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Demand-Side Perspectives on the Democratization of Finance through Crowdfunding: Opportunities and Challenges for Early-Stage Finance Research

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In this chapter, we discuss the impact of crowdfunding to resolve early-stage funding gaps among young ventures, evaluating the extent to which different forms of crowdfunding function as a digital substitute for traditional sources of early-stage finance. We then discuss the unique challenges crowdfunding creates for young ventures. We conclude the chapter with a set of theoretical arguments to explain how the emergence of crowdfunding is enabling entrepreneurs to resolve key organizing problems common to young ventures.
The explosive worldwide growth of crowdfunding is a testament to the power and
effectiveness of digital technologies to facilitate novel forms of engagement and exchange. By
2025, the World Bank predicts that over $90 Billion (USD) will be invested in emerging markets
through more than 1250 crowdfunding platforms – which is almost 2 times as large as the global
venture capital industry (World Bank Report, 2013). Based on these trends, a growing number of
industry experts predict that crowdfunding platforms will soon become a dominant source of
financing for entrepreneurial ventures since they allow firms to access capital from a wider
audience than typically participate in traditional private equity markets (Drover et al., 2017).
At the same time, while numerous advocates laud the ability of crowdfunding platforms to
“democratize” access to the early-stage financing (Mollick & Robb, 2016) and to disrupt
traditional sources of early-stage financing, the long-term impact remains an open issue. Despite
the accelerating growth and popular appeal of technology-based and social network-driven
alternatives like equity-based crowdfunding, it is unclear whether or not these financing vehicles
will remain a colorful niche or will one day mature into a direct competitor and credible substitute
for more formal sources of financing. Setting aside the exaggerated expectations and hyperbolic
promises of crowdfunding as the panacea for all that ails capital-constrained ventures, scholars
need to develop a deeper understanding of why entrepreneurs choose to finance new products and
business models through crowdfunding. A detailed exposition of emerging alternatives is
necessary in order to identify and assess the causes and consequences of the significant challenges
facing entrepreneurs, many of whom choose to fund their early-stage ventures through
crowdfunding (Hui et al., 2014).
Thus, to balance the “democratization” hype surrounding crowdfunding, the purpose of
this chapter is to situate crowdfunding as one of several financing vehicles potentially available to
early-stage entrepreneurial ventures, replete with a varied assortment of benefits and pitfalls, many
of which are not entirely clear to either entrepreneurs or scholars. Public financing of nascent-stage
ventures through multi-sided platforms is at once cornucopia of opportunity and a quagmire of
complications and challenges. For scholars, these issues have generated a wellspring of important
research questions regarding the willingness of entrepreneurs to utilize crowdfunding as a funding
source and the efficacy of strategies entrepreneurs use to manage successful campaigns.
Recognizing that crowdfunding is neither a panacea nor a curse for short-pocketed ventures, our
goal is here to balance the hype surrounding the emergence of crowdfunding with a reasoned
approach that constructively considers both the limitations and opportunities of crowdfunding to
resolve key organizing problems common to early-stage ventures: coordination, gatekeeping,
inexperience, and patronage
We strive to accomplish these objectives in the following manner. In the following section,
we discuss the pernicious impact of the funding gap in early-stage financing that stems from a
perceived undersupply of early-stage financing options for young ventures. We then discuss
current research on the democratizing power of crowdfunding to resolve the funding gap among
young ventures. After situating crowdfunding as a digital substitute for traditional sources of early-
stage finance, we then follow-up this discussion with an assessment of the challenges
crowdfunding creates for young ventures. Based on these arguments, we then outline a set of
theoretical arguments to explain how the emergence of crowdfunding mechanisms arise in
response to demand-side forces among entrepreneurs that are seeking to resolve key organizing
problems common to young ventures. Based on these arguments, we then outline a series of future
research opportunities for exploring demand-side drivers of crowdfunding among early-stage
Funding Gap in Early-stage Entrepreneurial Financing
One of the fundamental questions in the entrepreneurial finance literature addresses the
persistence of the “funding gap” for early-stage ventures (Mason & Harrison, 1996; Cressy, 2002;
Mason & Harrison, 2003). This funding gap is thought to be driven largely by the relative
imbalance in early-stage capital markets between the available supply of early-stage financing and
the demand for such financing from startup ventures (Freear, Sohl, & Wetzel, 2002). For example,
Freear and colleagues (2002) contend that there is a funding gap between the ability of new
ventures to generate internal financing and the minimum likely investment of stage formal venture
capital financing. While informal sources of financing such as angel investors have emerged to fill
this gap at least partially, the complex interaction of the source of funding, quality and type of due
diligence processes, governance arrangements, and investment objectives (Freear et al., 2002)
generate an array of opportunities and trade-offs that different early-stage asset classes fill. As a
result, funding gaps exist not solely as a result of incomplete or inefficient early-stage capital
markets but also because of the sheer diversity of and relative specialization of a growing set of
asset classes that seek to fill different funding needs in the marketplace.
