Learning Through Crowdfunding

In our recent paper, we develop a framework that highlights the economic rationale for the existence and success of reward-based crowdfunding platforms.

Reward-based crowdfunding reflects a consumer-producer relationship rather than an investor-producer one. This form of crowdfunding explicitly forbids financial rewards: backer rewards typically take the form of promises to deliver a product by a specified date. Further, such a direct relationship involves moral hazard – provided a campaign succeeds the firm obtains the funds before it invests, and may be tempted to divert them instead of investing and delivering the products. Backers participating in reward-based crowdfunding have little legal protection against such behaviour. And although firms that do not deliver the product may face some reputation costs, these costs are unlikely to be very high.

Despite this moral hazard, the vast majority of firms that succeed in their crowdfunding campaigns deliver rewards. Furthermore, reward-based crowdfunding appears to be particularly attractive for innovative and risky projects such as technology gadgets or video games. When successful, these projects tend to raise the highest total contributions from backers: these massively exceed the funding targets set by the firm.

We argue that it would be misleading to consider reward-based crowdfunding to be merely a source of funding for firms that are unable to raise funds from other sources (eg, from banks or angel investors). Instead, we show that reward-based crowdfunding creates value mainly because it enables firms to learn whether there is enough interest for their project idea, and to make better investment decisions that depend on the outcome of the crowdfunding campaign. The greater the uncertainty about future demand, the higher a firm’s gain from such learning. This can explain why innovative projects have indeed most to gain from crowdfunding.

We argue that the inability to raise funds before the campaign is not the main driver of the firm’s decision to engage in crowdfunding. In fact, large unconstrained corporations appear to be using crowdfunding when launching new projects more and more frequently. A large number of firms have raised financing from angel or venture capital investors after a successful crowdfunding campaign, including after unsuccessful attempts to raise such capital before. A campaign that attracts a sufficient number of backers increases both expected future demand and firm value. This makes investment more attractive both for internal and external parties. Firms may be unable to raise funds before their campaign, but they may cover their investment needs ex post and they are more likely to be able to raise external financing after a crowdfunding campaign.

Both the success and the failure of a crowdfunding campaign are valuable to the firm. Indeed, a firm benefits from learning that demand is low, as it can then choose to not invest and to not develop the product, saving unnecessary investment costs associated with negative NPV (net present value) projects. These cost savings are important. We show that firms facing very low investment costs that could credibly commit to invest and deliver the product would choose not to participate in crowdfunding, opting instead for an alternative source of funding.

We also explain the frequent oversubscription of successful projects: as our argument goes, backer participation decisions do not need to be driven by their desire to ‘help the firm’ to cover its costs. The greater the funds a firm raises during a fixed length campaign, the higher future expected demand from the consumers who did not have the chance to participate during the campaign. This is precisely what is required to guarantee that firms do not divert the funds obtained during a successful campaign even in the absence of reputation costs or any legal risk from diverting funds. Learning not only creates value, but also mitigates moral hazard. Furthermore, third party crowdfunding platforms are beneficial because they enable firms to commit to keep the length of their campaign fixed. This facilitates public, accurate information sharing about backer demand.

Gilles Chemla is Professor of Finance at Imperial College London. Katrin Tinn is Assistant Professor of Finance at Imperial College London.