of crowdfunding came as an ideal
playground for this type of study, where empirical data from one of the largest
Australian crowdfunding platform have been analyzed in order to pinpoint common
drivers for offerings' success. The results emphasize the importance of financial
roadmaps (such as a pre-planned acquisition or IPO strategy), education level of
entrepreneurial team (measured as a number of members with MBA degrees) and
perceived risk factors (amount of equity offered and availability of financial forecasts)
in increasing the likelihood of attracting investors and the speed of capital rising. The
study also highlights once again the fact that equity crowdfunding operates in a
mostly rational manner, despite the participation of less sophisticated (retail)
investors. Another interesting point is that spatial distance between investors and
entrepreneurs remained a significant factor in investor decision making, particularly
in early-stage ventures where long distances create barriers to obtaining information
and tend to increase monitoring costs. One limitation of the study the authors did not
mention is related to ever increasing participation of sophisticated investors in this
field. It is questionable how many investors labeled "retail" are actually quite
sophisticated, at least in terms of knowledge and experience, if not for their net
worth. Ex facto during this year we have seen quite a lot of interest in crowdfunding
coming from institutional investors, with business angels investing extensively in
crowdfunding platforms (AngelsDen, SyndicateRoom), a development which will be
detailed further in subsequent sections. Thus it would be desirable to collect more
extensive data on the background and habits of "the crowd", which is at the moment
almost impossible given that very few platforms actually collect this kind of data from
investors due to privacy issues. However, upcoming regulation changes (discussed
later) and talk of introducing specific investor certifications might reshape this
roadblock in the near future.
23
Younking (2013) concludes that legitimacy of founders is likely to substantially
increase possibility of success, especially when it comes to having a famous affiliate
on team and (to a lesser extent) a high quality presentation. Strong support is also
found for the hypothesis that users who are more "embedded" in the community, i.e.
who participate actively and fund other peoples' projects, are more likely to be
funded. In this sense, a strong role of reciprocity is implied, totally in line with recent
works on social psychology (Kuppuswamy and Bayus, 2013). Data for this research
have been obtained from Kickstarter, which is a reward-based CFP, so further repeat
research would be useful to discover whether these conclusions hold also for
platforms utilizing different models like equity-based model. The same applies also to
research conducted by Ward (2010) and Burtch (2011), which both focused on
reward-based platforms intended for predominately artistic ventures, such as music
or digital journalism. Ward (2010) ascertains that it is essential for a crowdfunding
project to maintain momentum; otherwise it quickly falls out of favor with the
investment community, possibly due to peer effects rooted and driven by an
information overload. However, he does not elaborate on ways how projects acquire
that initial momentum necessary for success. Likewise, he also argues that investors
are strongly inÀuenced by success or failure of related projects, actively using
actions of other investors as a guide in the decision process. These findings are in
line with subsequent claims by Burtch (2011) who argues that indicators of
popularity, such as timing or nature of other investments, are deeply rooted in
crowdfunding marketplace where herding and other forms of social influence are
likely to occur.
Regulation and policy
Bradford (2012) was one of the first scholars to analyze the legal framework and
legislative barriers to crowdfunding in US, even before the JOBS (Jumpstarting Our
Business Startups) Act was enacted by President Obama. To facilitate crowdfunded
offerings, the SEC (Securities and Exchange Commission) needed to adopt an
exception which would strike balance between investor protection and seamless
capital formation. Bradford's paper outlines a number of considerations and practical
proposals, many of them ex post adopted by the SEC, which brought the securities
regulation more in line with the modern world of internet and social web. Another
academic to examine these proposals and the recent JOBS Act was Hazen (2012)
who stressed out that a crowdfunding exception conditioned on a meaningful
disclosure about the company and the terms of securities offering is the only suitable
compromise which would not unduly expose investors to a risk of abuses. Similar
stance has been taken also by Martin (2012), who emphasized the need for balance
between stifling regulations and necessity to protect integrity and stability of financial
markets. Exact rules as implemented by the SEC will be subsequently discussed in
Part II. There is currently fear (especially in the US) that the securities laws have
become too deregulated, which could potentially trigger fraudulent behavior and loss
of confidence in secondary markets for unlisted securities. Crowdfunded securities
24
still remain an unchartered territory and substantial research on this topic is
warranted once raising money from the crowd becomes a widespread practice.