Other scholars argue that funding gaps are solely a perceptual problem driven by the
hubristic over-estimation of the potential or quality of a new venture (Hayward, Shepherd &
Griffin 2006; Shane 2008). Through this lens, perceived funding gaps are thought by entrepreneurs
to arise as a consequence of systemic shortages of financial capital; basically, there’s not enough
money to fund all the good ideas. In actuality, however, scholars have demonstrated that these
perceived shortages are a function of market-based referenda on the founders’ lack of effort or
imagination in generating resources through internal development strategies such as bootstrapping
(Bhidé, 1992; Brush, Greene & Hart, 2001; Ebben and Johnson, 2006; Winborg and Landstrom,
2001). To the extent firms overcome these perceptual errors, they can better calibrate their
fundraising expectations to the realities of external markets. This is often easier said than done
since early-stage capital markets are notoriously inefficient and irrationally prone to fads and
fetishes (Harrison, 2013). Founders seeking reliable, transparent sources of financing confront
markets for capital that rarely, if ever, sort into smooth, normally-distributed equilibria where all
qualified firms receive the capital they should receive. Instead, because investor returns are outlier-
driven phenomena, where just a few ventures are responsible for the overwhelming majority of
financial returns in a given year, investors are increasingly chasing fewer and fewer deals, driving
up the valuations of a few companies, while the remaining companies must fight for a dwindling
supply of financing (Drover et al., 2017). Thus, while firms can certainly mitigate these outlier-
driven, capital market “imperfections” with creative approaches to bootstrapping, the basic reality
is that the complexities of internal resource development obstacles, asset specialization trade-offs,
and the distributional realities of external markets requires entrepreneurs to balance an array of
sometimes competing objectives when mobilizing resources.
External Sources of Early-Stage Financing
4Fs, Bank, Angel, & VC/CVC. Given the complex array of various financing choices
available to entrepreneurs, it is important to understand both the benefits and trade-offs associated
with choosing various forms of early-stage financing. This is important relative to our central focus
in this chapter in situating crowdfunding as a source of early-stage financing and to disentangle
the various benefits and trade-offs associated with selecting each form of external financing. In
this section, we will highlight and compare and contrast four different sources of external
financing: founders, friends, family and fools (4Fs), bank financing, angel financing, and venture
capital/corporate venture capital financing.
Our emphasis here will be on identifying the relative
specialization of these various forms of financing to disentangle how and why entrepreneurs may
choose one or more over the other forms of financing when electing to source external financing
to fuel the development of a new venture.
In most cases, the dominant form of external financing raised by entrepreneurs is sourced
from 4Fs (Kotha & George 2012). In the earliest stages of development, when uncertainties are
ostensibly at their highest level, leveraging strong network ties to source external capital is likely
the predominant mode of financing since these strong social ties would override any sense of the
economic (and almost certain) risks that the capital will not be returned to the investor. Given the
high rate of failure of early-stage ventures (Shane 2008), many 4Fs undoubtedly invest for reasons
other than in maximizing investment returns and as a result, these deals are often informal, rarely
specified through even incomplete contracts, and often largely viewed as sunk cost investments by
both the entrepreneurs and “investor.” Given these (almost certain) risks, most of these investments
are limited by small amounts of capital intended only to help ventures initiate operations.
