“Let’s be clear… Reward- and investment-based crowdfunding are VERY different funding models. The underlying economics are simply too different to ignore, and we have to keep that in mind and be clear on what model we talk about when we discuss CROWDFUNDING.”
A little while back, MIT Professor Christian Catalini shared this point of view at a crowdfunding symposium held at UC Berkeley. A straightforward and simple message, that unfortunately, often escapes the attention it deserves… especially in the media.
In this piece, I walk through some of the key differences between the two models; I try and explain (or justify) why it makes sense to discuss them in concert as crowdfunding; and finally I explore cases where the overlap between them yields synergies and hybrid crowdfunding models.
Reward-based crowdfunding as it presents itself today is a simple form of pre-selling (or advance selling). Corporations frequently use advance selling schemes to cover development cost, profit from price discrimination, and test the market. There are three popular ways of doing this.
Dynamic Pricing is the simplest one. Here the customers know the pre-selling price, but not the “real” retail price, once the product hits the market. Obviously, consumers are hesitant to jump on board early if the expectation is that the retail price will be lower than the pre-selling price. To overcome this, some companies use Price Commitment schemes where the retail price is announced simultaneously with the pre-selling price; or they use a Price Guarantee where the retail price is not announced early on, but where the consumer is refunded the difference in case the retail price is lower than the pre-selling price.
You can find an interesting analysis of optimal strategies for advance selling, as well as a very nice overview of the literature, in Profiting from Demand Uncertainty: Pricing Strategies in Advance Selling by Professors Zhao (University of Notre Dame) and Pang (Lancaster University).
When you look at a typical reward-based crowdfunding campaign (e.g. on Kickstarter or Indiegogo), no commitments are made to protect early supporters, which is why we can think of this type of fundraising as simple pre-selling with dynamic pricing. Given the continuous innovative flux of the crowdfunding industry it is probably safe to assume that this will change very soon. Indiegogo’s recent InDemand program is a good example of how the marketplace evolves.
For securities offerings (in this case private placements), a drop in valuation between two funding rounds is a well recognized part of the game. Being early does not necessarily mean that you get the best deal (especially if you add risk compensation to the calculation). Investors are well aware of that; and this level of “sophistication” is not a function of being an “accredited investor” or not. It’s simply a matter of understanding WHY startups are risky.
If we look at some of the typical red flags that investors use to assess startups’ risk structures, we see differences between the two funding models too. The usual suspects are:
- Team inexperience
- Industry risk
- Regulatory and legal challenges
- (Large) investment requirement
- Small return potential
- Poor public image
Which of these actually matter for supporters of a reward-based campaign? We don’t have any research on the matter, but it seems like a safe bet to rule a couple of these out right off the bat.
Since supporters of reward-based campaigns don’t hold any financial claim of the company, the Industry risk and Return potential shouldn’t matter at all. Although Legal challenges could translate into delivery risk, we have little evidence that this is a concern for supporters (a good example of a legal dispute in the crowdfunding space is 3D Systems’ lawsuit against Kickstarter back in 2012).
Whether the Public image has an impact on campaign success is anyone’s guess. On the one hand controversy boost sharability; but on the other hand, we simply don’t know enough about the rate of sentiment shifts on social media channels to say whether there is a positive effect for reward- based campaigns or not. Investor home biases are persistent, but of less importance for a crowdfunding deal (reward- and investment-based). You can find an analysis of this in Agrawal, Catalini, and Goldfarb’s The Geography of Crowdfunding.
There should be similarities however. Team inexperience translates directly into delivery risk, and as the crowdfunding marketplace matures, this is likely to become of greater importance than it is today. Gizmodo has published a “Hall of Shame” of 7 Spectacular Crowdfunding Fails. Clearly you don’t want to see your company in “this company,” but more importantly, for the transparency in the marketplace, crowdfunders become better aware of the inherent risk involved with funding entrepreneurial ventures.
I cannot write this without mentioning Zack Danger Brown’s Potato Salad project. At first glance, it looks like a counterexample where the crowd participated because of team (or founder) inexperience. Admittedly, I don’t know enough about the particular campaign to say if this is the case.
In terms of asking for “too much,” there might be similarities between the two funding models. Although, typical reward-based campaigns use the threshold-pledge-system, which protects supporters against hold-up problems of partially funded campaigns, it seems like the willingness to fund projects with huge funding goals is somewhat limited.
In a previous post, I’ve taken a deeper dive into what entrepreneurs can expect in terms of getting funded above their goal. There are several implications; both from the point of view of being able to deliver from the given budget, and in terms of extracting information about marketability from crowdfunding data. You can find the article, Twin Peaking Crowdfunding, on Wired Innovation Insights.
Synergies and Hybrids
I recently had the pleasure of interviewing two young entrepreneurs, from Out Tek, LLC, who are taking a Crowd-First approach to their 2015 business development. Since the JOBS Act implementation seems closer than ever, it was only natural to hear them out about the opportunity to turn customers into investors.
