The Danger of Crowding out the Crowd in Equity Crowdfunding

University of Pennsylvania ScholarlyCommons

Wharton Public Policy Initiative Issue Briefs Wharton Public Policy Initiative

8-2014

The Danger of Crowding Out the Crowd in Equity Crowdfunding

Ethan Mollick University of Pennsylvania, [email protected]

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Recommended Citation Mollick, Ethan, "The Danger of Crowding Out the Crowd in Equity Crowdfunding" (2014). Wharton Public Policy Initiative Issue Briefs. 29. https://repository.upenn.edu/pennwhartonppi/29

This paper is posted at ScholarlyCommons. https://repository.upenn.edu/pennwhartonppi/29 For more information, please contact [email protected]. The Danger of Crowding Out the Crowd in Equity Crowdfunding

Summary With regard to equity crowdfunding, too many policymakers and regulators are focusing their attention on the “funding” piece of crowdfunding, overlooking the fact that the true revolutionary power of crowdfunding lies instead in the crowd.

Keywords crowdfunding, kick-starter, indiegogo, rockethub, entrepreneurs, investors, equity

Disciplines Business | Entrepreneurial and Small Business Operations | Public Policy

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This work is licensed under a Creative Commons Attribution-Noncommercial 4.0 License

This brief is available at ScholarlyCommons: https://repository.upenn.edu/pennwhartonppi/29 AUGUST 2014 PUBLICPOLICY.WHARTON.UPENN.EDU VOLUME 2, NUMBER 8

brief in brief

• With regard to equity crowdfunding, too THE DANGER OF CROWDING many policymakers and regulators are focusing their attention on the “funding” OUT THE CROWD IN EQUITY piece of crowdfunding, overlooking the fact that the true revolutionary power of CROWDFUNDING crowdfunding lies instead in the “crowd.” BY ETHAN MOLLICK • The lessons of reward-based crowdfunding suggest that the success of equity crowdfunding will depend on fostering During the last four years, Kickstarter, the world’s largest long-term online interactions between crowdfunding platform, has grown quickly, rising from obscurity project issuers and potential investors in the crowd. Online communities make funding to become a verb: “I am kickstarting my project!” available to a wider range of entrepreneurs than traditional funding models and play important roles in reviewing and improving project offerings and preventing fraud.

