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Information Heterogeneity and Social Networks of Crowdfunders Small Bus Econ DOI 10.1007/s11187-016-9829-3 The wisdom of the crowd in funding: information heterogeneity and social networks of crowdfunders Friedemann Polzin & Helen Toxopeus & Erik Stam Accepted: 10 July 2016 # The Author(s) 2017. This article is published with open access at Springerlink.com Abstract Crowdfunding has enabled large crowds to Keywords Crowdfunding . Social networks . New fund innovative projects. This type of funding might tap ventures . Entrepreneurial finance . Information into the wisdom of crowds who were previously discon- asymmetries nected from the funding process. We distinguish be- tween in-crowd and out-crowd funders (with and with- JEL codes G23 . G32 . D82 . D85 . L26 out ties to project creators) in order to test for heteroge- neity in their information use. Based on the analysis of a large-scale survey amongst project funders, this paper 1 Introduction shows that in-crowd investors rely more on information about the project creator than out-crowd investors. Out- The funding of innovative start-ups has always been crowd investors do not seem to attach more importance challenging due to a lack of track record, collateral and to information about the project itself than in-crowd technological uncertainty (Engel and Stiebale 2014; investors, except in the case of donation-based Hall 2002; Giudici and Paleari 2000). More generally, crowdfunding. For financial return crowdfunding, fi- small- and medium-sized firms face greater capital con- nancial information becomes less important once a straints than large firms, lacking access to market-based strong relationship with the project creator is funding due to the high fixed costs associated with established. Our study allows project creators to target issuing equity and the unwillingness of institutional information to specific audiences based on their rela- investors to take small holdings. This leaves start-ups tionship strength across different types of crowdfunding highly dependent on bank credit, venture capital funds, projects. angel investors and bootstrapping for their liquidity needs (Chittenden et al. 1996; Ebben and Johnson F. Polzin (*) : E. Stam 2006; Giudici and Paleari 2000;Keaseyand Utrecht University School of Economics (USE), Kriekenpitplein McGuinness 1990). Access to bank credit has become 21-22, PO Box 80125, 3508 TC Utrecht, The Netherlands more transactional in recent decades with increased e-mail: [email protected] centralization and computerised assessment of credit- F. Polzin worthiness (Bhidé 2010) and is often restricted due to Sustainable Finance Lab (SFL), Kriekenpitplein 21-22, PO Box a lack of profit and collateral. This shift severely affects 80125, 3508 TC Utrecht, The Netherlands innovative small firms due to their disproportionate reliance on soft information in the lending process H. Toxopeus Impact Centre Erasmus (ICE), Erasmus School of Accounting and (Brancati 2014; Cosci et al. 2016). Furthermore, the Assurance, Burgemeester Oudlaan 50, 3062 PA Rotterdam, willingness of venture capitalists to fund start-ups is The Netherlands often limited to certain sectors (Huyghebaert et al. Polzin et al. 2007) and there is evidence that the financial crisis has Are crowdfunders well informed about the project dampened their willingness to invest, particularly in they invest in or are they jumping on a band-wagon follow-up rounds (Block and Sandner 2009;Cowling setinmotionbyotherinvestorsinacampaign? et al. 2016; Migendt et al. 2014). Structural financing This study offers the first detailed empirical analysis constraints for small firms impede economic growth on heterogeneity in information use by crowdfunders when firms downplay their growth strategy to match and how this is affected by their social networks. The available funds (Beck and Demirguc-Kunt 2006;Binks ability to distinguish between investors based on their and Ennew 1996; Chittenden et al. 1996; Rostamkalaei interpersonal ties to the entrepreneur offers insights into and Freel 2015). the application of theories about information The rise of crowdfunding over the past decade in part asymmetries and social networks in funding decisions addresses this funding gap by offering entrepreneurs an and serves as input for public policy for entrepreneur- alternative to traditional finance channels. ship and finance. Our main research question is: How Crowdfunding caters well to innovative, opaque, small does the type of information used by crowdfunders vary firms and makes use of social networks in the funding with the strength of their ties to project creators? process (Colombo et al. 2015; Vismara 2016a). It builds This article is structured as follows: first, we review on and expands beyond the traditional ‘in-crowd’ of the