CrowdfundingFunding Innovation throughInnovation in FundingNiels Schlesier & Sergio GutiérrezMSc Economics of Science and ...
2                                      Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & S...
3                                        Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier &...
4                                        Crowdfunding Funding Innovation through Innovation in Funding      Niels Schlesie...
5   Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & Sergio Gutiérrez    3.5 Meet the cro...
6   Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & Sergio Gutiérrez    less wise, is ho...
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8                                  Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & Sergi...
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12                                  Crowdfunding Funding Innovation through Innovation in Funding                Niels Sch...
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14   Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & Sergio Gutiérrez     8 Conclusion  ...
15   Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & Sergio Gutiérrez     Bibliography  ...
16   Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & Sergio Gutiérrez     Knowledge@Whar...
17   Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & Sergio Gutiérrez     Sorenson, O., ...
18   Crowdfunding Funding Innovation through Innovation in Funding   Niels Schlesier & Sergio Gutiérrez        Appendix   ...
Crowdfunding: Funding Innovation through Innovation in Funding – BGSE Thesis
Crowdfunding: Funding Innovation through Innovation in Funding – BGSE Thesis
Crowdfunding: Funding Innovation through Innovation in Funding – BGSE Thesis
Crowdfunding: Funding Innovation through Innovation in Funding – BGSE Thesis
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Crowdfunding: Funding Innovation through Innovation in Funding – BGSE Thesis


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Do you know crowdfunding? In an online survey conducted primarily among entrepreneurs and students in the field of innovation and entrepreneurship, almost 50% answered “No”. Even cutting-edge innovator Google continuously suggested the authors of this thesis to check the spelling of “crowdfunding” when writing the thesis on Google docs. Further anecdotal evidence can be found in our classes and seminars. During our master program, we have been taught different ways how startup ventures can raise capital and have engaged in discussions with entrepreneurs and technology transfer officers. Crowdfunding was not mentioned. Yet, we remember our thesis advisor and innovation consultant Paco Conde of LTC saying that many of his clients, when thinking about innovation, primarily think of their production process thereby neglecting the importance of innovation at the financing (and distribution) stage.
In July 2010, thus almost coinciding with the beginning of our studies at Barcelona Graduate School of Economics, the search term “crowdfunding” for the first time generated enough traffic to be spotted by Google Trends (Figure 1). Throughout the last year search volume has steadily increased, demonstrating growing interest and awareness of the topic.
Crowdfunding in general and crowdfunding for startup companies in particular are nascent phenomena that made it to the headlines only recently but bear the potential to drastically change the way startup companies are financed today.

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Crowdfunding: Funding Innovation through Innovation in Funding – BGSE Thesis

  1. 1. CrowdfundingFunding Innovation throughInnovation in FundingNiels Schlesier & Sergio GutiérrezMSc Economics of Science and Innovation, 2011Barcelona Graduate School of EconomicsSupervisor: Paco Conde, LTC Project (Barcelona).1. INTRODUCTIONDo you know crowdfunding? In an online survey conducted primarily among entrepreneurs and studentsin the field of innovation and entrepreneurship, almost 50% answered “No”. Even cutting-edge innovatorGoogle continuously suggested the authors of this thesis to check the spelling of “crowdfunding” whenwriting the thesis on Google docs. Further anecdotal evidence can be found in our classes and seminars.During our master program, we have been taught different ways how startup ventures can raise capitaland have engaged in discussions with entrepreneurs and technology transfer officers. Crowdfunding wasnot mentioned. Yet, we remember our thesis advisor and innovation consultant Paco Conde of LTC sayingthat many of his clients, when thinking about innovation, primarily think of their production process there-by neglecting the importance of innovation at the financing (and distribution) stage.In July 2010, thus almost coinciding with the beginning of our studies at Barcelona Graduate School ofEconomics, the search term “crowdfunding” for the first time generated enough traffic to be spotted byGoogle Trends (Figure 1). Throughout the last year search volume has steadily increased, demonstratinggrowing interest and awareness of the topic.Figure 1 Google Trends SearchVolume Index for “crowdfunding”,July 2010-June 2011.(Source: Google Trends)Crowdfunding in general and crowdfunding for startup companies in particular are nascent phenomenathat made it to the headlines only recently but bear the potential to drastically change the way startupcompanies are financed today. With this thesis we seek to give an overview of where the crowdfundingphenomenon ideologically comes from, which form it currently takes and where crowdfunding for startupcompanies may potentially go.Therefore, the remainder of the thesis is organized as follows: Section 2 briefly comments on the me-thodology. Section 3 introduces a definition and discusses the background and basic ideas of crowdfun-ding. Section 4 explains changing paradigms that relate to crowdfunding. Section 5 analyses the currentcrowdfunding market. Section 6 shifts the focus to the current regulatory environment. Section 7 is devo-ted to the future of crowdfunding for startups. Section 8 concludes.