By 2012, more money was flowing to the than investors, of the projects they fund. • Research shows that such vibrant online arts through Kickstarter than the National In return for their donation, backers get a communities arise when they have a Endowment of the Arts. By mid-2014, $1.2 reward from the project creators. This can wide variety of potential investments to billion had been distributed to over 64,668 include being credited in a movie, having examine and discuss. So the SEC and projects on Kickstarter alone, supported by creative input into a product under devel- Congress would do well to ensure that well over six million people, and other sites, opment, or receiving the opportunity to financial and regulatory barriers to entry ranging from Indiegogo to Rockethub, also meet the creators of a project. Alternatively, for crowdfunding are not so high as to have been expanding quickly. The result has reward-based crowdfunding treats funders drive the best investment opportunities been the rapid growth of a powerful new as early customers, allowing them privileged tool to fund creative and for-profit endeav- access to the products produced by funded toward other funding mechanisms. ors, from films to technology startups. projects at an earlier date, better price, or • Only by refocusing on the crowd will equity To date, almost all of these funds have with some other special benefit. The “pre- crowdfunding bring the greatest benefit to been given either as donations or in return selling” of products to early customers is investors, entrepreneurs, and the overall for some future reward. This approach, a common feature of those crowdfunding economy. commonly called reward-based crowd- projects that more traditionally resemble funding, treats backers as patrons, rather entrepreneurial ventures. With the success of reward-based female cofounders, and only 1 percent of Further, crowdfunding can lead to crowdfunding as an example, in 2012 Con- VC-funded startups are founded by African the creation of real companies and jobs. A 2 gress passed the Jumpstart Our Business Americans. Further, VC is highly con- previous survey of design, technology, and Startups Act (The JOBS Act). The JOBS centrated, with most investment occur- video game projects that raised money on Act makes a number of changes to security ring in just a few locations, particularly Kickstarter before mid-2012 found that laws, and a substantial effect of the legisla- the San Francisco, Boston, and New York non-equity crowdfunding can indeed sup- 4 tion, under Title III, is to legalize equity metropolitan areas. This lack of diversity is port more traditional entrepreneurship. A crowdfunding. This allows companies to use problematic on its face, but even more so very high percentage (over 90%) of success- crowdfunding to raise money in return for if you follow the overwhelming evidence ful projects remained ongoing ventures, 32 equity, rather than restricting fundraising to that innovation can come from anywhere. percent of which reported yearly revenues a patron model. Rather than drawing our entrepreneurs of over $100,000 a year after the Kickstarter While the SEC has yet to finalize regu- lations on crowdfunding under the JOBS FIGURE 1: GEOGRAPHIC DISTRIBUTION OF KICKSTARTER PROJECTS AS OF JULY 2012 Act, it is not clear that the current draft regulation will do much to make crowdfunding a useful tool to encourage innovation and job growth, as it makes equity crowdfunding too expensive and difficult. For example, Crowdfund Capital Advisors used estimates from the SEC to determine that raising $100,000 under the JOBS Act would result in up to $39,000 in compliance fees, and that raising larger amounts would still require that almost 8% of the proceeds 1 go to fees. Further, even if the regulation changes, I worry that both the SEC and many of the other players in the space are paying too much attention to the “funding” piece of crowdfunding, concentrating on creating a new financial vehicle. My research Status Failure Success shows that the true revolutionary power of N Projects 1 2,000 4,000 6,000 7,106 crowdfunding is instead the “crowd”—and that only by refocusing on the crowd, and understanding its value, will equity crowd- from across the nation, the current fund- campaign (10 percent of these represented funding lead to improved innovation, more ing system only truly works for a very small ongoing companies that already had been jobs, and better outcomes for investors and segment of people. making that much). Further, successful proj- entrepreneurs alike. On the other hand, as can be seen ects added an average of 2.2 employees per in Figure 1, crowdfunding projects are project—and this does not include outliers THE VALUE OF distributed across the country. Further, the like Oculus VR, sold to Facebook for $2 CROWDFUNDING typical disadvantage faced by women in billion, which did not respond to the survey. raising VC funding is completely reversed The survey also suggested that crowdfund- The true power of crowdfunding is its ability in crowdfunding. All other things being ing did much more than provide funds, to democratize entrepreneurship. Currently, equal, women are 13 percent more likely unlocking the ability to reach customers, access to startup capital is tremendously than men to succeed in raising their goal in press, employees, and outside funders. limited. Overwhelmingly, the companies a crowdfunding campaign because they are Crowdfunding, then, is more than 3 that receive venture capital investment helped by other women. This suggests that a theoretical source of opportunity. The are founded by white males; less than 3 crowdfunding may truly democratize access research shows that it actually does increase percent of VC-backed companies have to capital, if done correctly. opportunity and helps lead to the estab-