In a descriptive study Heminway (2013) analyzed funding portals (CFPs) from a
theoretical point of view, by positioning them in existing taxonomical constructs and
providing vital preliminary observations on potential issues these intermediaries
might face in the future. Depending on the context, portals can be treated as either
informational, collectivizing or reputational liaisons, which means they are likely to
face typical intermediary-related issues such as conflicting interests, fiduciary duties,
biases and gatekeeper liability. The CROWDFUND (Capital Raising Online While
Deterring Fraud and Unethical Non-Disclosure) Act, a part of the JOBS Act,
introduced what seems like a rather burdensome regulatory context which might
deter formation of new portals and increase transaction costs. The author concludes
that only when the SEC's rulemaking is fully in place and that enough crowdfunding
offerings have been conducted under those rules; it will be possible to judge overall
efficiency and benefits of these intermediaries as well as inherent legal issues. Given
the current progress on SEC's rulemaking, this should not be expected before the
middle of this year while generating a meaningful time series and collecting empirical
research data will probably take a couple more years before welfare effects become
evident.
Vitale (2013) from the Monash University in Melbourne built upon the work of Wong
(2013) in order to provide an assessment of the Australian regulatory framework and
give recommendations how it could be adapted to the post-crowdfunding world, as to
obtain full benefits of this new mechanism for raising funds without unduly
compromising protective regulatory aims. The Australian regulator ASIC (Australian
Securities and Investments Commission) and the facilitator ASSOB (Australian Small
Scale Offerings Board) are encouraged to liaise with interested parties and the public
in order to identify key issues and craft regulations conductive to effective and
concurrent local crowdfunding space. The most up to date developments regarding
these aims are further discussed in the context of similar efforts in the European
Union and the USA in the Part II of the research.
Recent study by infoDev, a global partnership program within The World Bank,
emphasizes the uprising of crowdfunding and its emergence in developed and
developing countries as an important catalyst in the global innovation ecosystem.
Closed nature of investing in small businesses is to change rapidly as the social web
affects both the flow of information and capital to these startups. However, existing
securities regulations were not designed for today's environment and policymakers
worldwide still have to craft new regulations, empower new technologies and
educate entrepreneurs about this new vehicle (The World Bank, 2013). So an overall
enabling policy, including both "light touch" regulation on crowdfunding and
enhanced "easiness of doing business" is a pre-requisite for successful
implementation of this funding concept which should lead to more innovation and
creation of jobs in a relatively stagnant economy. Similar opinion was voiced also by
25
Alberg et al. (2013) from Kauffman foundation who acknowledged that many young
firms continue to face hurdles due to lack of capital and that "the SEC should
approve rules under the JOBS Act that encourage experimentation without
excessive regulation".
Dynamics of the crowdfunding process
Hildebrand et al. (2013) criticize the lending-based model, claiming existence of
perverse incentives which are not being fully recognized in the social lending
marketplace and which lead to some bids being (wrongly) perceived as good quality
loans when in fact they are quite the opposite. Empirical evidence from Prosper, one
of the most prominent lending-based CFPs, suggests that the rewards received by
some group leaders for promoting specific deals introduce adverse incentives in
deals selection. Group leaders act as a form of endogenous intermediary in order to
facilitate vetting and moderate activities on the platform. In presence of rewards
group leaders' bids result in substantially lower interest rates but higher default rates,
this suggests that they behave strategically and maximize their own financial
interest. It is only once that these actors have sufficient skin in the game that the
agency problem subsides. These findings provide a valuable input in ongoing debate
about the regulatory framework for consumer protection and how to achieve proper
incentives for all participants in the crowdfunding market.
Ghose et al. (2013) conducted an interesting study on privacy and information
control mechanism on crowdfunding platforms. They found evidence that individuals
are more likely to conceal private information when investing if the campaign they
are supporting has received a great deal of public exposure and if their contribution
amount is substantial. Secondly, average amount of prior contributions tend to
influence future pledges by other contributors through an anchoring effect. So if prior
contributions are rather small, concealing this information from the eyes of the public
is likely to be preferred by the campaign organizer and vice versa. This certainly has
interesting implications for the design of online information handling mechanisms.