  2. 2. 2 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez 2 Methodology propose a crowdfunding definition within the Due to its short history, only very few data scope of high-growth startup financing. In simple on crowdfunding for startup companies are terms, crowdfunding is “the financing of a project available. In an attempt to collect primary data, or a venture by a group of individuals instead of we have set up an online survey that was spread professional parties, [i.e. instance, banks, venture through relevant LinkedIn groups, personal con- capitalists or business angels]. Individuals already tacts and to potential multipliers such as the 22@ finance investments indirectly through their Barcelona Incubation Center or the ESADE- savings —since banks act as intermediary. In con- Creapolis network. Unfortunately, with only 99 trast, crowdfunding occurs [ideally] without any responses out of which 46% had not heard about intermediary”. However, as we will see along this crowdfunding before, the survey did not generate paper, crowdfunding faces some legal challengesSidenote 1 In Appendix 1, we provide enough data to draw conclusions from1. that oblige indeed to use some mediation.a link and a password to the surveyresults. For the same reason as data scarcity, theoretical 3.2 Different kinds of investments research on the topic has just begun. Where Investments in the crowdfunded venture can take possible we will refer to research that focuses on different forms. Schwienbacher and Larralde crowdfunding in general rather than aiming at (2012) propose three different stages: The lowest startup companies. Since crowdfunding for star- level of engagement takes place when the crowd tup ventures is driven by practitioners, weblogs donates money instead of investing. A well- are one major sources of information. We have known example is the grassroots fundraising also leveraged on relevant research from other campaign of Barack Obama during the 2008 fields. presidential campaign. Since crowdfunding originated in the social and cultural sector and already is at a more mature development stage 3 Definition and basic ideas than in the startup sector, donations still play a 3.1 Definition of crowdfunding major role. For the scope of this paper, they are, Crowdfunding, particularly for startup com- however, of minor interest. panies, is still in its early development stage. Until now, the amount of theoretical research is At the next level, passive investments by the limited. Thus, there is no agreed-upon standard crowd also do not offer any engagement in the definition. invested project. Unlike donation, passive inves- tments are, however, based on the expectation of Reflecting that crowdfunding, by its name, is a return. Project owners seeking passive inves- an effort of the crowd, Lawton and Marom tments do no offer active involvement. Rather, (2010) use the crowd-generated definition cu- they are solely interested in raising money. rrently available on Wikipedia, which describes Active investments on the other hand, actively crowdfunding as “a collective operation, atten- involve the crowd, e.g. through requiring infor- tion and trust by people who network and pool mal expertise, formal investor boards or votings their money and other resources together, usually about product characteristics. Offering active the Internet, to support efforts initiated by other investments is a way to access “smart money”, i.e. people and organizations”. financial investments plus the promise to support the project in some additional way. Investors, Among the efforts taken at a theoretical level, who actively engage in the production process, Kleemann et al. (2008) highlight the trade- yield valuable information about the market sen- off factors involved in the phenomenon and timent and may help to select optimal consumer describe crowdfunding as “an open call, essen- targets. tially through the Internet, for the provision of financial resources either in form of donation or The latter two forms include rewards for the in- in exchange for some form of reward and/or vo- vestors either in kind or monetary. Rewards can ting rights in order to support initiatives”. More take various forms from pre-ordering discounts recently, Schwienbacher and Larralde (2012) at a discount to profit shares or equity in the
  3. 3. 3 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez startup. Different forms of financial rewards will 1. Collaboration permits to combine each be discussed in sections 5 and 6. other’s knowledge and resources. 2. Openness allows people to contribute freely Turning from the dimension of the involvement to different projects. to the type of investments, financial support, 3. Participation is increased thanks to the ease the crowd can also contribute in kind. Platforms of access. such as GrowVC (see Appendix 2) allow parti- cipation as ‘expert’. Under this scheme, valuable In line with Lee et al.’s arguments, Kleemann et consulting inputs count as investments. In this al. (2008) underline the importance of the “Web respect, we can find in the literature (Schwienba- 2.0 prerequisite” for the development of the cher & Larralde, 2012) cases where the inputs in crowd: professional services have reduced the need for cash initially calculated:, a tourism- 4. From the social point of view, the Web 2.0 related French website, had the goal of raising allows for an easier gathering of people who €90,000 (divided in 300 shares of €300). Since share a common interest. some people in the crowd was actively collabora- 5. From the economic point of view, the abili- ting with them in the development of the site — ty of anyone to create content and upload it in exchange for shares— but also helping spread on the web, for public viewing and sharing. the word on the internet. Given that they were getting from the crowd services that otherwise Motivation is also a key element to understand would had being commissioned to ‘normal’ the inner workings of the crowd. Kleemann et al. suppliers— their cash needs decreased and they claim that participants in crowdsourcing projects were able to stop the process at €55,800. have both an intrinsic motivation (that relates to the pleasure or fun of doing the particular task) 3.3 The origin of crowdfunding: and an extrinsic motivation (particularly, external Web 2.0 and crowdsourcing reward —money and goods— career benefits, Crowdfunding has its roots in the advent of the learning, recognition or even dissatisfaction with social web and its capacity to leverage on massive current products —prosumer2 behavior).Sidenote 2 In this context prosumer groups of individuals to perform certain tasks:can be thought of as converse to the crowdsourcing. The term itself was coined by Jeff Establishing the relation between crowdsourcingconsumer with a passive role, denotingan active role as the individual gets Howe and Mark