Reward Crowdfunding and Entrepreneurial Moral Hazard

Given the well-documented problems of entrepreneurial moral hazard, the recent popularity of crowdfunding, with its defining feature that there is no active financial intermediary who demands partial control rights or monitors the entrepreneurial venture, is surprising. Indeed, the main economic rationale for the empirical observation that financial intermediaries such as investment banks and venture capitalists are the usual source for entrepreneurial financing, is their ability to limit moral hazard. In particular, coordinating investment through a single financial intermediary mitigates free riding problems in controlling the entrepreneur, and prevents a duplication of monitoring costs.

The recent popularity of reward crowdfunding platforms such as Kickstarter and Indiegogo, who take no active role in managing or monitoring the entrepreneur’s project, is therefore puzzling. Especially so because even these platforms themselves are fully aware of the problem and explicitly warn potential backers of crowdfunding projects about entrepreneurial moral hazard. On the other hand, the recorded incidences of moral hazard in crowdfunding are surprisingly low. This raises two basic questions. First, are there any economic benefits to reward-based crowdfunding which traditional forms of entrepreneurial financing cannot provide? Second, how does crowdfunding manage to control entrepreneurial moral hazard so well? In a recent paper, I give answers to these two questions.

The answer to the first question is that reward-based crowdfunding provides innovation by giving an entrepreneur ready access to his or her consumers before the final investment decision has been taken. This allows an entrepreneur to learn about the potential demand for the product and, thereby, the project’s profitability. Hence, crowdfunding enables the entrepreneur to base his or her final investment decision on more accurate information. By specifying hard funding targets, so-called ‘all-or-nothing’ crowdfunding schemes do this automatically. Only if enough consumers pledge and the funding target is met - revealing that demand for the product is high -, the entrepreneur receives the money to invest. If, in contrast, the funding target is not met - revealing that demand is low - the entrepreneur receives no money. These schemes, therefore, address a problem which standard financial intermediaries do not: learning about whether consumers’ demand justifies the investment. In other words, reward-based crowdfunding has the economic advantage over traditional forms of entrepreneurial financing of providing more accurate information about whether there is enough demand for the product to make the investment worthwhile.

The answer to the second question is that crowdfunding platforms limit moral hazard by allowing entrepreneurs to sell their crowdfunded product also to non-crowdfunding consumers in an aftermarket. The prospect of these aftermarket sales acts as the carrot that keeps entrepreneurs in check. In particular, if entrepreneurs do not complete their project diligently, they forgo on the profits attached to these sales. Current crowdfunding schemes, however, not only limit the threat of moral hazard by explicitly allowing entrepreneurs to sell goods in aftermarkets: their specific structure also enables the crowdfunding consumers themselves to actively manage moral hazard. In particular, the fact that pledging takes place sequentially and that platforms report up-to-date information about the pledged funding level allows consumers to adopt the following conditional pledging strategy. A consumer pledges only if the contributions of previous crowdfunders do not yet meet the funding target. That is, as soon as the funding target is met, the consumer does not participate in the crowdfunding but acquires the entrepreneur’s product in the aftermarket. This conditional pledging behavior mitigates moral hazard in an informationally optimal way for two reasons. On the one hand, by setting a funding target above the investment cost, it informs the entrepreneur about whether there is sufficient demand to make the project profitable. On the other hand, it does not inform the entrepreneur about by exactly how much the project’s profits exceed investment costs. As I show in my paper, leaving the entrepreneur in the dark about the size of these extra profits is an optimal way to control moral hazard, because the moral hazard problem is most severe when there is only just enough demand to make the project profitable. Hence, by only allowing the entrepreneur to learn that there is enough demand, but not exactly how much, consumers minimize the threat of moral hazard when adopting these conditional pledging strategies.

While crowdfunding schemes allow consumers to mitigate moral hazard, the threat of moral hazard generally leads to inefficiencies. These inefficiencies express themselves in a funding target that, from an aggregate surplus perspective, is inefficiently high. In general, these distortions are needed to make it credible to consumers that the entrepreneur does not succumb to moral hazard. The need and exact size of these distortions depend on the degree of moral hazard and the ex ante expected surplus of the project in comparison to required investment costs. Only if the ex ante surplus is large enough in comparison to the investments costs, the efficient funding target prevents moral hazard. Only in this case the threat of moral hazard does not lead to inefficiencies.

Moreover, private information about investment and production costs may severely intensify the moral hazard problem. Yet, I also show that, without moral hazard, this type of private information does not affect the efficiency of crowdfunding. As a result, one may view moral hazard as a first order problem, while private information about the cost structure is of second order. Since, in general, private information concerning the entrepreneur’s cost structure affects the efficiency of crowdfunding, platforms have incentives to limit the amount of private information. In practice they do so by, for instance, requiring the entrepreneur to present a prototype which is to demonstrate the viability of the project at reasonable costs.

While crowdfunding has the advantage over traditional forms of entrepreneurial financing that it can provide more accurate information about consumer demand and thereby the profitability of the project, there is no inherent reason why this advantage of crowdfunding cannot be attained through a financial intermediary. That is, crowdfunding should be seen as a complement rather than a substitute to more traditional forms of entrepreneurial financing. As a concrete illustration of how combining crowdfunding with venture capital can help, consider the following sequential financing strategy. The entrepreneur first approaches a venture capitalist (‘VC’). The VC invests only if he is convinced that demand for the product is high. If not, the VC turns down the project and the entrepreneur starts a crowdfunding campaign with a funding target that, due to the moral hazard problem associated with crowdfunding, has to be set at an inefficiently high level. After a successful campaign, the entrepreneur finances her project through crowdfunding. If, however, the crowdfunding campaign falls short of its target by a relatively small amount then this reveals that, in principle, demand is high enough to make the project profitable, but not high enough to also cover the agency costs associated with moral hazard under crowdfunding. Given that the VC has better means to control moral hazard and, therefore, has smaller agency costs, the entrepreneur may then return to the VC to obtain funds.

Roland Strausz is Professor of Economic Theory at the Humboldt-Universität of Berlin.