Rubinton (2011) describes crowdfunding as disintermediated investment banking,
given that users directly interact without any private network or middleman in
between. A simulation model is created where debt and equity are modelled as
passive and active investment in order to generate theoretical insights about how
certain factors affect the dynamics of financing. Crowdfunding is praised as an
important evolution which should modernize obsolete banking processes and
commoditize access to capital markets. The model author provides is mostly
theoretical and could be still expanded and findings improved by fitting to real life
investment opportunities; however access to raw CFP data remains still an issue for
empirical research.
Reasons why entrepreneurs might want to take advantage of this new financing tool
have been somewhat discussed. Belt et al. (2012) mentions factors like frustrations
26
with costs and burdens of traditional fundraising, lack of access to angel or venture
capital, onerous bank lending procedures and a need for gap funding. Collins and
Pierrakis (2012) point to a larger outreach of crowdfunding to justify its potential in
entrepreneurial world, while also affirming that a combination of intrinsic social and
financial motivation is what drives funders to "take the other side" of the transaction.
Mollick (2014) seeks to describe the underlying dynamics of success and failure
among crowdfunded ventures by analyzing a dataset of over 48.500 Kickstarter
projects. Crowdfunding success appears to be related to (perceived) project quality
and participation of entrepreneurs in social networks (where the "social capital" is
estimated by the number of Facebook friends as a proxy). Further, the study finds a
significant local component in the nature of projects themselves, which tend to be
connected to entrepreneur's geographic area. Crowdfunding projects on average
either succeed by a narrow margin or fail by large amounts. Since most CFPs
operate on all-or-nothing basis, there could be an incentive for owners of smaller
projects to try and make up the slack by self-funding the project. However, the
findings reveal that smaller projects actually fail by larger margin than bigger ones,
despite the fact that self-dealing would be theoretically easier for smaller projects
due to lax logistical and financial constraints. This fact raises confidence that the
results are not being confounded by self-funding and suggests that the nature of
projects and a rational assessment process, similar to the one of professional
investors, dictate whether they will be backed or not. Finally, data from the sample
used indicate that almost all founders seek to fulfill obligations assumed during the
project pitch, through majority of overfunded and complex projects are likely to be
delayed. An empirical setting, enabled by crowdfunding, makes it possible to study
both successful and failed nascent ventures, thus overcoming a left-censoring bias
(Mollick, 2014). This new environment also has a potential to affect the kind of ideas
being forged into entrepreneurial ventures, in a similar way in which Web 2.0 caused
a subsequent proliferation of internet startups.
Similarly, Marom and Sade (2013) drew upon a unique sample of around 20,000
Kickstarter campaigns to gauge whether entrepreneurs should place more weight on
pitching their personage and background or the business itself. Among some
investors there is a mantra that it is better to invest in people, rather than ideas. This
"horse versus jockey dilemma" is well known in entrepreneurial finance, though up till
now it has not been tackled in the crowdfunding space or in the context of the very
early stage financing. The findings, obtained through a data mining technique and
verified by human coding, suggest that successful projects tend to focus more on the
business idea if they belong to a technology domain and on the entrepreneur if they
are of an artistic nature. Furthermore, a deeper understanding of entrepreneurial
pitches as a basis of almost all fundraising manners warrants that the results are
likely to be relevant also for other crowdfunding mechanisms and beyond.
27
The geography of crowdfunding
Agrawal et al. (2011) analyzed the broad geographic dispersion of crowdfunding
investors. Data collected from a CFP specializing in early-stage musicians' creative
projects (named Sellaband) reveal a mean distance between artists and investors of
approx. 3000 miles. Although this number is not uncommon for publicly traded
companies, early-stage ventures tend to stay closely clustered in areas near
investors since the costs of activities such as gathering information, monitoring
progress and providing input to entrepreneurs have been historically sensitive to
distance. This trend might have had reversed somewhat in recent years due to new
communication technologies, though probably not to the extremes seen in case of
crowdfunding (a repeated research on spatial proximity in angel and VC investment
would be warranted in order to definitely confirm this claim). Although the role of
geography appears to be greatly diminished in crowdfunding, there is an important
distinction between distant and local investors when it comes to investment timing,
with distant investors being more responsive to investment decisions of others. The
finance literature (Schwienbacher, 2010) justifies this by acknowledging the role of
family and friends in early-stage ventures who are likely to be local and face less
information asymmetries than other investors. General implication is that CFPs
eliminate most distance-related economic frictions but do not eliminate frictions
associated with information asymmetries where individuals personally connected to
the entrepreneur are likely to be favored. One potential limitation of this study could
be questionable extendibility of its results on other types of CFPs and project
categories. Creative projects, such as music or video games, mostly reside in a
digital space and might very well require different type of monitoring and investor
interaction compared to, for example, hospitality or food industry projects. It would be
also interesting to verify to what extent this effect remains prominent in a pure equity-
based model similar to that used by angels or VCs.