Robinson in the June 2006 issue and crowdfunding is fairly intuitive and onlymore involved in the creation and of Wired Magazine. takes a stone’s throw: substitute effort and con-development process. tent by money and the crowd turns from a source Kleemann et al. (2008) provide a good scholar into a fund. definition for the phenomenon: “Crowdsourcing takes place when a profit oriented firm outsour- 3.4 Risk, moral hazard, ces specific tasks essential for the making or sale and information asymmetry in the of its product to the general public (the crowd) crowdfunding setting in the form of an open call over the Internet, Crowdfunding involves also certain information with the intention of animating individuals to and uncertainty problems, similar to those in the make a [voluntary] contribution to the firm’s traditional settings but slightly different in their production process for free or for significantly impact. less than that contribution is worth to the firm.” One prime example is Wikipedia, where a large The sharing of risk in crowdfunding is explained enough number of individuals exerting a multitu- in the same way as in traditional funding setting. de of little efforts can produce a huge amount of According to Schwienbacher and Larralde (2012) high-quality content. equity investments are “a way to spread risk over different people” while debt financing makes “the Social web —or Web 2.0—, the context which entrepreneur, provided he is the only shareholder, enables the crowd has, according to Lee et al. bear the risk alone”. Since the amounts invested (2008), three main characteristics: in crowdfunding tend to be rather small, the
  4. 4. 4 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez risk borne by individual investors is lower than (they may not be specialized) and also the past in traditional investment form. One practical performance of the entrepreneur (out of the pla- example of how crowdfunding platforms address tform) and many other pieces of value-relevant the risk of loss, is discussed in the first case study information might be missing. on Grow VC (Appendix 2). The same authors argue that entrepreneur might Regarding moral hazard, traditional investors be even more reluctant to disclose information tackle this issue e.g. by the use of several finan- to this type of investors, due to their number and cing rounds, milestones, or due diligence. In the lack of professionalism. At the same time, the crowdfunding setting the same elements can be disclose of this information in public setting and combined with a constant flow of information the number of people that have access to it is so- between entrepreneur and investors by leve- mehow directly related to the investment levels. raging in the capacities of the social web. It is Schwienbacher and Larralde also argue that Idea also important to highlight, that in networked stealing may further be particularly strong here, environments the incentives for moral hazard be- since the entrepreneur needs to disclose sensible havior decrease since entrepreneurs are strongly information to a wider audience than under observed by their investors. If the effort is not traditional forms of fundraising. However a well- high enough, this will circulate quickly among designed screening process can decrease the risk investors and other people on the platform. Once involved in this operation. the reputation of an entrepreneur decreased, future investments are likely to decrease signifi- Lawton and Marom (2010) present a potential cantly. solution to this problem. They propose a sequen- tial model in which entrepreneurs initially only With regard to the state of information asym- expose a little part of their idea. As the intensity metry in the crowdfunding setting, when of interactions between the crowd and potential striking a deal the parties engaged in a deal may investors increases, thus the audience decreases, not have the same level of information (Myers & the entrepreneurs publish more information, Majluf, 1984; and Naranayan, 1998). In this res- thereby decreasing the information asymmetry. pect, Schwienbacher and Larralde (2012) point At the same time, with a smaller audience, it out that in crowdfunding information asymme- becomes easier, to protect the idea, e.g. through try may be more acute, since the investors may a non-disclosure agreement. This process is not have so much information about the industry illustrated below. Amount of Lots of information information disclosed to few people Figure 2 Decreasing the information asymmetry through sequentially increased disclosure. (Source: Adapted from Lawton and Marom, 2010) Amount of Lots of information information disclosed to few people Audience size Little information to many people Amount of Lots of informationinformation disclosed to few people Audience size Little information to many people Audience size Little information to many people
  5. 5. 5 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez 3.5 Meet the crowd As early as 1907, Galton found evidence that the According to Lawton and Marom (2010), “one of median estimate of a group can be more accurate the most important components in the struc- than estimates of experts (Galton, 1907). Further ture of a networked crowd is formed by affinity investigating this effect, Surowiecki (2004) finds groups, which can be loosely defined as a group that the aggregation of information in groups, of people with similar interests or motivations.” results in decisions that are often better than they The crowd, being enabled by a globally accessible could have been if made by any single member of technology, i.e. the internet, is regarded as incre- the group. Hence, the funding crowd would be dibly diverse. This diversity (enriched by different more efficient than a few equity investors alone. cultures, points of view, backgrounds, etc.) is key However, crowds, and more specifically networ- when trying to explain its capabilities such as ac- ked crowds, face complex forces that undermine curate predictions. This effect is called “Wisdom this ‘wisdom’ quite easily. Drawing from the of the Crowds”. Relatedly, one can also speak of fields of psychology, sociology and social and “madness of crowds” at times, when an uncoor- network economics we review some explanations dinated crowds lead to sub-optimal outcomes. of the sources of this undermining. The current financial crisis is one example. Both topics the wisdom of the crowd and the process As mentioned, the basic argument is that the of undermining it will be carefully analyzed in crowd needs a sufficient level of diversity of following pages. opinions in order to be wise (Surowiecki, 2004). This necessary diversity is narrowed by social in- Although there is no clear average internet user, fluence (“knowledge about estimates of others”), the profile of individuals engaging in higher level making subjects’ predictions and valuations internet activities such as crowdsourcing has converge (Lorenz, Rauhut, Schweitzer & Hel- some common features. According to Brabham bing, 2011). Lorenz et al. argue that the effect is (2008) who investigated users of IStockPhoto, weakened in three different ways: the so-called ‘web elite user’ is middle-to-upper class, highly educated, married, middle-aged, 1. The “social influence effect” diminishes white man with high speed Internet connec- the opinion diversity of the crowd without tion. Even though there are no data available, improvements of its collective error. it is rational to assume that the average startup 2. The “range reduction effect” moves the crowdfunder would be even less diverse, with position of the truth to peripheral regions a larger proportion of business-minded, highly of the range of estimates so that the crowd educated, high income types. This collides becomes less reliable in providing expertise frontally with the theoretical, widely regarded for external observers. diversity of the crowd. The crowd, greatly diverse 3. The “confidence effect” boosts individuals’ in principle, can indeed be culturally, socially and confidence after convergence of their estima- economically biased to a great extent. As we will tes despite lack of improved accuracy. see in section 5, e.g. 60% of the startup-oriented crowdfunding sites are located in Anglo-Saxon Social influence among human group members countries. The lack of diversity has important may trigger individuals to revise their estimates implications for the effectiveness of the crowd in for various reasons: developing certain tasks which will be analysed in the next section. • The belief that others may have better information. 3.6 Analyzing the ”Wisdom • Peer pressure toward conformity. of the Crowd” effect • Inclination to adjust their opinion to those Understanding the capabilities, formation logic of others so that they gradually converge and behavior of the crowd is key to paint a richer toward consensus. picture of crowdfunding and also has implica- tions for a more effective design and implementa- Another concept that tries to explain the tion of crowdfunding platforms. narrowing of diversity, thus making the crowd
  6. 6. 6 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez less wise, is homophily which is the tendency of on networks built by traditional methods –e.g. agents in some networks to connect to others si- meetings, congresses, and personal introduc- milar to them in parameters such race, education, tions. The potential of the used methods used religion (and possibly professional background are somehow limited.With the advent of the in the case of crowdfunding); (Lazarsfeld & information technologies and, more specifically, Merton, 1954). the development of the internet a better way to gather, discuss, interact, organize and decide was Also important is the concept of diffusion and put in the hands of people and companies. The imitation as studied by Bass (whose model digital agora has the same use as the ancient one, describes the process of how new products get but is by far more powerful: more agile, with the adopted as an interaction between users and capacity of reach many individuals at the same potential users) and Rogers (whose theory seeks time but, more importantly, an unprecedented to explain how, why, and at what rate new ideas capacity to create larger economies of scale than and technology spread through cultures [or also ever before. The internet is rapidly disrupting the network clusters in the case of crowdfunding]. structure of many industries by a flow of creative destruction never seen before: transport, com- munications, retail, and publishing all are going 4. Changing paradigms through severe changes. “Society rearranges itself —its worldview—; its In this new state, traditional institutions that basic values; its social and political structure; its have enabled certain processes, not only demo- arts; its key institutions. Fifty years later there is a cratic but also legal, financial and those created new world. And the people born then cannot by citizens themselves in a more direct way, even imagine the world in which their own parents become obsolete. These formerly necessary were born.” institutions incurred in huge inefficiencies, e.g. in the form of transaction costs or due diligence Quote from the book “The Crowdfun- processes. ding Revolution”, by Kevin Lawton and Dan Marom. Institutions are not the end but the means that societies figured out to solve different challenges. Because of the explosion of the digital era these Societies have been using institutions as tools to institutions have become somehow obsolete. deal with different problems since the wake of Because of social networking, institutions such civilizations. To give an example, to implement as VC are no longer the only way to get the right democracy, citizens vote, elect representatives, amount of money for an enterprise. Through the and these take the will of the people to an insti- use of crowdfunding platforms, micro contribu- tution (namely, congress or senate). Ideally, this tions by a far larger group of people can equal, created institution provides the means to elicit in total, the money that a group of wealthy people desires and manage a country accordingly. investors allocates through an investment fund. When it comes to allocation of capital, countries Besides this quantitative factor there are others rely on their financial sectors to invest money. that make of crowdfunding a powerful tool. In- This money is saved previously by different teraction with a massive group of people provides individuals and companies and is invested in a great amount of information about the state of the most valuable enterprises, projects, etc. In the markets which is very difficult to reach in the this respect commercial banks provide cash for traditional setting. individuals and small companies and, typically, Venture Capital Funds, place the money if its 4.1 The Trust Economy investors in risky projects with the potential of The network and possibilities provided by yielding high returns. The reach of these ventures a crowdfunding platform are much larger was somehow limited consisting only on per- than those of traditional ‘investing relations’. sonal “face-to-face” interactions and leveraging Crowdfunding e.g. provides enhanced partner
