Crowdfunding has emerged as a mechanism of project financing in creative industries, publishing activities and in modern art. Recent success of some platforms, such as Sellaband and Kickstarter indicates a high potential of this mechanism for other areas, however, principles of its functioning have not been still given an adequate meaning in the economic theory. As distinguished from the venture capital funding, crowdfunding does not rely on the risk management framework like social ties and due diligence since it works based on online platforms where strangers meet.
Why Does It Work?
Crowdfunding has become possible due to commercialization of the Internet network. Searching for information online is very cheap: it cuts costs of search for authors of projects and makes the information gathering process about them and monitoring of their implementation easier for investors. More importantly, the Internet made it possible to finance with small amounts invested by an unlimited number of investors, i.e. literally by a ‘crowd’. The minimum size of each participant’s investment decreases in proportion to the increase in their quantity: gradual investing of small amounts significantly mitigates the risk for each individual investor.
The possibility of cutting the cost of funds compared with conventional sources of funding is the major impetus for entrepreneurs. Theoretically speaking, the presence of a large number of potential investors (a ‘crowd’) itself, challenging for the opportunity to invest in a promising project, lowers the cost of funds. Moreover, the financing through crowdfunding has no geographical borders. As contrasted with venture capital investments, which are concentrated in the regions with a large number of tech entrepreneurs and venture capitalists, most crowd investors are physically located at a great distance away from the entrepreneurs they finance (3 thousand miles for Sellaband at the average.) The number of people, who are willing to invest in a risky project in a specific region, or among an entrepreneur’s friends and relatives is limited one way or another. In online crowdfunding, on the contrary, anyone can take part and a pool of potential investors is considerably expanded. Last of all, crowd investors are often ready to invest more money or to undertake higher risk in the search for a non-financial reward, for example, to get access to a limited edition of these or those goods (a book signed by its author) or the privileged customer status (an extended service set for first subscribers for online TV.)
'Crowd' as a Venture Capitalist
Inasmuch as the project implementation is monitored by a ‘crowd’ of investors, many of whom are potential users of the final product, the project creators can take into account the feedback from the audience thereby enhancing the willingness of investors to invest money in the project. The opposite effect is also possible: the dissatisfaction of potential users will make further investments in the project more expensive for its creators.
The presence of a ‘crowd’ of interested investors monitoring the development of the project carries with it one more essential advantage: they can play a role of a sort of a ‘distributed venture capitalist’. Where there are quite many crowd investors, it is likely that there will be people among them, who are able to provide special knowledge required to develop the project, for example, to adjust its business plan or to clarify technological aspects. Therefore, crowdfunding allows entrepreneurs to use knowledge of the crowd for free, which can increase the economic merit of the project. Moreover, where many crowd investors are potential users of the final product, crowdfunding turns into a valuable marketing tool since it makes it possible to assess demand for a product at early stages of its development.
Democratization of Investing
Advantages of crowdfunding, from an investor standpoint, include ’global’ search capabilities already mentioned above, not limited to a specific region; early exclusive access to new products and services; a non-financial reward. More importantly, crowdfunding gives to 'ordinary’ investors access to projects participation in which otherwise would require large-scale investments and formal accreditation as a ‘professional investor’. In this view, it is a tool of democratization of investing: platforms secure the minimum formalization of funding and make it possible for an investor to avoid risking large amounts of money.
That is the value of crowdfunding platforms, the vast majority of which are commercial enterprises. Generally, platforms make money on commissions from successful projects (4-5% of total amount of investments received.) To function effectively they need to involve quite many quality projects, to counteract fraud and to ensure the effective circulation of information. The purpose of functioning of platforms is to maximize the number of successful projects, the volume of investments received by them as well as the public interest to attract new investors.
The risks of crowdfunding are related to the non-proportional distribution of financing and the excessive optimism of investors. According to the statistics of 2013, 10% of Kickstarter projects got 63% of all investments; in 2006-2009, 0.7% of projects on Sellaband won 73% of all investments, while 61% of projects did not get anything at all. Crowd investors invest rather in projects, which are at the final stages of a fundraising campaign: prospects for success are doubled for projects that have already got 80% of a required amount, in contrast to the projects that succeeded to raise 20% only. As a general thing, crowd investors are too optimistic and have to revise their expectations: a study of 2012 has showed that out of 247 successful projects on Kickstarter under ‘design’ and ‘technologies’ categories, only 50% met the declared deadlines due to insufficient competence of their founders. Furthermore, entrepreneurs cannot keep up with excessive demand for their product due to the lack of managerial competence. Vagueness of the ‘quality’ of the project founders is an unavoidable source of the risk for crowd investors.
Fraud is one more important risk. Small size of investments weakens incentives to study projects thoroughly. Since information about investments is publicly available, and participation therein is almost not limited, herding behaviour is possible, i.e. instead of an in-depth analysis investors make investments in the projects already funded by others. Given excess optimism of crowd investors, this results in the regular underestimation of the risk of fraud. On the other hand, the cheapness and simplicity of online communications substantially simplify the creation of fraudulent web pages, which look like authentic crowdfunding companies. Thus, the advantages of crowdfunding make it vulnerable to manipulations on the part of unfair investment seekers. To mitigate this risk, the platforms have to implement tougher standards for disclosure of information making crowdfunding closer to conventional financial markets.