The Economics of Crowdfunding

This chapter discusses how crowdfunding fits into the traditional financing cycle of small businesses. It further raises the question as to whether crowdfunding resolves a funding gap, a necessary condition to justify crowdfunding as a viable source of entrepreneurial finance. Finally, the chapter elaborates on the types of entrepreneurial activities and entrepreneurs who are more likely to benefit from crowdfunding.

This chapter positions the study of signals in crowdfunding within the broader literature on signaling in entrepreneurial finance. I deliver a theoretical discussion and definition of signals in crowdfunding, including examples of penalty and handicap signals, differentiating them from passive characteristics and cheap talk. I propose a taxonomy of signals that matches the senders—namely, such organizations as firms and nongovernmental organizations, and individuals, including both proponents and fellow crowd-funders—and receivers, such as backers, lenders, and investors. Existing studies are classified in this taxonomy based on the definitions of reward- and donation-based crowdfunding, crowd-investing, and crowd-lending. I conclude by identifying future research directions and calling for studies on post-signal performance.

This chapter discusses the crowd–entrepreneur relationship as an important foundation for crowdfunding success. We present community benefits enjoyed by the crowd as crucial in shaping the entrepreneur’s choice between different business models (crowdfunding vs. crowdinvesting). Then, in the crowdinvesting context, we show that this crowd–entrepreneur relationship is plagued by persistent asymmetric information problems of hidden information and hidden action, which undermine financing decisions and campaign outcomes. We highlight how entrepreneurs can address these problems by taking sophisticated investors or a syndicate of investors on board.

Evidence on fraudulent behavior in crowdfunding is scarce. This does not mean that there is no fraud. Hainz discusses the incentives to engage in fraud in a very simple theoretical model and highlights the role of uncertainty. She shows that the terms of the underlying contract influence the incentives to behave honestly and that a reduction of information asymmetries can help to limit fraud. The fact that we observe hardly any fraud cases may be due to low incentives to detect fraud. Although the costs of gathering information leading to the detection of fraud in crowdfunding might be lower than in the corporate world in general, the benefits might be low as well because many investors participating in a campaign contribute only small amounts and cannot coordinate their efforts to detect fraud. Reviewing the existing evidence on potentially fraudulent behavior by backers, borrowers and entrepreneurs Hainz shows its limitations. She argues that counting fraud cases underestimates the true problem because the incentives to report fraud are limited. The figures on non-deliveries and defaults, however, tend to overestimate the problem as non-fraudulent projects also fail.

For the last decade economists have been preoccupied with the decline in bank financing to small businesses and entrepreneurs. We examine the market and policy instruments that in some sense encourage more bank lending to SMEs. This leads us naturally to explore the recent surge in Fintech lending that has affected the ability of SMEs and entrepreneurial firms to obtain loans. We consider recent evidence that the growth of alternative online lending has supplied new competition to traditional banks and is beginning to disrupt the tradition of business of lending. Finally, we examine the regulatory responses to Fintech in 17 jurisdictions. We examine the first time that venture capitalists invest in fintech companies to determine whether there is a meaningful connection between levels of investment and regulatory choice. Our findings have implications for how regulation is likely to play an important role in the development of Fintech.

Crowdfunding has attracted considerable interest as a new way of financing a variety of ventures, from creative works to for-profit companies. For example, as of 2017, Kickstarter, the largest reward-based crowdfunding site, has facilitated the raising of over USD 2.9 billion from over 12 million people, funding over 100,000 projects. In this chapter, I will use data from two large-scale surveys of Kickstarter funders to shed light on the impacts of reward-based funding. I will first examine whether crowdfunded projects actually provide their promised rewards. Then I will delve into the wider impact of reward crowdfunding projects.

Entrepreneurs are turning to crowdfunding as a way to finance their creative ideas. Crowdfunding involves relatively small contributions of many consumer-investors over a fixed time period (generally a few weeks). The purpose of this chapter is to add to our empirical understanding of backer dynamics over the project-funding cycle. Publicly available data of two years on projects listed on Kickstarter are used to establish that the typical pattern of project support is U-shaped—in general, backers are more likely to contribute to a project in the first and last weeks as compared to the middle period of the funding cycle. We further establish that this U-shaped pattern of support is pervasive across projects, including both successfully and unsuccessfully funded projects, those with large and small goals, and projects in different categories. We then empirically explore the dynamics associated with several factors, including collective attention effects from platform-sorting options, the role of family and friends in supporting projects, the effects of social influence, and the role of project updates over the project-funding cycle.

The regulation of crowdfunding in the United States is multifaceted. Donation- and reward-based crowdfunding are essentially unregulated, subject only to the prohibitions on fraud and false advertising that apply to all commercial transactions. But crowdinvesting and most forms of crowdlending must comply with the registration and prospectus requirements of the Securities Act of 1933, unless an exemption is available.

Four different exemptions are available. Two of these, Rules 506(b) and 506(c), allow sales to wealthy or sophisticated investors with little additional regulation. Section 4(a)(6) of the Securities Act and its implementing regulation, Regulation Crowdfunding, allow sales to the general public, but at a high regulatory cost. Section 4(a)(6) and Regulation Crowdfunding heavily regulate all three participants in the crowdfunding process—issuers, intermediaries, and investors—and impose significant limits on the structure of offerings. Finally, many US states have adopted state crowdfunding exemptions that are coordinated with the federal intrastate offering exemption. These state exemptions are of limited usefulness because the issuer and all investors must be located in a single state.

This chapter aims to give an overview of the regulation of crowdinvesting in Europe. It also tries to assess whether there is need for further regulation. To these ends, it outlines the general regulatory framework on the supranational EU level. With regard to the Member State level, the chapter discusses the laws of the UK and Germany, two almost antagonistic approaches to the regulation of crowdinvesting. Finally, it sheds light on the contractual terms under which crowdinvesting is taking place in Europe and discusses investor protection mechanisms crowdinvesting platforms have developed in the absence of regulatory requirements.

Crowdinvesting—raising many small contributions of capital from individual funders via specialized online platforms—is a burgeoning phenomenon. This chapter first highlights the perils to which individual investors are exposed when they access these platforms. Next, it describes the legal regime in two sample jurisdictions, the US with its tradition of high-fixed-cost, disclosure-intensive securities laws that had to be tweaked to make equity crowdfunding viable, and the UK, which has early on provided for a nimble set of rules for the same. Finally, the chapter offers some thoughts on the merits of introducing a lighter regime for equity crowdfunding.