  7. 7. 7 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez searching capabilities, expert advice, and the based of free market and individual freedom opportunity to build a collaborative ecosystem. rights. The key elements fit perfectly the bill for However, due to several factors, strong and trust- crowdfunding: worthy relationships are harder to build in this online environment (Hoffman, Novak, & Peral- 1. allows and supports the development and ta, 1999). But the fact that members’ behavior is accumulation of rational science; ‘observed’ by the crowd eliminates the incentives 2. channels the personal pride into non- for wrongdoing to a great extent as observed by destructive forms and the people focus on Mao (Mao, 2011) in his manifesto “Sharism”, and economic wellbeing; supported by extensive research in the field of 3. allows regular change and refreshment of behavioral economics. the social leadership. Another important implication for the use of In this framework, Fukuyama proposes inter- Web 2.0 for funding ventures is that the likeliho- personal trust and social virtues as a conduit for od of two strangers exhibiting trust depends on economic growth and prosperity. The author social, legal, biological and economic environ- develops a scheme where the advantages of high ments, namely, those of the ‘hybrid environment’ trust are: created from the crowdfunding platform and the country where the transaction, operations and 1. lower administration costs, higher institu- enforcement happens. In connected environ- tional reliability; ments, trust, built by the use of market-driven 2. large and efficient organizations; institutions, rather than just legal frameworks, will provide the stability needed to carry on Crowdfunding is a collaborative effort. Accor- with economic actions (Hoffman, Novak, & ding to La Porta et al. (1997), trust is a strong Peralta, 1999). GrowVC, for example, argues driver for cooperation, especially in large organi- that by increasing the levels of trust, the need zations, or transferred to crowdfunding in large for legal counseling decreases thus increasing networks.Sidenote 3 For further information the efficiency of the system and its growth rate3.on Grow VC refer to the case study This argument is clearly in line with abundant Fukuyama (1995) also points out that personal(Appendix 2). research around the topics of trust and growth, and institutional networks are means of trust from which we provide some insights with impli- generation and that their trust-producing abilitySidenote 4 In a crowdfunding environ- cations for crowdfunding. depends on their rules. Ideally, they should bement the role of the press is carried out simple, transparent, coherent, and applied withby the crowd itself. Crowdfunding networks can be seen as a form of consequence. economies. Not enclosed in national boundaries but rather acting as a meta-entity that potentially However, the most useful research to understand spans across different countries. Crowdfunding the crowdfunding phenomenon so far may be can be also seen as the purest way of free market ‘Neuroeconomics of Trust’. Zak (2005) argues capitalism, where formal institutions, transaction that neoclassical economic theory -agents always costs are and public intervention are rather light. try to maximize their profits- does not apply very much to certain observed behaviors. Instead, These networks are self-regulating environments. persons as social animals, care strongly about However lack of trust, because of the implica- what people think about them. In the heavily tions, can be a downside when trying to promote networked environment of crowdfunding, this economic growth of these networks. Trust in an element is key to retain the favor of the crowd economic environment, both offline and online, and succeed socially and, thus, economically. is a key factor for its sustained growth, as discus- Moreover, increased trust reduces transaction sed by many authors. costs. Under this framework, Zak recommends trust-building policies including education which Fukuyama (1995) argues that best way of promo- strongly improves the quality of institutions, ting economic growth is the liberal capitalism press freedom and civil liberties4.
  8. 8. 8 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez 5 Status quo: the crowdfunding well recognized that attracting external finance environment for startup ventures at the very initial stages of a venture is one of The rising interest in crowdfunding as a way to the biggest challenges of entrepreneurs (Cosh, fund startup companies does not come out of Cumming, & Hughes, 2009). In the aftermath the blue. It can be traced back to two funda- of the financial crisis, the global venture capital mental trends. As described in earlier sections, industry currently recovers from a severe slump. the rise of the internet and its evolution from a According to Dow Jones VentureSource (2010) source of information to an arena of interaction total investment in the United States fell by 36% and networking was a necessary condition for in 2009. Outside the U.S. the picture was even entrepreneurs, investors, and experts to link up bleaker with a fall of 51%. In the first quarter with each other. of 2010 the worldwide VC investment made a return, increasing by 13%. One trend, however, Crowdfunding originated as a funding mecha- seems to be persistent. Venture capital funds seek nism for cultural and social projects and only less stormy waters and shift their investments recently started to diffuse into a business-orien- from the startup and early stage towards later ted direction. This leads to the second driver stages of the funding process. According to behind the increasing interest in crowdfunding: Knowledge@Wharton (2010), the VC funds’ a shortage in traditional funding. Before the continuous growth in size and number increa- internet enabled niche interests to gather online, ses competition for large venture investments. funding a project like the Catalan film [No-Res] The need to invest larger sums goes in line with that criticizes Barcelona’s ongoing gentrification coming on board later in a startups life-cycle. Be- in the district Colònia Castells, might have sides this economic argument, VCs also usually been a major obstacle. Donation from directly have minimum threshold investments beyond involved people would probably be the major the capital needs of early stage ventures (Bhidé, source. By applying crowdfunding, the project 1992). The consequences are twofold: while com- not only receives inter-regional attention but petition keeps valuations of later stage ventures widens the reach of potential donors to anyone inflated, the interest in early stage investments interested in Barcelona, gentrification or urban decreases. Lawton and Marom (2010) connect documentaries. The shortage in funding argu- the latter to the exponentially increasing rate of ment also partly explains why crowdfunding for technological change and conclude that “chasing financing startup companies and strictly profit- later-term deals is in some ways, an attempt at oriented projects increasingly gets traction. It is chasing history”.Figure 3 The Rate of Change(Source: Adapted from Lawton and RATE OFMarom, 2010). CHANGE Twitter Internet Browser Google Facebook TIME