In other cases, banks can be a source of early-stage financing (Schwienbacher & Larralde
2010). For this financing, new or emerging ventures utilize debt instruments, often sourced from
local financial institutions, using personal assets or creditworthiness to collateralize the loan. In
rare cases, entrepreneurial ventures are able to secure financing utilizing corporate assets as
security for the loan, but in most cases, given the lack of cash flows, most of these deals use
personal assets to secure the loan. Since these loans often require frequent or periodic repayment,
the lack of cash flows of early-stage ventures creates both supply-side and demand-side constraints
on the availability of these loans (i.e., banks are reluctant to lend to new businesses and
entrepreneurs are often reluctant to utilize debt instruments to finance startups).
In addition to sourcing financing from strong-tie network relations, such as 4Fs and bank
financing, some entrepreneurs also source “informal” financing from weak-tie social relations with
wealthy individuals. Typically, these wealthy individuals are willing to fund ventures due in part
to the presence of liquid assets, a desire to diversify, and sometimes due to previous experience or
personal interest in a particular market (Prowse 1998). The emergence of angel investors fills a
critical hole in early-stage capital markets by providing larger tranches of capital to new ventures,
intended to fuel the future growth of these companies. However, both the experience of the investor
and the relative formality of the deal structures varies widely from case to case, and so the
effectiveness of angel investors remains broadly mixed in early-stage capital markets (Prowse
1998; Wong, Bhatia & Freeman 2009).
Lastly, in relatively select instances, formal seed and early-stage investments from
professional and corporate venture capital firms play an important role in early-stage capital
markets (Kleemann et al., 2008; Schwienbacher and Larralde, 2010). Formal investors like VCs
are able to invest larger tranches of capital in early-stage ventures while also providing support
services to professionalize early-stage companies (Hellman & Puri, 2000). However, VC
investments are largely concentrated in specific geographic locations and in specific industries
(Chen, Gompers, Kovner & Lerner, 2010). Furthermore, as numerous critics have pointed out, to
a surprising degree, VC investment portfolios tend to lack both gender and ethnic diversity
(Greene, Brush, Hart & Saparito 2001). While the VC industry has begun to take steps to address
the lack of diversity among its portfolio companies, these biases appear to be deeply entrenched
in the current culture of the industry thereby raising important concerns about the lack of
innovation emerging from a relatively homogenous group of VC-funded founders (Kortum &
Lerner, 2000).
Formal sources of private equity financing are not limited to angel groups and VC firms;
companies also play a prominent role. Corporate venture capital (CVC) investments are
increasingly utilized by established firms as part of their respective strategic portfolios for
innovation (Dushnitsky & Lenox, 2005). In turbulent and uncertain markets, CVC investments
provide incumbents with access to promising technologies and business models (Tong & Li, 2011).
Unlike traditional VC investments, CVC investments are not implemented solely to generate
returns to an investment portfolio; Instead these investments are utilized to advance the strategic
goals of the CVC parent company (Keil, Autio, & George, 2008). In doing so, CVCs sometimes
create incentive problems for firms when the quest to maintain compensation equity between
members of the CVC arms and the company as a whole leads to more conservative investment
decisions (Dushnitsky & Shapira, 2010). CVC investments can also cause problems for firms
seeking to raise financing. Recipients of CVC financing navigate a narrow channel between the
risks to their knowledge stocks at the hands of opportunistic corporate investors versus the benefits
associated with being aligned with a powerful industry incumbent (Dushnitsky & Shaver, 2009).
If the smaller firm’s intellectual property (IP) regimes are weak or the power dynamics between
the companies is skewed in favor of the larger, more dominant partner, early-stage companies are
often better-off avoiding becoming too entangled with CVC investors to maintain their freedom to
operate without facing significant exposure to knowledge stock appropriation or onerous
monitoring costs to protect IP (Dushnitsky & Shaver, 2009).
