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Financing by and for the Masses: An Introduction to the Special Issue on Crowdfunding

EXECUTIVE SUMMARY

 

Introduction

In the past, launching a company and shipping a product was something that could only be done by those who had money, or those who could attract investment from venture capitalists. But things are changing. The advent of crowdfunding platforms -- internet-based marketplaces that connect those seeking funds with hundreds if not thousands of supporters -- has been greeted with enthusiasm by entrepreneurs, policymakers, and the general public alike. Their enthusiasm is understandable: today, normal people can invest in ideas that they think might gain broad appeal. But crowdfunding remains an emerging and evolving phenomenon that is not well understood. Who will be the winners and losers in this new game? How and when should entrepreneurs, managers, and investors shift their strategies to contend with these new players? It is important to examine not only the present state of crowdfunding, but also the ways in which it might shape the future.

"The advent of crowdfunding platforms has been greeted with enthusiasm by entrepreneurs, policymakers, and the general public alike."

What is Crowdfunding?

The idea that an entrepreneur would raise funds from hundreds or thousands of investors, each providing just a small amount, is hardly new. In 1985, Paul Hogan and John Cornell tapped 1400 Australian investors to produce the blockbuster movie Crocodile Dundee. In the 1970s and 1980s, limited partnerships, which required minimum investments of no more than $2,000, became a popular form of financing everything from shopping malls to oil and gas exploration. And charities, of course, have long relied on funding drives that aggregate thousands of small donations.

What is new is the emergence of powerful platforms to facilitate these campaigns. As in so many other cases, the internet has played an instrumental role. Crowdfunding websites like Kickstarter and Indiegogo dramatically lower the costs of a campaign by leveraging the geographic and social reach of the internet to connect fundraisers to millions of potential backers. In exchange, platforms charge those receiving funds a small fee, typically a percentage of the amount raised.

Crowdfunding Models

Equity
Equity-based sites, such as AngelList and CircleUp, offer a platform on which one can sell shares of a company. Only a tiny fraction of the overall funds that have been raised to date -- perhaps 7% -- have been in exchange for equity. Legal and practical constraints have stood in the way of its growth.

Debt
Crowdfunded debt, often known as peer-to-peer lending, is part of a larger revolution in “FinTech,” internet software that aims to disrupt traditional finance industry. While banks have traditionally served as an intermediary for loans, the peer-to-peer model allows people to lend money directly to those who need it, allowing savers to earn more and borrowers to pay less. However, these platforms increasingly do not involve crowds.

Rewards
Rewards-based sites represent one of the real innovations in crowdfunding. From a legal point of view, reward-based sites have usually been organized as donation sites. Funders provide backing with the promise of something in return, but with relatively little recourse if it never arrives. Kickstarter is the most well-known example of this model, and has been used to fund everything from the creation of albums and short films to the development of 3D printers and smartwatches.

Charity
On charity platforms, such as Causes or Crowdrise, fundraisers usually do not offer anything in return for the donations, except for information and feedback about the good deeds that those campaigns have enabled.

Implications

Crowdfunding has been growing at a steady rate worldwide. Crowdfunded debt accounts for the largest share of the overall volume, but donation-based funding has been growing a little more rapidly. The popularity of crowdfunding has opened up new opportunities for both entrepreneurs and investors.

Entrepreneurs are excited by the opportunity to receive support for their projects, even when they themselves are not located near major hubs of entrepreneurial activity like Boston, New York, or the Bay Area -- a limitation of traditional venture capital. There’s another major advantage of crowdfunding, too. Evaluating pre-sales, particularly under the rewards-based model, allows entrepreneurs to get a sense of the probable demand for their products before investing heavily in developing or manufacturing them.

Investors are excited about the idea that a larger range of individuals might invest in the next Amazon or Google. This excitement, however, raises some concerns. For one, even professional investors find it difficult to select winning startups. As an investment class, venture capital has lagged behind the S&P 500 for most of the last decade. In the case of peer-to-peer lending, there are no banks to absorb the risk of default. But along with the risk comes the possibility of much larger returns, and crowdfunding platforms are already innovating ways to address concerns at each stage of investment.

Crowdfunding remains in its early days. As the underlying economy and regulatory climate continue to evolve, it is difficult to predict the future. Broad trends in technology have led to a growing democratization of the tools and resources necessary to ideate, create, and share. Time will reveal the true value of crowdfunding in promoting innovation, wealth creation, and more.