  9. 9. 9 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez The initial funding stages are traditionally the plethora of microcredit initiatives that aimSidenote 5 For further information on home to Family & Friends, personal savings and to fuel entrepreneurship in developing coun-Diaspora, refer to Appendix 3. business angels but the declining engagement tries. Smarter Money lists 19 of these platforms, of venture capital funds leaves a gap crowdfun- among them powerhouses such as Kiva whichSidenote 6 http://www.smartermoney. ding platforms might tap into. The potential of has already connected more than one millionnl this gap becomes clearer when reflecting that entrepreneurs and lenders and channeled loans according to a University of Dartmouth study worth more than $200M.Sidenote 7 For a study of a truly “only 1% to 2% of all business plans presented tointernational crowdfunding platform either angels or VCs receive funding” (Center for The geographic pattern raises an interestingthat addresses startup founders referto Appendix 2. Private Equity and Entrepreneurship, 2005). issue. Agrawal et al. (2011) show that that average Since the use of crowdfunding for entrepre- distance between a crowdinvestor and the projectSidenote 8 Smarter Money does not neurial ventures is very young - according to owner is approximately 3,000 miles 9. While thislist VC4Africa which, however, would be Belleflemme et al. (2010) it dates back only to confirms the bias towards a regional scope alsoassigned to the Netherlands. 2007 - market data are scarce. To date Belleflem- from the investors’ perspective, it contradicts tra-Sidenote 9 The study of Agrawal et al. me et al. is the only study yielding empirical data ditional theory and empirical observations which(2011) is based on data from Sellaband, on the topic. Focusing on crowdfunded projects predict that investors in early stage entrepre-a crowdfunding platform to financethe production of music. Although the and ventures and projects instead of intermediary neurial ventures tend to be local; e.g. Sorensonplatform does not allow investing in platforms, their study finds that about 60% took and Stuart (2001), Zook (2002), Mason (2007).startups, the authors still extrapolate- place in Anglo-Saxon countries. The sample did More specifically, Sorenson and Stuart (2005)their results to this field. not show a tendency towards certain industries find that the average distance between the leadSidenote 10 Brazilean platform but covered a wide range including e.g. infor- VC and the firm they finance is about 70 miles.Ikermart was removed due to its beta mation and communication technologies, sport, Accounting for business angels, Sohl (1999)stadium and no detailed information. journalism and movies. The median targeted and Wong (2002) report that they also tend to funding sum was about € 100,000 and entrepre- locate in rather close proximity to their targeted neurs raised around € 28,500 (median). Bearing ventures. in mind outliers such as Diaspora5 or the IPod Nano-based wristwatch LunaTik that raised 3,000 miles Crowdinvestor — Entrepreneur (avg. distance) nearly $1M through Kickstarter, these numbers indicate that crowdfunding primarily appeals toFigure 4 Average distance between entrepreneurs during the seed and early stages of 70 miles VC — Entrepreneur (avg. distance)Investors and Entrepreneurs. their venture.(Source: the authors) Turning to the platforms, the crowdfunding blog Smarter Money6 currently lists 217 crowdfunding Thus, while most crowdfunding platforms platforms, 31 of which are exclusively dedicated directed at startups are still act within national to investing in startups. Most of the platforms boundaries, they bear the potential to overcome only emerged in 2010 and some of them still distance-related frictions often faced in the finan- run as beta versions. Looking at geographic cing of entrepreneurial ventures. One crowdfun- patterns, it turns out that although enabled by ding example that illustrates the international po- the World Wide Web, crowdfunding companies tential is discussed in Appendix 4. The primary for startups still largely operate with a national obstacle towards a truly global crowdfunding or regional scope 7. The origin of the platforms environment, namely regulatory inconsistencies, reflects Belleflemme et al.’s findings. Approxi- will be discussed in the next section. mately 60% of startup-oriented crowdfunding platforms are located in Anglo-Saxon countries Finally, the market of crowdfunding platforms and serve these markets. Furthermore, South for startup companies can be divided according African and Brazil are the only countries to host to the investment structure. There are three startup crowdfunding platforms outside North major channels through which investors can earn America, Europe and Australia 8. Concluding that a return on their investments: equity, interest crowdfunding for entrepreneurial purposes is a on loans and revenue shares. Figure 5 shows the first world phenomenon would, however, neglect financing means of the Smarter Money sample10.
  10. 10. 10 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez While six platforms offer various ways to invest, a cial transactions as a given, the dichotomy does majority of 54% employs equity-based crowdfun- not end here. Despite initial efforts during the ding. world financial crisis from 2007 to 2010, financial regulation remains fragmented as a largely na- tional undertaking. Reflecting the high mobility of money, this may be criticized as a general VariousFigure 5 Financing structure of shortcoming. Certainly, it is a major obstacle if 6startup-oriented crowdfunding crowdfunding is to unfold its entire potentialplatforms. (Source: the authors) Bonds 1 that yields beyond national borders. 16 Equity Profits share 4 Remaining at the national level, the United 3 States are of particular importance for the future development of startup-oriented crowdfunding. Debt Not only do the United States regularly appear among the top entrepreneurial economies and rank third in the Global Entrepreneurship and Differences in the structure of the financing mo- Development Index, they are also particularly dels are due to different objectives and, leading strong in startup skills and new technologies; Acs to the following section, reflect the regulations of & Szerb (2009) and Acs & Szerb (2010). Further the countries where the crowdfunding compa- reasons are the sheer size of their economy and nies are based. Again, entrepreneurship-oriented that about 40% of startup-oriented crowdfun- microcredit platforms such as Kiva but also ding platforms according to the Smarter Money peer-to-peer lending platforms that give business list are based in United States. loans, e.g. Lending Club, are not included. At its current state, U.S. American law allows crowdfunding through donation, debt-based 6 Status quo: the regulatory instruments and revenue shares but prohibits environment