Crowdfunding: Promise or Peril?

The numbers seem astonishing: Last year, Kickstarter, the largest crowdfunding site, raised over $312M from over 2 million backers, funding 18,000 projects.  Though raising money from large crowds to fund new artistic and cultural endeavors is not new, the speed at which internet crowdfunding has taken off – from almost nothing to hundreds of millions of dollars in just a couple of years – has caught the notice of policy makers, entrepreneurs, and investors.

On this wave of optimism, in April of 2012, President Obama signed the JOBS act, legalizing equity crowdfunding (previously, crowdfunding investment was strictly a donation, perhaps in return for a product or reward).  As of today, the SEC is still writing the rules that will allow equity crowdfunding to occur in practice, and over 1,000 companies appear to be ready to enter the equity crowdfunding space as soon as those regulations are finalized.  But not everyone is excited about crowdfunding, a number of pundits and analysts have expressed concern that crowdfunding, especially equity crowdfunding, is likely to lead to a lot of fraudulent projects, failed businesses, and naïve investments.

Though many people have been weighing in on crowdfunding , there have been relatively little hard data about what makes crowdfunding projects succeed (or fail), and how many projects actually deliver on their promised goals.  In two draft research papers, “The Dynamics of Crowdfunding” and “Swept Away by the Crowd,”  I have used data from Kickstarter to understand the underlying patterns of crowdfunding in the first case, and the ways in which crowdfunding compares to Venture Capital, in the second. Among a number of findings in the papers, I want to highlight two of them:

Project founders try to deliver on their promise.

Fraud in crowdfunding should be easy. People post projects online, without having to prove any deep credentials, and, if they raise the money, have little legal obligation to actually deliver on their promises.  With such a perfect environment for people to take the money and run, some observers suspect that fraud might be common.  To find out if this is true, I looked at the 381 successful Kickstarter projects in the categories of Design and Technology (these are the projects that most resemble traditional startups) that had promised delivery dates for rewards to funders before July, 2012.  I found that fraud was relatively rare.  Only 14 out of 381 products, or  3.6%, had stopped responding to backers and could potentially have given up on delivering entirely.  To see how small this category is, compared to the amount of money spent on the space, look at the chart below.  Dark green projects were those that were delivered, light green were promised projects on schedule, and yellow is projects that were delayed, but were making efforts to deliver. Only the thin red line are those cases that are possibly fraudulent.

Kick_Post_Delivery

But they are often late in doing so.

The large, and growing, yellow section in the graph below illustrates an issue with crowdfunding, however.  The majority of projects I studied were late in delivering their promised products.  This shouldn’t be a big surprise, as entrepreneurs are over-optimistic, and this is just as true among crowdfunding entrepreneurs.  The statistics are fairly stark: only 24.9% of projects delivered on time, and 33% had yet to deliver when I conducted my study.  The bigger a project was, and the more successful it was, the longer the delay.  After 8 months of delay, only 75% of projects had delivered, though, as CNN pointed out in their examination of the 50 biggest Kickstarter projects, project creators were still working to deliver on their promise.  The graph below shows the number of projects delivering over time.

Project Delivery Delays

Promise or Peril?

To date, the data seems to show that the worries about fraud in crowdfunding are perhaps more overblown than might be expected (my letter to the SEC on crowdfunding explains some of the reasons why fraud is rare). But, even with the best of intentions, crowdfunded entrepreneurs are like other sorts of entrepreneurs – likely to learn a lot of tough lessons about the reality of their plans in the process of executing them.  The challenge for equity crowdfunding will be to ensure that investors in crowdfunding are patient enough to see new ventures through their inevitable evolution, and helpful enough that they can actually provide useful advice and guidance to help their portfolio companies succeed.

4 comments on “Crowdfunding: Promise or Peril?

  1. It is exciting to see these new equity (and in some cases debt) funding options come on line for entrepreneurs; however in mentoring and advising startups, it is clear that most of these freshly-minted entrepreneurs will need a lot of help to grow their companies to the point of Series A funding – the current bar seems to about $1 million in annual revenue.

  2. This paper provides evidence that we should do crowdfunding thing. In my experiences, crowdfunding is a good thing for university startups. But using a donation approach, we are only able to raise very limited funds. So US SEC needs to set policies clear for good startups/spinoffs to use equity to get crowdfunding for growing company to benefit all involved. Fengzhi Li

  3. Some of the data points you present in this article are interesting, however, there is a fundamental problem with your thesis: fraud is not comparable to the metrics you analyzed.

    The kind of fraud that the SEC is concerned about is a legal concept, not a colloquial expectation of the public. The legal definition of fraud involves the making of a false representation, which a person relies upon to their detriment. Fraud has nothing to do with whether a startup remains in communication with pre-sale customers. In fact, many notable fraudsters who were busted did stay in communication with their customers and the public (e.g., Bernie Madoff). Similarly, whether or not a startup delivers a pre-sold product (on time or otherwise) has only a tiny thread of relevance to the question of fraud. At best, that metric only addresses a fragment of a representation – not even the whole question (such as whether the delivered product conformed to the pre-sale representations regarding product specifications and performance) – and this fragment of a representation is just one out of an unlimited number of representations that are made in a crowdfunded project. Simply put, fraud is a far larger issue than your metrics address, and both the metrics you present and the things that you talk about in your letter to the SEC refer to a colloquial notion of fraud, not the kind of fraud that the SEC is required to regulate.

    Kickstarter for product pre-sales is dramatically different from crowdfunded equity investments, where people will rely upon a startup’s representations, will generally contribute larger amounts of capital, and will form expectations of return on investment based on a startup’s representations. The relevant representations go far beyond delivery of a product — it includes every factual and forward looking statement made by the company and its representatives.

    Like you, I’m keen to see crowdfunding available for securities sooner rather than later. Further, I commend your efforts to demonstrate that there should be less delay from the SEC — I agree. However, the analysis provided in this article and in your letter to the SEC misses the mark regarding the risk of fraud.

  4. James – Good points, and I agree it is worth making clear the difference between legal fraud and “fraud” as I am using the term – they are definitely two separate things (this came up when I was presenting to the SEC as well). To add a bit to your points: First, in the data, I did check to see whether the products were delivered in conformance with what was promised, and the cases where the majority of people were unhappy with delivered products was very rare. Secondly, I counted as “potentially fraudulent” products that had not delivered, were in communication with customers, but who had, in the eyes of most customers on Kickstarter, been lying or stringing along customers, so it wasn’t merely lack of communication. Also, in the latest version of my paper, I look at artistic projects as well, and find similar rates of “fraud”.

    Finally, I would strongly defend the idea that delivery (or “fraud” in my sense) in a reward-based system is actually a particularly interesting signal. Since there is little to no obligation to deliver, and no clear legal recourse for those who chose not to deliver products, the fact that failure to deliver is so rare suggests that most people who succeed in receiving funding feel compelled to fulfill promises to the best of their ability. A well-designed equity system should be able to add legal protections that reinforce this existing propensity.

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