Crowdfunding in Business

Crowdfunding in business is a contemporary method of raising capital through collective contributions from a large number of individuals, often facilitated by online platforms. This approach provides an alternative for innovators and entrepreneurs who struggle to secure funding through traditional avenues like banks or venture capital firms. By presenting their ideas or projects online, creators can attract financial support from interested contributors, who may receive incentives such as early access to products or equity in the venture.

While crowdfunding has gained popularity since its emergence around 2006, its underlying concepts, such as the subscription model, have historical roots dating back centuries. The model enables small-scale projects to flourish that would otherwise be overlooked by conventional financial entities. It encourages collaboration and taps into the "wisdom of the crowd," suggesting that collective input can validate and support new ideas.

However, crowdfunding is not without its challenges, including potential backlash when well-resourced individuals or organizations utilize these platforms, as well as issues related to project management and fulfillment. Despite criticisms regarding platform fees and the equitable distribution of funds, crowdfunding continues to evolve and adapt across various sectors, including charitable causes and artistic endeavors. This innovative financing method promotes a community-driven approach to entrepreneurship, highlighting diverse perspectives and the potential for social impact.

Published in: 2021

By: Zimmer, Scott

Subject Terms

Crowdfunding in Business

Abstract

Crowdfunding is a method of acquiring the capital necessary to finance a new business, new product, or project. Some innovators encounter difficulty in obtaining financing through traditional means, such as banks and venture capital firms. The Internet provides people in this situation with an alternative: They can raise the money needed by accepting small amounts of money from a large number of people, i.e. a crowd. Usually, members of the public who are interested in having the proposed product or service become commercially available will agree to donate a relatively small sum in exchange for some sort of incentive.

Overview

The usage of the term "crowdfunding" dates back only to about 2006. In its typical form, crowdfunding involves three different groups. The first group is the inventor, entrepreneur, or promoter of the new product or service. This person has what he or she thinks is a good idea for a commodity that many people would be interested in, if only it were available. Often, the commodity involves a "chicken and egg" dilemma: Many people would be willing to put their money behind the commodity if only it were commercially available (Chakradhar, 2015). However, the commodity is not commercially available precisely because no one is willing to take a chance on funding it. In traditional economics this type of situation would be seen as a failure of the marketplace, because there is a need that actors in the market are aware of, but the dynamics of the marketplace make it impossible for this need to be met.

The investors make up the second of the three groups involved in crowdfunding. Prior to the advent of crowdfunding, investors tended to be established financial institutions such as banks. This is because banks, in the immortal words of bank robber Willie Sutton, "are where the money is"; that is, only banks had enough money to be able to finance ventures on the scale required to launch a new product or company. This began to change toward the end of the twentieth century, as venture capital firms arrived on the scene (Ennico, 2015). Venture capitalists operate in a way similar to banks but on behalf of one or more wealthy investors who pool their investments into a fund that is used to support new ideas that the fund managers determine to have a reasonable chance of turning a profit. Venture capital availability did help to encourage the Internet boom of the late 1990s by providing greater access to investment funding, but this still occurred on a very large scale, with huge amounts of money involved. This meant that smaller projects continued to have difficulty surmounting the chicken and egg dilemma—they knew their product could be successful because they knew lots of people who were interested in it, but they were unable to convince financial institutions or venture capitalists to give them a chance.

The third group involved in crowdfunding is the one that was able to fill this gap: the developers and managers of crowdfunding infrastructure services. By observing the unmet demand for financial backing of smaller projects, the crowdfunding developers were able to devise a solution to the problem. This solution is a combination escrow service and social media promotion platform, exemplified by the company Kickstarter (Lawton & Marom, 2013). The purpose of the crowdfunding platform is to give those with the idea for a product a place to describe their idea, using text, pictures, video, etc., and a way to communicate that description to the rest of the world. It also includes a built-in mechanism by which members of the public can pledge their financial support for the project.