Lin and Viswanathan (2013) performed a similar research to that conducted by
Agrawal et al. (2011), seeking to further explore whether investors on online
investment platforms exhibit a home bias similar to one present in an offline context.
Agents in offline environment, such as businesses and fund providers, are more
likely to conduct transactions with parties residing in a close geographical proximity
(Lewis, 1999), which is generally considered sub-optimal. After a number of tests
using data obtained from debt-based CFP called Prosper, initial findings suggest that
home bias persists also in the crowdfunding space. Existence of home bias in online
investment is being justified by Lin and Viswanathan (2013) as due to emotional,
rather than social or economic reasons. It is worthwhile to note that these results are
at odds with those obtained by Mollick (2013), whose claim is that crowdfunding
might be less subject to geographic biases compared to traditional investments. The
latter researcher used data obtained from Kickstarter, a CFP which operates a
reward-based model instead of a debt-based model used by Prosper, which could
explain the anomaly. However this raises some doubts about robustness of
28
generalized findings and re-states the necessity for further research in this domain
using more comprehensive datasets. Any additional findings would certainly provide
a valuable input for design of future regulatory framework and policies.
The most recent research by Kim and Hann (2014) provided clear evidence in favor
of crowdfunding's potential to democratize access to capital for entrepreneurs who
have difficulty accessing traditional sources of funding. Their analysis showed that
small cities seem to reap proportionally bigger benefits from crowdfunding since
limited access to bank loans in these areas pushes entrepreneurs to rely even
further on crowdfunding. It is worthwhile to note that all these findings relate to
reward-based model and that it would be necessary to repeat a similar research
considering only equity-based platforms in order to check whether the same
geography dynamics apply.
Common points and research gaps
Albeit scarce, existing academic literature still covers some very interesting aspects
of crowdfunding. However, an important gap which applies to most of the studies is
that virtually all focus on reward or donation based models, with equity model hardly
represented. Given the novelty of the concept, this is most likely due to a lack of
available data. Even where data is present, future studies could go a step further and
analyze for instance different revenue sharing models in the context of equity
crowdfunding (Mitra, 2013). Another area which is barely touched upon is the
question of strategic and product development decisions, mainly to what extent the
crowd should have voting rights in enterprise it funds (Belleflamme, 2013). CFPs
themselves have been scarcely researched, with most papers focusing on projects
listed therein and related dynamics and little regard to how exactly platforms facilitate
transactions in those two sided markets (Hildebrand, 2013), how information
asymmetry issues are being managed and to what extent success of otherwise
comparable projects depends on particular CFP which is being used.
An additional topic for research could be the relevance of pecking order theory in this
space and impact crowdfunding might have on the equity food chain of new
ventures. Effects on the economic system as a whole should also be examined as
well as positioning of this concept in relation to conventional sources of finance (as
either complementary or opposing) and dynamics of any interplay which might arise.
Some of these gaps should be hopefully filled, at least partially, in this work which
aims to lay down the first bricks on a path of understanding equity based
crowdfunding and the far-reaching impact it might have in the years to come.
Furthermore, an analysis of motivators for participation in crowdfunding ecosystem
and the consequences of having "lean intermediaries" such as CFPs instead of
traditional intermediaries would help answer questions such as what are the
incentives of entrepreneurs for using this fundraising method or whether
sophisticated investors are taking advantage of retail investors in this space and to
29
what extent. One could also study the level to which a crowdfunding demand is
predictive of future demand for a product or service and to what extent are
intellectual property rights protected in such a context where entrepreneur basically
discloses his product idea in front of a large population. Crowdfunding offers a path
through which user innovators, a frequent source of radical innovation, can transition
to entrepreneurship (Shah and Tripsas, 2007). In this sense, the role of online
communities inside a future venture and to what extent they could replace the know-
how and networks of traditional investors is definitely a stimulating question for future
research.