Crowdfunding. In general, crowdfunding refers to an emerging set of funding mechanisms
in which an entrepreneur, owner, entity, or campaign creator (e.g., person, group, company,
organization) develops a campaign to fund a novel product, good, service, or charitable cause from
a potentially large number of backers on a digital platform (i.e., “the crowd” - Belleflamme et al.
2014; Mollick 2014). Although numerous new innovative funding mechanisms continue to emerge
in this industry space, what crowdfunding platforms have in common are that they are distributed
and disintermediated, digital-exchange networks (Morse, 2015; Frydrych, Bock, Kinder, & Koeck,
2014; Lambrecht et al. 2014). Crowdfunding offers numerous advantages over more traditional
forms of financing – namely that entrepreneurs can raise funding from a more diverse set of
investors and backers from more geographically diverse locations (Agrawal, Catalini, & Goldfarb
2014). Furthermore, crowdfunding offers entrepreneurs the ability to fund the development of
more diverse projects than are typically funded through traditional early-stage financing modes
such as venture capital or angel investments (Mollick, 2014). Emerging evidence also suggests
that crowdfunding enables historically underrepresented groups such as women and minorities to
gain access to early-stage funding (Mollick & Robb, 2016). Overall, the arguments regarding the
ability of crowdfunding campaigns to democratize access to early-stage funding generally focus
on three main areas: geographic dispersion of funding agents, access for underrepresented groups
to pools of financial capital, and a broader set of projects that can be backed by investors or backers
than would traditionally be able to raise funding from early-stage investors (Mollick & Robb,
2016; Mollick, 2014).
At the same time, however, evidence is mounting that the democratization of financing
through crowdfunding is creating new challenges for entrepreneurs who choose to utilize such
funding mechanisms to fund early-stage projects. In our view, three main challenges exist which
continue to create novel challenges for entrepreneurs. These challenges include: (1) the mixed
motives and capabilities of project backers, (2) the complex relations among campaign creators,
backers, and crowdfunding platforms, and (3) the challenges of distributed governance for
crowdfunded ventures. First, regarding the mixed motives and capabilities of project backers,
several issues are important to consider. Powell (2017) argues that crowdfunding backers utilize a
mixed set of motives when choosing to fund projects that reflect a novel mix of instrumental and
charitable motivations. In 2014, one of the most successful Kickstarter projects to-date, Oculus
Rift, leveraged the success of a $2.5 Million Kickstarter campaign into a $2 Billion acquisition
from Facebook (Schwienbacher, 2018). Many of the more than 9000 original backers of the
Kickstarter campaign, however, expressed considerable frustration at the announcement of the
acquisition of Oculus Rift by Facebook and expressed in numerous public forums that they felt
betrayed by the campaign’s decision (Kuppuswamy & Bayus, 2015). In many of these cases, the
backers thought they were supporting grass roots efforts to create a new class of technology and
felt betrayed when the company made the controversial decision to be acquired by a large,
incumbent technology company. Second, while many of the platforms such as Kickstarter openly
note that each backer must evaluate campaigns with a caveat emptor approach, numerous high
profile failures (e.g., “Coolest Cooler”) suggest that the hands-off approach to managing campaign
risk by the crowdfunding platforms might potentially undermine their long-term viability (Hazen,
2011). Third, the relatively open access of crowdfunding platforms enabled through both the
emergence of novel platforms (e.g., Kickstarter) and through legislative fiat (e.g., JOBS Act in the
United States), both creates difficult challenges in regards to the distributed governance of these
campaigns by backers/investors who might not be properly motivated to scrutinize and to address
emerging agency concerns (see Agrawal et al., 2014).
The diffuse nature of crowdsourced funding is part of its tremendous appeal to small-scale
investors, but it also guarantees that governance is diffuse, which may be sub-optimal. This creates
a set of circumstances in which the individual stakes are so small that few, if any, of the investors
may be motivated to incur the monitoring costs that are necessary to insure that even minimal
levels of accountability are maintained. Scholars have investigated whether contributors to
crowdfunding campaigns have the requisite expertise or capabilities to conduct effective due
diligence processes in order to manage their risks effectively (Malgrem, Holm, & Bertilsson,
2016). The findings are mixed, but generally point towards a greater degree foresight and
circumspection than one might imagine, given the relatively limited flow of information regarding
completed campaigns.