For example, an inventor who came up with a way to make a standard lawn mower operate in complete silence might have difficulty obtaining the money needed to produce a prototype, file for patent protection, and begin production. In order to obtain those funds, they could create a crowdfunding project and offer anyone who invested $100 a free lawn mower silencer from the first production run. They could also create different contribution tiers, so that a person contributing $200 would receive three silencers, $300 would entitle one to five, and so on. As users contribute more and more money, it goes into a combined fund which has a predefined fundraising goal. The inventor of the lawn mower silencer would set this goal based on their calculations of the startup costs. So, if they had determined that creating an initial batch of silencers for the product launch would cost $500,000, then their crowdfunding project would run until that goal had been reached.

Crowdfunding clearly serves an important role in the Internet economy. It is especially apt for projects of such small scale that banks and venture capitalists would not be interested but whose startup costs are out of reach for an individual or small group of investors. It is also attractive to some innovators because of its ability to act as its own advertising; this is because it exists almost entirely online and is designed from the ground up to take advantage of social media and word of mouth promotion. In addition, because the very concept of crowdfunding is still relatively new, it carries with it a certain cachet that sometimes spreads to the image of the product it is being used to fund and promote.

Applications

Although crowdfunding as an online activity is quite new, its conceptual origins can be traced back at least a few hundred years. As early as the seventeenth century there was something called the "subscription business model." Under this model, as with crowdfunding, projects were undertaken after first obtaining financing commitments from members of the public. For example, if a small group wished to begin publishing a newspaper in order to disseminate its political views, it would begin by soliciting subscriptions for the as-yet unpublished paper. If enough people could be persuaded to commit to subscribing to the paper, then the publication could actually launch and begin producing issues, which would be distributed to the paying subscribers. This model was used to finance part of the construction of the Statue of Liberty.

Crowdfunding, despite its application to the Internet, has been adapted for a wide range of uses (Steinberg, 2012). In addition to the customary product development use, there are also crowdfunding platforms geared toward raising money for charitable purposes such as defraying the cost of medical care for vulnerable individuals. A typical example of this type of crowdfunding might involve a person who has been in a serious car accident and has medical bills that are not covered by insurance. A crowdfunding campaign might be started by the injured person or those acting on his behalf. Artistic endeavors have also experimented with the crowdfunding model, particularly in the music industry, where performers have used crowdfunding to finance the production of recordings and the logistics of performance tours. By the late 2010s, virtually every industry could be seen to intersect with crowdfunding, with some, such as real estate and property investment, giving rise to their own specialized platforms (Stepek, 2018).

In the United States, changing investment rules helped drive the expansion of crowdfunding into new markets. In May 2016 the Financial Industry Regulatory Authority (Finra) and the Securities Exchange Commission (SEC) enacted policies allowing loan solicitation as well as equity investment in small businesses through crowdfunding. Under this regulation, anyone could invest up to $2,500 or 5 percent of their net income in return for equity in a small business (previously only those deemed accredited by meeting certain income and net worth minimums could receive equity) (Brodsky, 2017).

Viewpoints

Crowdfunding has been the source of controversy on several occasions. Typically these incidents occur when the crowdfunding model is used by a person or organization that already possesses access to what most people would consider adequate resources to accomplish its goal. In these situations, prospective donors may resent that they are being asked to financially support activities that the person or organization should be paying for themselves. This can result in backlash against the project, particularly on social media. In other cases, the mechanics of crowdfunding can prove to be the downfall of some projects (Sagall & Vega, 2014). This tends to happen when a project's financing phase takes longer than expected or encounters unforeseen challenges. The financing phase is the period in which contributions are solicited and stored. This phase generally lasts from the time the crowdfunding project is launched until the funding goal is reached and actual production begins. It is not uncommon for the financing phase to take several months or even a year or more, depending on the size of the project and the amount of starting capital needed to get it off of the ground.

