Optimal crowdfunding design

Crowdfunding has shaken up the world of traditional financing. Bank loans, venture capital, personal wealth or a willingness to risk penury are no longer fundamental for financing and developing innovative projects. Platforms such as Kickstarter.com allow anyone to present an idea as a project to the crowd in the hope of finding enough people willing to support it financially, making its realization possible.

Optimistic observers predicted that crowdfunding would completely substitute more traditional forms of financing, since digital technologies dramatically reduce the cost of matching projects to people likely to be interested in them. Crowdfunding combines marketing and finance, but is not free. There are costs involved in pitching a virtual project rather than a tangible product to potential funders. In addition, platforms like Kickstarter.com demand quite high fees from successful projects, often higher than those paid to traditional financial intermediaries for their expertise.

So crowdfunding’s growth prospects and its promise to democratize access to finance remain an open question. Indeed, it is not actually clear that funding is fundamental to crowdfunding, nor that it should be seen as a substitute to traditional sources of funding.

In their BSE Working Paper (No. 871) titled “Optimal Crowdfunding Design” (latest version available on SSRN), Matthew Ellman and Sjaak Hurkens address these and other questions that help shed some light on a world that has grown very quickly but remains relatively unknown. They focus on the most widespread format, reward-based crowdfunding, where funders are compensated with the project’s product. The entrepreneur sets a minimum price for the product, and a funding threshold. Funders, who are in this format also buyers, then bid. The project is successfully financed if the sum of the bids exceeds the threshold. Along with this simple aggregate funds threshold, crowdfunding gives funders two important guarantees:

  1. They pay nothing in the event of funding failure.
  2. They pay exactly their bids in case of success.

These properties explain why such a large number of small funders have been willing to participate in crowdfunding.

The main insight the authors highlight throughout their rigorous analysis is that in crowdfunding, the crowd’s information might be much more important that the funding. This is why crowdfunding might be a complement, not a substitute, of traditional fundraising. In fact, developers may turn to crowdfunding purely to exploit the potential of market-testing and price-discrimination.

Crowdfunding allows an entrepreneur to test the demand for her product before actually producing it, in contrast to the traditional approach where project finance is decided before producing and marketing the good. By combining marketing and finance, crowdfunding’s market test allows adaptation of production to demand. The entrepreneur sinks the fixed cost of production only in projects where demand is high enough.

Crowdfunding also allows rent-extraction because funders with high valuations may bid above the minimum price to raise project success so that they can consume the good. Entrepreneurs strategically raise the funding threshold to induce them to do so.

The authors analyze when and how such interactions can improve social welfare. They also show that reward-based crowdfunding, relying on simple rules, is optimal: no other mechanism, however complex, achieves higher profits in the stylized but representative setting.

As we underlined before, this does not mean that crowdfunding has to completely substitute traditional finance. Traditional loans may still be important because they might be cheaper for some kind of products and because limited crowdfunder participation implies sales to later buyers can make a project viable but cannot be used to fund ex-ante costs. Traditional finance and crowdfunding then often are mutual complements. Crowdfunding raises demand for credit and signals project profitability so that financiers supply this demand.

Despite the media hype around viral projects that attract tens of thousands of funders, 99% of projects have less than 1000 funders, and a typical crowdfunding project has just about 50. These numerous, small-to-moderate projects generate large positive externalities, via ex-post sales and entrepreneurial careers. Indeed, crowdfunding was, and will be, a vital stepping stone in many careers.

Original image source: us_sec on Flickr