Although, it isn’t clear at the moment whether JOBS Act (Title III) crowdfunding will be in Out Tek’s pineline this year, similar companies’ experiences are very intriguing. One of the earliest examples of companies that run reward-based and investment-based initiatives is Off Grid Solutions and their WakaWaka Lights campaigns. They ran campaigns on Kickstarter and Symbid, so I spoke with Symbid’s CEO, Korstiaan Zandvliet, about this.
Korstiaan: “WakaWaka is something of a special case. Their first Kickstarter campaign began in January 2012 and by April they were already celebrating a successful Symbid campaign with almost $90,000 invested. These guys were very quick to recognize that crowdfunding – whether it’s reward- or equity-based – is far more than just a way of raising cash. It’s also a cost-effective market research tool and launching customer group.”
Korstiaan: “They took the decision to “upgrade” to equity crowdfunding because they appreciated that while Kickstarter may deliver customers and short-term publicity, investors are lifelong brand ambassadors. At Symbid we encourage our community of 28,000 active investors to act as a knowledge base and think-tank for all our start-ups. It’s this added value that consistently persuades our entrepreneurs to sell equity rather than promise rewards. Investors ask for more, but give more in return.
Of course, this doesn’t mean that equity is right for all business ideas. WakaWaka was successful because it’s a beautifully unique product backed up by an emotive brand strategy and marketing campaign. They were able to engage a global community of environmental and sustainability enthusiasts. It would’ve been almost impossible for them to ask for “too much” from the crowd. Investors were confident that the founders had the requisite experience, know-how and network to deliver business growth – three crucial elements that someone making a potato salad on Kickstarter doesn’t necessarily need, or have.”
Kevin: “Is WakaWaka’s experience normal for entrepreneurs on Symbid’s platform?”
Korstiaan: “With over $7.4m invested through our funding network so far, Symbid has happily reached the stage at which our entrepreneurs generally don’t feel the need to complete a Kickstarter campaign beforehand, or offer rewards as an incentive. Similarly, our investors can feel secure in the knowledge that all Symbid campaigns are evaluated thoroughly before going live.
There are several other ways for a start-up to minimize risk for potential investors, if an entrepreneur is concerned about the attractiveness of their campaign. A few months ago, the data exchange platform OnlyOnce completed a second funding round with us for a total of almost $600,000. It soon became apparent that the majority of investors were actually beta users of the platform itself. They knew the product intimately, invested early, and word of mouth did the rest. The beta testers pledged their time and were rewarded with the opportunity to invest – the early backers of Oculus Rift were never offered such a chance. I can only assume more products, especially apps, will find funding in this way.”
Kevin: “Where do you see the biggest potential for synergies between the two models?”
Korstiaan: “I do see some potential for crossover between reward- and equity-based crowdfunding when it comes to the film and music industries. Symbid recently launched a campaign for Oscar- winning director Mike van Diem’s latest film, ‘The Surprise’, which offers both equity and unique rewards to its investors. Of course, the film industry is no stranger to crowdfunding, but the chance to actually buy shares in a genuinely high-profile movie title is, I think, pretty revolutionary. We at Symbid see this campaign as evidence of the progress crowdfunding is making towards becoming a serious alternative to traditional finance.”
Korstiaan: “Symbid does enable start-ups, particularly those with marketable consumer products, to reward their investors with “perks”. In this sense, we actively encourage our entrepreneurs to turn a potential customer into an investor. Nevertheless, for many people, especially larger, angel-like investors, a free or discounted product clearly isn’t enough. I believe the European crowdfunder, thanks to the delay in JOBS Act legislation, is a few steps ahead of the American in this sense. People here are starting to question the notion of pledging money to an idea in return for a vague promise of future rewards, when there are plenty of innovative, high-growth start-ups offering a higher level of participation and return through equity.
Without doubt, equity crowdfunding – at least in Europe – is maturing into a more serious and profit- generating system of online investment. Think less Kickstarter-like ‘advance selling’ campaigns, more online stock markets for start-ups. Therefore I’d expect hybrid models to remain in the minority as investment crowdfunding platforms, Symbid being a prime example, seek to align themselves more with the bigger competitors in the world of finance (while retaining their democratic identity). In truth, Symbid is hybridizing its equity model, but with loans rather than rewards. Our funding network is designed to help anyone become an investor, big or small.”
Kevin Berg Grell, PhD is CEO at APEN Designs, a next generation presentation tool for startups and SMEs. Responsibilities include investor and industry relations, financials, and strategy development. Besides this venture, he consults for private enterprises on the implications of crowd dynamics, online investing (incl. crowdfunding and P2P), and Web 2.0 driven business models. Kevin has a PhD in Finance and MSc in Mathematics and Economics. He also practices capoeira and archery, but rarely simultaneously.