In some cases, funding may start out strong, with contributions from many interested parties, but then begin to taper off, slowing down gradually and even coming to a stop before the funding goal has been met. When this happens, it can cause those who have already contributed to become dissatisfied with the process. This is not because they have lost money, since the funds they have pledged are only committed if the funding goal is met—otherwise the investors keep their money. The dissatisfaction is usually a mixture of disappointment at the product continuing to be unavailable (this disappointment is perhaps more intense because the crowdfunding project makes it more tantalizingly real) and frustration with the managers of the crowdfunded project, who may be perceived as not working hard enough to promote the idea and obtain buy-in from a large enough number of investors (Short, 2014).

Wisdom of the Crowd. One basic assumption that crowdfunding is built upon is the notion of the "wisdom of the crowd." This idea comes from the social sciences and information theory, and attempts to explain the way that the behavior of crowds, i.e. groups of people affiliated in some way either temporarily or on a long-term basis, can exhibit insights that transcend those possible for any individual member of the group. This is a phenomenon that has been observed in many different contexts; one of the better known examples comes from Victorian intellectual Sir Francis Galton and involves a crowd at a rural fair competition in which the goal is to correctly guess the weight of an ox. While no one in the crowd is able to accurately guess the weight, when all of the guesses from members of the crowd are viewed in the aggregate, the average guess comes remarkably close to the true figure. The lesson drawn from this vignette is that somehow a large number of people influence one another in subtle ways that cause the group to arrive at the correct answer to a problem even if no single person in the group would be able to reach the same resolution on his or her own. Crowdfunding takes this lesson and applies it to the arena of business financing (Dresner, 2014). This means that some projects, products or services have a potential market that justifies their creation, but that this justification is somehow imperceptible to banks, venture capitalists and other traditional sources of capital. Only by presenting the idea for the new commodity to the crowd can the wisdom of the crowd have an opportunity to see the new possibility it represents.

Crowdfunding has inspired some interesting work in the fields of psychology and the social sciences, as its model appears to contradict the typical form of commercial transactions that people are accustomed to engaging in. Ordinarily, a consumer searches the marketplace for a product that will meet their needs. Once the product is located, the consumer initiates a transaction in which they trade something of value—money, in most cases—for possession and ownership of the product. The merchant agrees to give up possession and ownership of the product in exchange for the money or other form of value. Scholars observe that this type of exchange is rooted firmly in the present and past, because the product has already been created and the money has already been earned and made available, and the trade between consumer and merchant occurs in the present (Bennett, 2015). Crowdfunding alters the entire landscape of such a transaction by placing its focus on the future. In this forward-looking model, the investor and the designer of the product or service make an agreement about what will happen in the future: The investor will give her money to the designer if the funding goal is met, and the designer will give to the investor a reward for their financial support, which often takes the form of the product that the designer has designed.

Some psychologists liken this paradigm to one based on faith or trust, because both parties to the transaction must believe in each other on a fairly deep level—otherwise, there is no reason for them to engage in the transaction. Viewed in this light, the phenomenon of crowdfunding is seen as a positive development for society because it encourages so-called prosocial behaviors by creating opportunities for people with common interests to cooperate in order to produce a result not otherwise attainable.

Others make the observation that crowdfunding may produce positive effects, but it is usurping a role that might be better served by public spending. This view suggests that crowdfunding platforms are attempts at privatizing altruistic impulses and cooperative efforts, and that a better approach would be to use tax revenue to provide greater access to startup capital and microloans in order to help people bring their ideas to fruition. Advocates of this tax-based approach point to the government programs enacted during the Great Depression, such as the Work Progress Administration's funding of the arts, as evidence that such programs could be successful and that they would do so without charging fees. There are difficulties with this argument—a portion of taxation is used to pay for government overhead, after all, and publicly funded projects might be able to assist small businesses but would be unlikely to help with social causes such as severe medical bills—yet it has proven problematic to discount entirely. Suggestions to increase funding to the Small Business Administration in order to test the theory have tended to fall afoul of the perennial political debate over the appropriate size of government and the impropriety of government entering the marketplace to the detriment of private enterprise (in this case the crowdfunding platform developers).