While the presence of “dumb money” undoubtedly influences both the valuation and
successes of crowdfunding campaigns (Agrawal et al., 2014), new studies suggests that
crowdfunding backers on equity-based platforms are attuned to certain important signals when
evaluating potential investment targets (Ahlers, Cumming, Gunther, & Schweizer, 2015). In these
cases, the proper identification and interpretation of quality signals from crowdfunding campaigns
hinge upon both the quality and transparency of the information released by the campaign as well
as the capabilities of the individual backers. Therefore, disentangling the effects of the relative
sophistication of crowdfunding backers must account for the quality of information released by
the campaign as “dumb money” will always chase “dumb deals” while “smart firms learn to
signal properly to attract to “smart investors.”
Table 6.1 provides a comprehensive summary of the differences between these sources of
external financing for early-stage ventures. Over and above the details pertaining to investment
size and sources, the defining contrasts among these financing options relate to the inter-twined
features of governance and anticipated return. In order to understand the importance of these
differences – and thereby fathom the underlying causes of crowdfunding’s mercurial rise and
uncertain future -- in the following section, we will situate crowdfunding within a demand-side,
lifecycle model of entrepreneurial finance. In doing so, we will identify the special benefits
crowdfunding provides to entrepreneurs during the early stages of development, while at the same
time challenging some of what we believe is over-wrought hype surrounding the ability of
crowdfunding to disrupt and radicalize traditional markets for early-stage financing through
democratization and digitization.
Please Insert Table 6.1 about Here
New venture creation process and lifecycle models abound in the entrepreneurship
literature (Parker, 2006), ranging from models of organizational emergence (Gartner 1993) to
finance-oriented models that trace the funding stages through which ventures tend to progress
(Berger & Udell 1998; Brophy & Shulman 1992; Gompers & Lerner 2004). New venture lifecycle
models are often constructed to follow a common trajectory of organizational emergence, starting
with concept or idea creation and culminating in organizational death or closure (Parker, 2006).
Although the specific stage in which these organizations sit within the lifecycle ostensibly impacts
the types of resources they utilize, resource mobilization processes tend to be placed in the middle
of these process models as a critical step between firm creation and firm growth, ostensibly fueled
by an infusion of financial capital (Gompers & Lerner 2004). Similarly, finance-oriented process
and lifecycle models tend to reflect supply-side perspectives on the sequencing of both financing
types (Gompers & Lerner 2000) and investor decision-making (Drover et al., 2017).
In either case, however, one of the central criticisms of process and lifecycle models is that
these models often are interpreted as implying a relatively rigid sequencing of action steps and
capitalization outcomes that do not always correspond to the action sequences firms experience in
situ (Berger & Udell 1998). Clearly, ventures can and do raise various sources of financing at all
stages of the process and while certain forms of capital may correlate with particular stages more
than others, the operative link may center more on the problems and needs driving the pursuit of
capital versus the actual stage of development of the venture.
To date, only a few studies have examined the types of entrepreneurs that make use of
crowdfunding, much less why they crowdfunding over alternative forms of financing (Ahlers et
al., 2015). One popular thesis posits what essentially amounts to an adverse selection story:
entrepreneurs utilize crowdfunding because they are unable to access early-stage financing from
other traditional sources of financing such as those highlighted in Table 6. 1 above (Bruton et al.,
2015; Blaseg & Koetter, 2015). Indeed, given the millions of crowdfunding campaigns that have
been initiated across many different types of platforms, there are clearly entrepreneurs who pursue
funding from the crowd as a last resort. Although few studies have explored these questions in-
depth, early evidence indicates that the vast majority did not pursue these campaigns as a last resort
(Brown, Mawson, Rowe, & Mason, 2017). Instead, these entrepreneurs were able to raise funding
more quickly and at a better comparative valuation than through traditional funding sources
(Brown et al., 2017). Apart from the funding benefits, other entrepreneurs utilize different forms
of crowdfunding to solicit early feedback and engagement from potential customers (Belleflamme
et al., 2014). In these cases, the funds that are raised might in some cases be subordinate to the
goal of reducing demand uncertainty through direct customer engagement (Strausz, 2017).