1 Sherwood Neiss, “It might cost you $39K to crowdfund funding” (July 3, 2014). Available at SSRN: http://ssrn. ssrn.2376997. org/10.2139/ssrn.2376997. $100K under the SEC’s new rules,” VentureBeat, January com/abstract=2462254. 5 Ethan Mollick (2014), “The Dynamics of Crowdfunding: 2, 2014. 4 Ethan R. Mollick and Venkat Kuppuswamy, “After An Exploratory Study,” Journal of Business Venturing, 29 2 CB Insights, “Venture Capital Human Capital Report,” the Campaign: Outcomes of Crowdfunding (Janu- (1), 1-16. August 3, 2010. ary 9, 2014).” UNC Kenan-Flagler Research Paper 6 Ibid. 3 Jason Greenberg and Ethan R. Mollick, “Leaning In or No. 2376997. Available at SSRN: http://ssrn.com/ 7 Mollick and Kuppuswamy, “After the Campaign,” Leaning On? Gender, Homophily, and Activism in Crowd- abstract=2376997 or http://dx.doi.org/10.2139/ http://ssrn.com/abstract=2376997 or http://dx.doi. lishment of real companies, even though on potential issuances are made not just by bers. Otherwise, there will be little to draw crowdfunding remains limited to giving investors, but also by outside experts, com- a community to a portal. I would caution away rewards, rather than equity. The SEC munities of interest, and journalists. These against too many formal regulatory fil- and Congress need to consider the positive online communities play several important ings, as that may actually increase fraud by impact of crowdfunding on entrepreneur- roles in improving offerings, preventing discouraging high quality issuers with other ship and innovation, which lies in the fraud, and making crowdfunding successful. alternative fundraising options. This will relative ease with which individuals, even First, they allow a core-periphery make it hard to gain the interest of com- unlikely individuals, can raise funding for dynamic to develop, similar to that seen munity members to portals, and therefore good ideas. Focusing purely on crowdfund- in other functional online communities, reduce the ability of communities to help ing as an investment model might lead to ranging from Wikipedia to open source detect fraud. the creation of regulation that reduces the software development. Having many people In addition to preventing fraud by ability of crowdfunding to democratize examining issuances from the periphery, issuers, communities with persistent identi- startups, again limiting funding to the well- even if they may not all be core investors ties can prevent future fraud, including connected few. Trusting the crowd in crowd- themselves, greatly increases the chance that pump-and-dump schemes. If a community funding means not just paying attention to someone will have the expertise and desire around a particular investment consists of innovators, but also to the way the crowd to spot potential issues with a proposal. In known members with consistent identities effectively funds legitimate projects in what the case of Kickstarter, communities have (something not in the current SEC draft is currently a nearly unregulated market. regulation), it will immediately be obvi- ous if outside individuals attempt to falsely WHY CROWDFUNDING NEEDS “The government can play a promote or denigrate a funded company for THE CROWD fraudulent purposes. The community will vital role in helping crowd- be able to detect anonymous outsiders, and One of the big surprises of reward-based funding reach its full potential, community members will have reputational crowdfunding is that, contrary to expecta- reasons for avoiding these sorts of schemes, 5 but doing so involves taking tions, fraudulent projects are rare. Previous or their online identities will become associ- some risk on a radically new research indicates that the amount of money ated with fraud. pledged to projects that ultimately seem approach to funding ventures.” Crowds are not just about preventing to have no probability of being delivered fraud, however. They also provide ongo- accounts for less than 0.1 percent of all ing benefits. An analysis of the long-term pledged funds. This is despite the fact that results of reward-based crowdfunded reward-based crowdfunding sites have few if successfully detected fraudulent projects, projects showed that the money raised was any formal controls against fraud beyond an and had healthy debates over the merits of not considered to be the most important initial screen by the reward-based portal. other projects that have resulted in proj- outcome of crowdfunding. Instead, proj- Fraud is so low not because of registra- ects improving as a result of the feedback. ect founders were even more interested tion requirements, but because the com- Allowing ongoing discussions between in building long-term relationships with munity of investors plays a critical role in potential investors, community members, customers, getting information about detecting and deterring fraud. On sites like and issuers is a vital aspect of avoiding fraud markets, and marketing themselves. In a Kickstarter, investors look for signals of and improving proposed projects. Some of survey, when people that sought crowdfund- quality, and are more likely to fund projects this is already in the draft SEC regulation. ing were asked to explain why, the answer that show signs of the ability to succeed, Further, the network effects within that “the project could not have been funded such as clear plans for future development, communities enable one interested party to without [crowdfunding]” was actually the and appropriate backgrounds, past experi- draw others into the discussion, adding to fourth most popular reason, not the first 7 ence, and outside endorsements of the the possibility that investors or commenta- (see Figure 2). project creators. The crowd can be quite sen- tors with appropriate expertise will find the The lessons of reward-based crowd- sitive – a single spelling error decreases the relevant projects where their knowledge funding suggest that the success of equity 6 chance of funding success by 13 percent. would be most useful. Indeed, a decade of crowdfunding will depend on the long-term This process works because many individu- research has shown that vibrant communi- interactions between issuers and investors. als (with verifiable real-world identities) ties are key to harnessing the best ideas These communities over the longer term will weigh in on projects, discussing the merits from a crowd, and to improving exist- help keep crowdfunded companies account- and probability of success of each project. ing ideas, in order to create breakthrough able to investors. If investors are going to These discussions take place on Kickstarter, innovations. Communities can only form, be able to provide meaningful feedback but also on other social media sites, blogs, however, if there are enough quality issuers to companies when asked, or be able to and forums. The result is that comments to attract high-quality community mem- weigh in on potential pivots or changes of FIGURE 2: REASONS FOR SEEKING CROWDFUNDING fraud. This, in turn, will damage crowdfunding as a whole, and further drive quality To connect directly with a community of my fans and supporters issuers from the platforms, creating a vicious