Perhaps inevitably, the organizations that operate crowdfunding platforms online have begun to come under scrutiny. In some cases this is related to the fee that the platforms charge, which is usually a percentage of the funds being raised. Critics argue that the fee is too large, or that it is unfair because it takes advantage of projects that are already having difficulty obtaining funding. Defenders of crowdfunding argue that the fees are needed in order to make it financially viable to operate the crowdfunding platform. The fees cover the platform's online hosting, website development and maintenance, Internet bandwidth costs, as well as the salaries of the platform staff. Crowdfunding proponents also point out that crowdfunding services provide society and the economy with a valuable service, and that without their efforts, huge numbers of worthwhile projects would be unable to launch due to lack of funding and lack of interest on the part of traditional investors.

Terms & Concepts

Barker: A person hired to assist in the promotion of a crowdfunded project by distributing information and links throughout various online communities and forums. The term comes from the carnival barkers who call out invitations to participate in different types of entertainment at fairs and festivals.

Equity investor: Some crowdfunded projects reward sponsors with the product being created, while others reward investors with a share in the ownership of the newly launched company; the latter type of investor is an equity investor because he or she gains an equity interest (ownership interest) in the company.

Progress bar: Most crowdfunding sites include a visual depiction of how close the project is to being fully funded. This usually looks like a computer's progress bar or an old fashioned thermometer—as the project gains sponsors, the thermometer's "temperature" rises until the bar is completely full.

Social media: Online services that make it possible for users to create accounts and share information about themselves and their activities with friends, coworkers, and the general public.

Sponsor: A term sometimes used to refer to those who pledge money in support of a crowdfunded project.

Venture capital: Financial support given to a new product or service that is expected to be successful and highly profitable, thus earning a substantial return on the initial investment.

Bibliography

Assenova, V. (2016). The present and future of crowdfunding. California Management Review, 58(2), 125–135. Retrieved December 14, 2016 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=113184776&site=ehost-live&scope=site

Bennett, L. K. (2015). Crowdfunding the future: Media industries, ethics and digital society. New York, NY: Lang.

Brodsky, N. (2017). Taking advantage of crowdfunding’s new rules. Inc., 39(8), 48. Retrieved October 22, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124964185&site=ehost-live&scope=site

Chakradhar, S. (2015). In new crowdfunding trend, donors decide fate of clinical trials. Nature Medicine, 21, 101–102. Retrieved March 22, 2015 from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=100825302&site=ehost-live

Dresner, S. (2014). Crowdfunding: A guide to raising capital on the Internet. Hoboken, NJ: John Wiley & Sons.

Ennico, C. R. (2015). Crowdfunding handbook: Using equity funding portals to raise money for your small business. Place of publication not identified: Amacom.

Lawton, K., & Marom, D. (2013). The crowdfunding revolution: How to raise venture capital using social media. New York, NY: McGraw-Hill.

Sagall, R., & Vega, S. B. (2014). Crowdfunding: A non-traditional financial assistance opportunity. Revenue-Cycle Strategist, 11, 4-5.

Short, J. (2014). Social entrepreneurship and research methods. Branford, UK: Emerald Publishing.

Steinberg, D. (2012). The Kickstarter handbook: Real-life crowdfunding success stories. Philadelphia, PA: Quirk Books.

Stepek, J. (2018). Join the crowd. Business Traveller (UK/Europe Edition), 72. Retrieved October 21, 2018 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=132008628&site=ehost-live&scope=site

Crowdfunding in Business

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Subject Terms

Crowdfunding in Business

Abstract

Overview

Applications

Viewpoints

Terms & Concepts

Bibliography

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