of crowdfunding equity-based crowdfunding. Since equity inves- One reason why crowdfunding originated as a tments are widely regarded as the most appro- form of fundraising for artists and peer-to-peer priate structure to fund startups – after all, this is social lending was shortage in funding. A second what Business Angels and VCs do at a larger scale line of reasoning is related to the regulatory stan- – the progress of crowdfunding for startups is dards for online transactions that aim at earning slowed down. Equity-based crowdfunding is also a ROI and legal issues regarding equity issuance regarded as superior to debt because shares the and multiple investors in private companies. risk between the entrepreneur and the investor While in-kind rewards or non-interest microcre- and thereby aligns incentives (Schwienbacher & dits evoke less regulatory interest, crowdfunding Larralde, 2012). More specifically, two regulatory for startups embodies a risk of loss and potential interventions prevent crowdfunding as a mecha- profits. nism of equity-investing: First, Section 12 (g) of the Securities Exchange Act of 1934 requires In crowdfunding two antagonistic paradigms private companies to disclose their finances to clash with each other and will have to amalgama- the S.E.C. once 500 or more individuals have te to allow international scalability and larger- invested (S.E.C., 2009). The adverse effect on scale investments: On the one hand crowdfun- crowdfunded ventures, e.g. Diaspora with its ding derives its strength from libertarian and 6,479 backers, is obvious. Goldman Sachs has largely unregulated crowd phenomenon that recently increased public awareness of this regu- was described earlier. On the other hand, and as lation when setting up a Special Purpose Vehicle opposed to crowdsourcing, the defining element for high net worth individuals to invest in Fa- of crowdfunding for entrepreneurial ventures is cebook at a pre-IPO stage; e.g. Davidoff (2011). usually a financial investment and thus applicable Second, Section 4 (2) of the same Act basically to strict regulations. Taking regulation of finan- excludes the large parts of the crowd from inves-
  11. 11. 11 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez tments in private companies by requiring them as crowdfunding platforms, trust will replace to “have enough knowledge and experience in regulatory standards as the most important finance and business matters to evaluate the risks stability safeguard. To foster international best and merits of the investment (the “sophisticated practice sharing and discussion on the future sha- investor”), or be able to bear the investment’s pe regulation of crowdfunding, Lawton founded economic risk” (S.E.C., 2009). When this the International Organization of CrowdFun- regulation was introduced, in the aftermath of ding Commission (IOCFC) on LinkedIn. the Wall Street Crash of 1929, legislators aimed to protect unsuspecting investors from fraud. While reform efforts still go into different Almost eighty years later, these restrictions put a directions, public actors have recently picked up halt on equity-based crowdfunding in the most the ball. Responding to a letter of Congressman important economy. Darrell Issa, Chairman of the Committee on Oversight and Government Reform, Mary Efforts to update the backward legislation are Schapiro, Chair of the S.E.C., writes that “the well in place and take different forms. On a staff are taking a fresh look at the [SEC] rules to practical level, platforms such as Profounder develop ideas for the Commission about ways to switched to the second best alternative and offer reduce the regulatory burdens on small busines- revenue shares of funded ventures instead of ses capital formation in a manner consistent with equity. Others, such as GrowVC are registered investor protection.” Among these regulatory in Hong Kong and limit their funding side to burdens, she namely mentions the 500-rule experienced startup investors and entrepreneurs. (Schapiro, 2011). Another solution is discussed in the VC4Africa case (Appendix 4) where the final investment Meanwhile, Dutch authorities have taken the lead contract takes a rather traditional form while the by allowing a new kind of investment vehicle rather due diligence and networking engages the crowd. than applying new regulation. In nutshell, the On the legal side, several initiatives stimulate le- mechanism works as follows: Startup companies gislative change through petitions and discussion. place their equity in a cooperative holding com- Most prominently, the Crowdfunding Campaign pany (CHC) that acts as one single shareholder. to Change Crowdfunding Law jointly with the Members of the CHC can invest in the company Sustainable Economies Law Center submitted a through their membership units in the cooperative. “Petition for rulemaking: Exempt securities offe- Once the startup has raised its investment target, rings up to $100,000 with $100 maximum per the membership units are transferred to a second investor from registration” in July 2010. Another cooperative set up by the venture itself. Since the petition initiated by serial entrepreneur Sherwo- first platform exclusively acts as a mechanism od Neiss proposes an exemption framework for for facilitating the transaction between the investorsSidenote 11 The ‘Autoriteit Financiële small businesses with revenues below $5M and and the entrepreneur, it is not applicable to AFM11Markten’ (AFM) is the Dutch counterpart individual investments below $10K. Educational regulations; (Espoti, 2011).to the S.E.C.For further information on the mecha- measures for crowdinvestors and eliminating thenism refer to 500-rule add to the more sophisticated approach It will be interesting to observe which direction than the first petition. However, applying for the regulation takes. Financial services provider exemptions is not regarded as the silver bullet by have shown their ability to innovate around all crowdfunding advocates. Lawton and Marom regulatory barriers many times. Crowdfunding (2010) fear that arbitrary exemptions will hinder itself can be regarded as a disruptive innovation crowdfunding from unfolding its entire potential that challenges the current startup financing and and could rather be “a form of self-inclined pre- regulatory system. It is to be seen whether the vention.” They call for best practices instead and lack of consistent regulation will foster fur- claim that “regulation should follow crowdfun- ther innovation in the crowdfunding sector or ding leadership, and not the other way around”, whether it will put a brake on its future develop- i.e. they believe in self-regulation. This paradigm ment. Whatever shape a new form of regulation mirrors Hoffman et al.’s (1999) proposal accor- will take, it will heavily influence the future of ding to which in connected environments, such crowdfunding.
