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The Danger of Crowding Out the Crowd in Equity Crowdfunding
| Content Provider | Semantic Scholar |
|---|---|
| Author | Mollick, Ethan |
| Copyright Year | 2014 |
| Abstract | =2376997 or http://dx.doi.org/10.2139/ ssrn.2376997. 5 Ethan Mollick (2014), “The Dynamics of Crowdfunding: An Exploratory Study,” Journal of Business Venturing, 29 (1), 1-16. 6 Ibid. 7 Mollick and Kuppuswamy, “After the Campaign,” http://ssrn.com/abstract=2376997 or http://dx.doi. org/10.2139/ssrn.2376997. FIGURE 1: GEOGRAPHIC DISTRIBUTION OF KICKSTARTER PROJECTS AS OF JULY 2012 Status Failure Success N Projects 1 2,000 4,000 6,000 7,106 lishment of real companies, even though crowdfunding remains limited to giving away rewards, rather than equity. The SEC and Congress need to consider the positive impact of crowdfunding on entrepreneurship and innovation, which lies in the relative ease with which individuals, even unlikely individuals, can raise funding for good ideas. Focusing purely on crowdfunding as an investment model might lead to the creation of regulation that reduces the ability of crowdfunding to democratize startups, again limiting funding to the wellconnected few. Trusting the crowd in crowdfunding means not just paying attention to innovators, but also to the way the crowd effectively funds legitimate projects in what is currently a nearly unregulated market. WHY CROWDFUNDING NEEDS THE CROWD One of the big surprises of reward-based crowdfunding is that, contrary to expectations, fraudulent projects are rare. Previous research indicates that the amount of money pledged to projects that ultimately seem to have no probability of being delivered accounts for less than 0.1 percent of all pledged funds. This is despite the fact that reward-based crowdfunding sites have few if any formal controls against fraud beyond an initial screen by the reward-based portal. Fraud is so low not because of registration requirements, but because the community of investors plays a critical role in detecting and deterring fraud. On sites like Kickstarter, investors look for signals of quality, and are more likely to fund projects that show signs of the ability to succeed, such as clear plans for future development, and appropriate backgrounds, past experience, and outside endorsements of the project creators. The crowd can be quite sensitive – a single spelling error decreases the chance of funding success by 13 percent. This process works because many individuals (with verifiable real-world identities) weigh in on projects, discussing the merits and probability of success of each project. These discussions take place on Kickstarter, but also on other social media sites, blogs, and forums. The result is that comments on potential issuances are made not just by investors, but also by outside experts, communities of interest, and journalists. These online communities play several important roles in improving offerings, preventing fraud, and making crowdfunding successful. First, they allow a core-periphery dynamic to develop, similar to that seen in other functional online communities, ranging from Wikipedia to open source software development. Having many people examining issuances from the periphery, even if they may not all be core investors themselves, greatly increases the chance that someone will have the expertise and desire to spot potential issues with a proposal. In the case of Kickstarter, communities have successfully detected fraudulent projects, and had healthy debates over the merits of other projects that have resulted in projects improving as a result of the feedback. Allowing ongoing discussions between potential investors, community members, and issuers is a vital aspect of avoiding fraud and improving proposed projects. Some of this is already in the draft SEC regulation. Further, the network effects within communities enable one interested party to draw others into the discussion, adding to the possibility that investors or commentators with appropriate expertise will find the relevant projects where their knowledge would be most useful. Indeed, a decade of research has shown that vibrant communities are key to harnessing the best ideas from a crowd, and to improving existing ideas, in order to create breakthrough innovations. Communities can only form, however, if there are enough quality issuers to attract high-quality community members. Otherwise, there will be little to draw a community to a portal. I would caution against too many formal regulatory filings, as that may actually increase fraud by discouraging high quality issuers with other alternative fundraising options. This will make it hard to gain the interest of community members to portals, and therefore reduce the ability of communities to help detect fraud. In addition to preventing fraud by issuers, communities with persistent identities can prevent future fraud, including pump-and-dump schemes. If a community around a particular investment consists of known members with consistent identities (something not in the current SEC draft regulation), it will immediately be obvious if outside individuals attempt to falsely promote or denigrate a funded company for fraudulent purposes. The community will be able to detect anonymous outsiders, and community members will have reputational reasons for avoiding these sorts of schemes, or their online identities will become associated with fraud. Crowds are not just about preventing fraud, however. They also provide ongoing benefits. An analysis of the long-term results of reward-based crowdfunded projects showed that the money raised was not considered to be the most important outcome of crowdfunding. Instead, project founders were even more interested in building long-term relationships with customers, getting information about markets, and marketing themselves. In a survey, when people that sought crowdfunding were asked to explain why, the answer that “the project could not have been funded without [crowdfunding]” was actually the fourth most popular reason, not the first (see Figure 2). The lessons of reward-based crowdfunding suggest that the success of equity crowdfunding will depend on the long-term interactions between issuers and investors. These communities over the longer term will help keep crowdfunded companies accountable to investors. If investors are going to be able to provide meaningful feedback to companies when asked, or be able to weigh in on potential pivots or changes of “The government can play a vital role in helping crowdfunding reach its full potential, but doing so involves taking some risk on a radically new approach to funding ventures.” direction, there will need to be an ongoing engagement between investor communities and companies. On Kickstarter, communities of backers continue to give feedback on projects long after funding has closed, providing both a valuable resource and an important incentive for projects to deliver. Having issuers connected to persistent online identities, such as LinkedIn, ensures that founders of projects are held accountable for their actions and performance across many projects, and that their skills and backgrounds can be adequately assessed. Something similar will be needed in equity crowdfunding. Vibrant communities arise when they have a wide variety of potential investments to examine and discuss. I would urge the SEC and Congress to ensure that barriers to entry (financial and regulatory) are not so high as to drive the best investment opportunities towards other funding mechanisms. If platforms only attract a few issuers, communities will not have a chance to form, resulting in less crowd-based insight into projects and heightening the chance of fraud. This, in turn, will damage crowdfunding as a whole, and further drive quality issuers from the platforms, creating a vicious cycle. It would be better to err towards allowing more issuers, with a more vibrant crowd, than too few, without a crowd but relying on regulation alone. |
| File Format | PDF HTM / HTML |
| Alternate Webpage(s) | http://repository.upenn.edu/cgi/viewcontent.cgi?article=1022&context=pennwhartonppi |
| Language | English |
| Access Restriction | Open |
| Content Type | Text |
| Resource Type | Article |