To get ideas on how to improve my project cycle. It would be better to err towards allowing more issuers, with a more vibrant As a way of marketing my project crowd, than too few, without a crowd but relying on regulation alone. Other traditional financing options were not available REMEMBER THE CROWD To see if there was demand for the project

The project could not have been funded without raising the goal Crowdfunding is in its early days, and still has far to grow. The government can play a 0% 10% 20% 30% 40% 50% 60% 70% 80% vital role in helping crowdfunding reach its Successful Projects Unsuccessful Projects full potential, but doing so involves taking some risk on a radically new approach to Chart reprinted from Mollick and Kuppuswamy, “After the Campaign.” Available at SSRN: http://ssrn.com/abstract=2376997 or http://dx.doi. org/10.2139/ssrn.2376997. funding ventures. The only way it will work is if the focus remains on crowdfunding as a community-driven and inherently democ- direction, there will need to be an ongo- assessed. Something similar will be needed ratizing method of raising money, rather ing engagement between investor com- in equity crowdfunding. than as simply another investment category. munities and companies. On Kickstarter, Vibrant communities arise when they That means that the crowd needs to have an communities of backers continue to give have a wide variety of potential investments active role in sourcing, selecting, and dis- feedback on projects long after funding has to examine and discuss. I would urge the cussing the potential of new ventures. Even closed, providing both a valuable resource SEC and Congress to ensure that barri- in reward-based crowdfunding, the early and an important incentive for projects to ers to entry (financial and regulatory) are results are powerful – higher participation deliver. Having issuers connected to per- not so high as to drive the best investment of disadvantaged groups, greater geographic sistent online identities, such as LinkedIn, opportunities towards other funding mecha- diversity, and evidence of positive job ensures that founders of projects are held nisms. If platforms only attract a few issuers, growth. I hope that future regulatory efforts accountable for their actions and perfor- communities will not have a chance to preserve and build on what is right with mance across many projects, and that their form, resulting in less crowd-based insight crowdfunding, as well as worry about what skills and backgrounds can be adequately into projects and heightening the chance of might go wrong. ABOUT THE PENN WHARTON PUBLIC ABOUT PENN WHARTON PPI ISSUE ABOUT THE AUTHOR POLICY INITIATIVE BRIEFS

The Penn Wharton Public Policy Initiative Penn Wharton PPI publishes issue briefs (PPI) is a hub for research and educa- at least once a month, tackling issues that tion, engaging faculty and students across are varied but share one common thread: University of Pennsylvania and reaching they are central to the economic health of government decision-makers through the nation and the American people. These independent, practical, timely, and non- Issue Briefs are nonpartisan, knowledge- partisan policy briefs. With offices both at driven documents written by Wharton Penn and in Washington, DC, the Initiative and Penn faculty in their specific areas of provides comprehensive research, coverage, expertise. Ethan Mollick, PhD and analysis, anticipating key policy issues Assistant Professor of Management, The Wharton School on the horizon.

Ethan Mollick is the Edward B. and Shirley R. Shils Assistant Professor of Management at the Wharton School of the University of Pennsylvania. He studies For additional copies, please visit Follow us on Twitter: innovation and entrepreneurship, and the ways the Penn Wharton PPI website at @PennWhartonPPI in which an individual’s actions can affect firms publicpolicy.wharton.upenn.edu. and industries. His research includes early-stage entrepreneurship and crowdfunding; the way in which communities of users come together to innovate; and the factors that drive the performance of entrepreneurial companies. Professor Mollick also co-authored Changing the Game, a book on the intersection between video games and business that was named one of the American Library Association’s top ten business books of the year, and has studied the way that games can be used to motivate performance and education. He has pub- Penn Wharton Public Policy Initiative lished papers in leading academic journals, and he The Wharton School was among the 100 most downloaded authors (out University of Pennsylvania of over 230,000) on the Social Science Research Network and was named one of the “40 Most Outstanding Business School Professors Under 40.” Prior to his academic career, Professor Mollick was co-founder of a company and a management consultant. He has worked with organizations ranging from DARPA to General Mills on innovation and entrepreneurship. Ethan Mollick received his PhD (2010) and MBA (2004) from MIT’s Sloan School of Management and his bachelor’s degree from Harvard University, magna cum laude, in 1997.

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