  12. 12. 12 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez 7 Quo vadis: future scenarios to prepare their exit. The hybridization scena- Crowdfunding is currently experiencing a boom. rio can end in a win-win-win situation. Given New platforms pop up almost on a daily basis the current environment where seedfunding is and startup-oriented crowdfunding is the latest scarce and equity-based crowdinvestments are trend within the trend. Considering the very complicated in most countries, variations of this young phase of the industry, it does not take a scenario are the most likely future development. fortune teller to predict further growth in the Figure 6 illustrates the involvement of crowdfun- short-term future. Shifting perspectives towards ding in the different funding stages. Already the mid-term, there are, however, a few scenarios today, no two crowdfunding platforms are the worth taking a look at. same. This diversity might well lead to multi- CrowdfundingFigure 6 The Hybridization Model. 10,000K —integrated with other Stock exchange.(Source: The authors and Smarter forms of financing. Private equity.Money). 1,000K Venture capital firms 100K Informal investors 20K F&F Prepare Start Growth Consolidation The central question for the future development staged crowdfunding processes involving diffe- is connected to the prior chapter: What shape will rent platforms. A company like Diaspora that the future regulation of crowdfunding have? In a successfully raised first round capital through favorable legal environment crowdfunding might investments that grant only in-kind rewards, revolutionize startup funding. However, strict top- might at a later stage transfer their project to a down limitations might as well turn crowdfunding platform that offers non-dilutive debt or equity- into just one more source of capital. based investments. Moving between platforms, however, requires rigorous standards. However, Lawton and Marom (2010) develop one scenario the current fragmented, incoherent regulatory called hybridization. In this model old and new framework that forces crowdfunding platforms ways of funding merge with each other. Both to build around pre-internet laws is a major obs- GrowVC and VC4Africa indicate where the tacle. Another prerequisite for the multi-staged future may lie. VCs and angel investors tap the crowdfunding approach is for certain platforms crowd to screen new ideas, outsource due diligen- to become able to fund larger amounts than they ce or get contacts beyond their Rolodex and the do today, i.e. the crowdfunding ecosystem has to crowdfunding platforms reach out to profes- become more heterogeneous than today. Again, sionals as a signal our expertise and scalability hybridization may help here. of their projects. Entrepreneurs, finally, benefit from a wider choice of funding options and can Another potential advancement is coined as the use crowdfunding as an indicator of the market “rolling close” funding model. Crowdfunding potential while using professionals at a later stage gathers a group of investors and could, thanks
  13. 13. 13 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez Crowd-sourced Crowd-sourced IP Public Equity Exchange valuation platform & competitive diligence platform Publicly trade vehicle for crowd-funded startup Social networking site #1 investments. Crowdfunding Crowdfunding Private equity platform #1 platform #2 exchange Startup G Startup A Startup C Startup E Startup H Startup B Startup D Startup FFigure 7 Startups as an asset class.(Source: adapted from Lawton andMarom, 2010). to broadband internet connections, happen in in crowdfunded startups. Here, crowdfunded real-time. Using the rolling close funding model, includes various processes besides the actual in the future, entrepreneurs could take money funding, such as diligence, valuation, or team- from investors one-at-a-time. Y-Combinator has building. With regard to the capital allocation pioneered this model in Silicon Valley and is cu- decisions within these new vehicles, Lawton rrently hugely successful. According to its foun- proposes several groundbreaking mechanisms: der Paul Graham, rolling close funding “requires “decisions could stem from prediction markets, less reliance on a lead investor, takes less time out classic human oriented investment thinking, or of product development, and gives investors less even a democratic vote from the shareholders”. room to drag things along or collude” (Gannes, In a final consequence, the vehicles would open 2010). That being said, Y-Combinator neither investments in startups to the general public even uses an online platform nor does it involve the beyond the degree crowdfunding already does. crowd. Combining both strands might be one Figure 7 illustrates the proposal. future innovation. While the latest scenario obviously requires Finally, crowdfunding visionary Kevin Lawton fundamental ideological and legal changes, it is presents an idea how startups, thanks to certain to say that crowdfunding will grow in crowdfunding, might turn into an asset class scale and outreach. The future is uncertain and (Lawton & Marom, 2010). Thanks to “increa- thus prone to unpredictable events. Crowdfun- singly transparent seed-stage mechanisms which ding, however, is present and future and thus tend to also be inherently computer accessible”, here to stay. Lawton proposes that professional investors will not only co-invest with the crowd, as in the hybridization model. On top, he sees other private equity forms injecting money directly into crowdfunded startups and publically traded vehicles will be created with a charter to invest
  14. 14. 14 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez 8 Conclusion Crowdfunding for startups is undoubtedly an exciting phenomenon. It does nothing less than turning the traditional model on its head. His- torically, the “smaller” investors only enter when companies become large enough to get listed on a stock exchange. With crowdfunding, they can access innovative startups during their very initial phase. Throughout this paper we have introduced the crowdfunding phenomenon by showing its ideological sources. While there is no eventual agreement on the wisdom of the crowd, one thing is certain: irrespective of its “mental” ca- pacity, the crowd is here to stay. Social networks continuously change human behavior and have already disrupted various industries. At its current stage, crowdfunding is almost as diverse as the crowd itself. While GrowVC is often cited as a best practice, it is to be seen if one of the current models excels. The major impact of external interventions, namely regulation, has been stressed and will continue to affect the potential of crowdfunding. While the future form of crowdfunding remains highly uncertain, the current growth increases the probability that one future breakthrough innovation will be crowdfunded. If the “next big thing”, maybe even Diaspora, is crowdfunded, awareness and thus importance will rise. At the same time, and this risk also relates to Diaspora, a major failure would probably sustainably decrea- se the enormous potential of crowdfunding. This potential was illustrated in three cases that show different facets of crowdfunding for startup companies. In any case, the growing number of crowdfunded ventures will yield massive amounts of data that allow future research. Do crowdfunded ventures outperform traditionally funded ones? How are decision rights distributed among investors in the crowd? How do entrepreneurs optimally leverage the input of the crowd? And does crowdfunding foster entrepreneurship beyond the innovation clusters?
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  18. 18. 18 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez Appendix APPENDIX 1: Online crowdfunding survey Link: Password: mesi_thesis_nssg