Although information cascades have been linked with crowdfunding (Vismara, 2018), the
effectiveness of these tactics remains an open question and appears to hinge directly upon the
social proximity of campaigns and backers (Morse, 2015).
These demand-side considerations are further complicated by the emergence and continued
evolution of new of distributed, disintermediated, digital-exchange networks that continue to lead
to the emergence of different types of financing arrangements (e.g., donation, reward-based,
equity, lending, micro-lending, or hybrid combinations of these and other financing vehicles). In
many cases, these platforms often operate as a digital exchange equivalents of traditional sources
of early-stage financing (Younkin & Kashkooli, 2016). According to Younkin and Kashkooli
(2016), the proliferation of these different crowdfunding platforms is in response to the need to
solve four key organizing problems: coordination, gatekeeping, inexperience, and patronage. As
the platforms continue to innovate to create robust and effective models to addressing these
problems, it is clear that new types of platforms will continue to emerge thereby raising the
question of whether it is logical to attempt to situate crowdfunding within a particular stage in the
firm’s capitalization lifecycle. Given these issues, in this section, in order to develop a more
complete demand-side perspective of the crowdfunding decision by entrepreneurs, we now take
the step to link these problems to the selection process of entrepreneurs of choosing to utilize
crowdfunding as a financing vehicle.
Coordination Costs & Distributed Organizing. One of the central organizing problems
entrepreneurs face during the early stages of development involves coordinating actions among a
broad set of potential stakeholders and audiences (Schwienbacher & Larralde, 2010). While
mature and established firms can rely upon established routines and organizational structures to
reduce coordination costs, entrepreneurs must create these same routines, structures and business
models during the earliest stages of development of a new venture (Dosi & Fagiolo, 1997). Part of
these efforts includes hiring new employees and other internal development tasks (Ardichvili,
Cardozo & Ray, 2003; Gnyawali & Fogel, 1994). For internal development tasks, firms often rely
upon traditional sources of financing to provide the capital needed to hire key employees.
Traditional funding can also be used to invest in research and development activities to fund the
creation of prototypes and early versions of products and services to test with customers (Scott &
Bruce 1987; Storey, 2016).
Part of these efforts also includes coordinating the engagement of the external audiences
and potential customers with the venture’s products and services (Jones & Rowley, 2011).
Crowdfunding provides several unique avenues through which early-stage ventures can reduce
coordination costs with external stakeholders and audiences. On reward-based platforms, offering
an early version of the firm’s product is often a critical way which ventures can test the expected
preferences of customers (Gerber, Hui & Kuo, 2012). This often involves soliciting feedback from
the “crowd” about the product or service features, pricing, or other related factors to reduce overall
demand uncertainty (Strausz 2017). Reward-based and other crowdfunding campaigns are
sometimes effective ways to incentivize and enlist the support of external audiences in promoting
the product or service to other customers (Gerber et al. 2012). Backers and supporters often
become willing participants in encouraging their friends and family to support these campaigns
both due to their interest in the campaign and sometimes to ensure that the campaign is successful
so they can receive their purchases rewards (Mitra 2012; Schwienbacher & Larralde, 2010).
Overall, entrepreneurs can utilize the digital exchange technologies underlying many
crowdfunding campaigns to reduce many of the coordination costs of aligning both internal and
external stakeholders and supports around the firm’s products, services, or business models.
Gatekeeping, Investor Inexperience, & Disintermediation. Consistent with our discussion of
the persistence of funding gaps in early-stage capital markets, one of the central functional roles
of early-stage investors is to identify and fund promising new ventures (Drover et al., 2017). In
this regard, formal investors such as VCs generate “selection” pressures to that remove less
promising ventures from the pool of available companies (Gompers & Lerner 2004) by investing
in companies with the highest potential for growth and development (Puri & Zarutskie, 2012).