relevant literature and introduce the theoretical family and friends by allowing both in- and out-crowd framework. Next, we present the research design includ- investors to provide finance through digital platforms ing our quantitative research approach and data. We then (Bruton et al. 2015;Salomon2016). Furthermore, it has display the results which form the basis for the conclu- lowered the transaction costs for entrepreneurs to collect sions in the final section. small investment amounts from a dispersed set of inves- tors and is becoming an increasingly sizable source of funding for start-ups and other bottom-up initiatives in 2 Literature review and theoretical framework the economy (Massolution 2015; Wardrop et al. 2015). However, it is unclear whether crowdfunding provides 2.1 Signalling in early-stage finance and information access to the wisdom of the crowd, or whether it opens cascades up a wider audience of fools alongside the usual family and friends in-crowd. The way entrepreneurs obtain capital when forming a In line with the growth of crowdfunding, academ- new firm has important implications for future perfor- ic research directed at understanding this phenome- mance (Bosma et al. 2004;Cassar2004). Their search non has emerged in recent years (Moritz and Block for external finance is characterised by agency problems 2016). Much of this literature focuses on success between the entrepreneur and funder due to information factors driving crowdfunding campaigns, such as asymmetries that lead to adverse selection and moral the role of early contributions (Agrawal et al. hazard (Denis 2004; Jensen and Meckling 1976; Parker 2015; Cholakova and Clarysse 2015; Colombo 2009). This is especially the case for new firms that face et al. 2015). There is also considerable attention on high financing costs (Rostamkalaei and Freel 2015) the role of social networks in crowdfunding driven by cumbersome information gathering, a lack (Agrawal et al. 2015;Horvátetal.2015;Huietal. of track record and, often, collateral (Blumberg and 2014) and on overcoming informational Letterie 2007;Cassar2004). asymmetries (Ahlers et al. 2015; Lin et al. 2012; Scholars suggest signalling can overcome these Vismara 2016b). Lacking attention until now is the agency problems (Akerlof 1970;Amitetal.1990; bridge between these two topics, namely, how social Gompers 1995; Myers and Majluf 1984;Stiglitzand networks affect the type of information used by Weiss 1981). Signalling can take place using different investors in crowdfunding decision making. Al- kinds of information, for example, the availability of though there are suggestions regarding patents and prototypes or the track record of entrepre- crowdfunding information mechanisms and the role neurial team (Audretsch et al. 2012; Becker-Blease and of social networks (Ter Wal et al. 2016), there is Sohl 2015;Busenitzetal.2005; Gompers and Lerner little empirical evidence about the type of informa- 2001; Spence 1973). Many studies in the signalling tion that funders use to make investment decisions. literature establish a positive relationship between The wisdom of the crowd in funding: information heterogeneity early-stage investments and firm success (Bernstein anynewinformationtoadecisionprocess et al. 2016a; Bosma et al. 2004;Kerretal.2014; (Bikhchandani et al. 1992). Kortum and Lerner 2000; Samila and Sorenson 2010) Hornuf and Schwienbacher (2015) find that specific and link an entrepreneur’scharacteristics,suchashu- kinds of information, such as updates to investors, sig- man capital, to venture performance (Becker-Blease and nificantly drive investment as funders update their pref- Sohl 2015; Ouimet and Zarutskie 2014; Pukthuanthong erences in the light of project assessment. Moritz et al. 2006). Bernstein et al. (2016b) examine venture attri- (2015) examined investor communication in equity butes used to signal quality to investors, i.e. the team, crowdfunding, highlighting that perceived sympathy, track-record of the venture and identity of current inves- openness and trustworthiness in the relationship be- tors. They suggest that information about the person(s) tween venture and investor reduced perceived informa- behind the venture is crucially important for obtaining tion asymmetries. They also found that third-party com- external finance, which is in line with the practice of VC munication influences the decision-making process of and business angels (Alexy et al. 2012; Becker-Blease crowdfunders. Furthermore, allowing crowdfunders to and Sohl 2015; Vismara 2016a). adjust privacy settings regarding information about their Crowdfunding,1 as a new form of seed finance, acts contribution deters some investors but increases average as a platform (agent) between investors and entrepre- contribution size (Burtch et
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