Five forces that shape the crowdfunding industry
Porter's five forces model encompasses a generation of business practice and
academic work. The basic premise is that even industries which appear different on
the surface have similar underlying factors which drive their profitability. Following
this framework, strategists are encouraged to move beyond direct competitive
analysis and look into forces surrounding and shaping the target industry. The latest
work by Porter (2008) himself goes a step further to stress the importance of subtle
factors such as mutual interplay between seemingly unrelated industries and
strategic decisions which tend to benefit the industry as a whole, rather than
maximize profits of individual participants. Having this in mind, five forces analysis of
the crowdfunding industry is conducted following the "Typical Steps in Industry
Analysis" outlined in Porter (2008).
Crowdfunding is currently in an early stage of development and growing at a very
fast pace. Between 2011 and 2012 the industry grew by around 80%, measured by
the amount of money raised by the biggest crowdfunding platforms worldwide
surveyed by Massolution (2013). The same consultancy forecasts an even faster
growth for 2013, estimating value of the market at around 5 billion USD at the end of
2013. Crowdfunding, narrowly defined, is an intangible goods industry. The final aim
is to "produce" funding for successful startups or realize specific projects and goals.
From a different perspective, the goal could be to "produce" successful crowd
investors and boost economic activity for whole regions. Most often though,
crowdfunding industry is viewed from the angle of crowdfunding platforms (CFPs)
which act as an intermediary connecting all the parties involved in the ecosystem. In
this sense the industry can be viewed as a liaison, facilitator and provider of
transaction services for participants. Consequently entrepreneurs or project initiators
can be viewed as "suppliers" since they supply ideas and projects and the investors
can be viewed as "buyers" who "buy" the ideas and ventures pitched to them.
Starting from this basic setup, substitutes can be explored and new entrants
identified by looking both inside the industry as well as beyond it. The task of
crowdfunding intermediaries is thus two-fold, first to create value in a two-sided
market and second to capture a part of that value. The intermediary is dependent on
participants for the provision of its services, since if there are no subjects interested
30
in a deal the CFP cannot charge commissions or fees. So while the service provided
per se is not highly dependent on other industries (if we omit non-core competencies
such as legal, accounting or banking services), its ability to actually generate service
flows depends strongly on dynamics inside and between respective industries of the
participants. The geographic scope of competition is generally global, though many
platforms do specialize in serving particular local markets.
The participants of the crowdfunding ecosystem are identified and segmented into
strategic groups as presented in Fig. 4. Overall rivalry resulting from these five forces
shapes the industry's structure and the nature of interaction between CFPs as well
as profitability.
Fig. 4 Underlying drivers for competitive forces in the CFP industry
Competitive
forces
Participants Segment
Underlying
drivers
Strength
Buyers
Individual
professional
investors
(angels or
angel
syndicates)
VC Funds
Special
purpose
(mutual) funds
Companies
Accredited
investors
relatively price
insensitive when it
comes to
commissions and
fees charged by
CFPs
large number of
potential crowd
investors
service offered
by CFP is
important to buyer
Modest buyer
power
(=) outlook
Retail investor
(non-
accredited and
non-affiliated
with the project
owner)
FFF (Family,
Friends and
Fools; affiliated
with the project
owner)
Retail
crowd
some ability to
substitute
Suppli
er
s
Business
owners raising
equity
Individuals
rising money
for one-off
Entrepreneurs increasing
competition
between CFPs
some switching
costs
Moderate
supplier power
( ) outlook due
to a rising
number of
CFPs
Details
- Pages
- Type of Edition
- Erstausgabe
- Publication Year
- 2015
- ISBN (eBook)
- 9783954898633
- ISBN (Softcover)
- 9783954893638
- File size
- 2.6 MB
- Language
- English
- Publication date
- 2015 (February)
- Keywords
- crowdfunding overview