Research on VC intermediation activities reports VCs enhance the enterprise value and
productivity of portfolio companies at each stage of investment (Fitza et al., 2009; Croce et al.,
2013). Others report that VC-backed ventures grow faster over a 5-year window versus firms
without the backing of professional investors (Puri & Zarutskie, 2012).
Critics, however, note that the gatekeeping role of investors sometimes produces unintended
consequences where ventures managed by ethnic minorities or women often have a difficult time
raising financing (Brush et al. 2004). The gatekeeping role of investors also tends to cluster finance
investments into a few industries where firms operating outside of these boundaries might find it
difficult to raise financing while firms in the industry might find that there is too much money
chasing too few deals. In contrast, recent research on crowdfunding suggests that the
disintermediation of traditional financing arrangements through this digital form of exchange
enables entrepreneurs to raise funding from a more diverse set of investors and backers from more
geographically diverse locations (Agrawal, et al, 2014). Furthermore, crowdfunding offers
entrepreneurs the ability to fund the development of a more diverse set of projects than are typically
funded through traditional early-stage financing mechanisms such as venture capital or angel
investments (Mollick, 2014). Emerging evidence also suggests that crowdfunding enables
traditionally underrepresented groups such as fe male-led ventures to gain access to early-stage
funding (Mollick & Robb, 2016). Crowdfunding platforms can also internalize the tools necessary
to conduct effective due diligence and investment decisions through both standardizing investment
processes as well as through the active development of assessment tools that can help
inexperienced funders both identify and evaluate potential funding targets (Valanciene &
Jegeleviciute, 2013). Furthermore, since many platforms are not subject to the prevailing legal
restrictions on both investor solicitation and participation, crowdfunding platforms can expand the
range of potential funding agents to a broader set of entrepreneurs and innovators (Mollick &
Robb, 2016). Overall, by disintermediating the gatekeeping role of professional investors,
crowdfunding platforms can provide their own legitimation of emerging projects thereby
expanding the pool of innovative projects and entrepreneurs who can access external funding.
Patronage, & Digital Exchange. Lastly, one of the primary areas of research in the early-
stage finance literature explores the nature of the exchange relationship between entrepreneurs and
their investors (Bygrave, 1988; Chua & Woodward, 1993; Norton, 1996). These dyadic
relationships (Lockett, Ucbasaran, & Butler, 2006) are shaped by the task uncertainty and agency
risks, as well as the frequency and types of interaction determined by mutual goal alignment,
relative development maturity of the venture, and the overall amount of technological uncertainty
(Sapienza & Gupta, 1994). These relationships are enhanced through more open communication
channels (Sapienza, 1992), timely feedback (Sapienza & Korsgaard, 1996), and other types of
engagement (Busenitz, Fiet, & Moesel, 2004).
The relative fairness with which entrepreneurs are treated throughout the capitalization
lifecycle is a crucial determinant as to how the relationships evolve. Although moral hazards exist
on both sides of the transaction since although entrepreneurs may shirk in their duties, VCs also
tend to pay less than they “should” (Elitzur & Gavious, 2003). “Extortionary terms” (Bowden,
1994) combined with onerous contractual covenants elevates the risk that the procedural justice of
the dyadic exchange will be violated (Busenitz, Moesel, Fiet, & Barney, 1997). This state of affairs
stresses the dyadic relationship and reduces the willingness of entrepreneurs to heed the strategic
guidance of investors (Barney, Busenitz, Fiet, & Moesel, 1996). Trust violations also damped the
extent to which investors evaluate portfolio companies favorably (Bammens & Collewaert, 2014)
thereby decreasing the likelihood of follow-on investments (Collewaert, 2012).
The rise of crowdfunding platforms alters the pattern of relationships among backers and
entrepreneurs (Mollick, 2014). Pools of backers and supporters are more diffuse and less
interconnected than many investor syndicates (Belleflamme et al. 2014). Since these supporters
individually only provide small amounts of financial capital, there is a key question as to whether
the supporters or backers would have the proper incentive to monitor agency risks? Perhaps in
these settings, crowdfunding backers and supporters might diversify their risks by supporting
multiple campaigns, but it also seems likely based on previous research that backers engage with
these platforms for a variety of reasons including enhancing their own reputations and benefitting
from the general knowledge shared by others (Wasko and Faraj 2005).
