Crowdfunding and entrepreneurial finance expert Karthik Krishnan shares insights on the state of crowdfunding and expands on findings from his recent paper, What do crowds really want? Crowdfunding and early product access, which he co-authored with Lucas Lohmer and Pinshuo Wang.
Q. How did crowdfunding start and what is reward-based crowdfunding?
Crowdfunding was originally meant for creative activities such as music, books, and art to raise funds from end users. One of the early examples of crowdfunding through the Internet was the British Rock band Marillion who raised $60,000 from fans to finance their US tour in 1997.
Reward-based crowdfunding that we see at portals such as Indiegogo and Kickstarter are relatively new and started as arts-support and donation portals. People then realized that this can be a way to raise money for startups at the very initial stages. They also realized that crowdfunding can be a way to get feedback from the markets about a product itself. As a result, reward-based crowdfunding has been used to access financing in a different way – directly from potential customers.
Q: Why is it critical to have a product (pre-sales) reward for the backers of crowdfunding campaigns?
People participate in reward-based crowdfunding for many reasons. These include the desire to support a cause or an idea (in the case of arts), the desire to be part of a community, and the desire for pre-sales products. We study this last reason for crowdfunding. In particular, the idea is that crowdfunding may be a way to buy a product that is not available from conventional outlets for a relatively low price.
Using data obtained from Indiegogo, we find that people invest in certain campaigns because they want a product. Campaigns offering presales products are more likely to raise more than 150% of their campaign goal than other campaigns. This seems to be reflective of a population of potential funders that want a product in return for their investment.
Q: How does the technological novelty of a product effect crowdfunder behavior?
Funding a product that you can buy anywhere else is not worth the risk of crowdfunding, where failure to perform is a big concern. Crowdfunding portals such as Indiegogo make no promises about whether you will get anything in return for your contribution, and market themselves as donation portals. In fact, there are cases where people invest money in crowdfunding campaigns seeking product-based rewards, and do not get anything.
Rather, you want to fund something that is new and you cannot get anywhere else for it to be worth the risk of investing in crowdfunding campaigns. Technologically novel products, that are relatively new and that are unavailable from conventional outlets, are such products.
In our paper, we use devices connected to the Internet, which are termed collectively as the Internet-of-Things (IoT) as our proxy for technological novelty. We see more and more how machines that we use every day are getting connected to the Internet, including our cars, watches, home appliances, etc. The Pebble watch, which was the first-of-its-kind smart watch, is an example of such devices. This campaign, for example, raised $200,000 in the first hour it was up on Kickstarter, and raised a total of $10 million.
Consistent with this, we find that our results on pre-order sales driving campaign success are partly driven by IoT campaigns. We also do a keyword analysis of funder comments and find that anticipatory keywords such as “excited,” “can’t wait,”“hurry” and “look forward to it” are more likely to be associated with such technologically novel products, confirming that individuals want these products (and that they want to use them as soon as possible).
Q. What are fixed- and flexible-funding campaigns, and how do they predict crowdfunding success?
Indiegogo is one of the few portals that offers a choice between fixed-funding and flexible-funding campaigns. Effectively, campaign teams choosing fixed-funding campaigns only raise money when they get pledges for at least the campaign amount, whereas teams choosing flexible funding campaigns get any amount of money that they raise, even if they do not reach their campaign goals.
We find that fixed funding campaigns with pre-sales products are more likely to be successful in raising substantially more money than their campaign goal. We argue that fixed funding campaigns are chosen by entrepreneurs that have more developed and later stage products, and our evidence is consistent with this. In particular, teams choosing fixed-funding campaigns are more likely to deliver the pre-sales product to funders.
Q. Can crowdfunding success lead to follow-on financing success?
Researchers in this area have shown that successful crowdfunding campaigns can increase the likelihood of follow-on financing from outside investors. Success in crowdfunding, albeit rare, sends a positive signal to outside investors of both the product viability (potential customers are willing to fund it) and better developed products (due to access to more funds). Venture capitalists and angel investors, who are taking a lot of risk investing in startup firms, will view such a positive signal as a vindication of the underlying business model and the commercial value of the product.
Q: What is the main concern that policymakers have in regard to crowdfunding?
Policymakers are primarily concerned that individuals that have little money and little understanding of crowdfunding campaigns or the underlying business can lose their money on bad or fraudulent campaigns. It is the same reason, for example, that seed-stage investing by angel investors has so far been restricted to “accredited” individuals, which refers to individuals who have certain minimum wealth levels.
The SEC has only recently allowed equity-based crowdfunding in which small investors can invest in stock of small firms and startups, albeit with certain limits. These limits try to ensure that individuals can make riskier bets with the promise of higher returns and allow startups to raise money from additional sources, but at the same time prevent individuals from losing a significant proportion of their wealth on bad investments.
Q: What do you believe is the future of crowdfunding?
We should see some early interest in equity-based crowdfunding, which may lead to some levels of overvaluation in these markets. However, our paper’s results suggest that individuals are, on average, relatively rational in reward-based crowdfunding campaigns.
I would be interested in knowing what would happen if securities brought through crowdfunding were allowed to be traded in a secondary market (currently they are not). On the one hand, individuals can get out of their positions in a more liquid market, but, on the other hand, it can facilitate bubbles if individuals try to buy securities that they think that others will buy at an even higher price.
We may also see funds that bundle crowdfunded securities into mutual-type funds or even collateralized securities (in case of debt). History is full of such examples – and then the question becomes how far do we see this go?