Digital exchange through crowdfunding also generates social ties (Molm 1990) and
reciprocal obligations through which both the backers and ventures might receive direct benefits
from the network at a later time (see Shibayama et al. 2012). By this we mean that in addition to
creating their own campaigns, project creators also support other unrelated projects. In doing so,
these individuals contribute to the common good through the sponsorship of other projects. When
creators and entrepreneurs contribute to the collective good through supporting other projects, in
many cases, they also increase the likelihood the community will support their efforts thereby
increasing their likelihood of success. Lastly, many project backers donate money directly to
campaigns without receiving a defined benefit. This type of altruistic giving reflects raise
important questions about the nature of social and economic exchange relationships among project
creators and backers. Collectively, this type of social engagement raises important questions about
the post-campaign engagement between founders and backers. Most of the research on
crowdfunding thus far has focused on key decisions, primarily by founders, on matters such as
whether or not to launch a campaign, or which factors will determine the success of campaign.
Conversely, few studies have taken up the most critical issue for backers: what are the long-term,
post-campaign outcomes? Since these long-term outcomes are likely to be shaped by the ties
created during the initial funding campaign, there are important questions to be explored in future
research that are highly relevant to building credible demand-side, full lifecycle conception of both
the practice and study of crowdfunding.
Overall, it is clear from our overview of emerging streams of research in the crowdfunding
arena that the use of crowdfunding as a mechanism for resource mobilization is strongly shaped
both by evolving resource needs and the continued evolution of crowdfunding platforms to meet
these needs. As new crowdfunding platforms continue to emerge, and as they increasingly function
as digital equivalents of traditional sources of financing, the manner in which entrepreneurs select
and operationalize fundraising campaigns on these platforms will continue to evolve. Regardless
of the novelty of the financing source and arrangement, entrepreneurs will continue to need to
solve four key organizing problems: coordination, gatekeeping, inexperience, and patronage
(Younkin & Kashkooli, 2016) and the unique circumstances under which these campaigns unfold
will go a long way towards shaping the future success of crowdfunding as an digital exchange
The central purpose of this chapter is to develop a balanced approach to the hype of
“democratization” purportedly surrounding the emergence of crowdfunding platforms. While the
momentum and reach of crowdfunding is undeniable, our aim is to provide an equilibriating
overview of the many challenges and opportunities such novel funding mechanisms create for
entrepreneurs. In our view, these opportunities and challenges will continue to shape how these
various funding mechanisms continue to emerge and will continue to shape the willingness of both
backers and entrepreneurs to utilize such funding opportunities to commence successful
transactions. By seeking to provide a balanced account of the many challenges and opportunities
created by the digitization of finance through crowdfunding, it is our central goal to identify a core
research agenda for shaping future research in this important arena.
Based on our review of existing crowdfunding research and on situating crowdfunding
relative to other forms of early-stage financing, it is clear that while crowdfunding potentially fills
an important gap with the lifecycle of new ventures, it is less clear whether crowdfunding will
serve as an effective substitute for other forms of early-stage financing. Instead, given the unique
problems crowdfunding both solves and creates for early-stage ventures, it seems apparent that
crowdfunding functions as a complementary source of financing to other traditional sources of
early-stage capital. In the remaining sections of this chapter, we outline a set of future research
questions to help guide demand-side research on crowdfunding in early-stage capitalization
Challenge #1: Coordination Costs of Managing Complex Platform Relations
While crowdfunding platforms provide tools and capabilities entrepreneurs can leverage
to coordinate an array of stakeholders and audiences during the early stages of development, the
proliferation of feedback from audiences, the intensity engagement of stakeholders, and the
increasing transparency of entrepreneurial actions to the general public can also increase the
inherent complexity of the organizing process. As with any organizational system, increasing
complexity generates an exponential increase in coordination costs associated with linking and
aligning the interests and efforts of a diverse set of actors. In this section, we will highlight several
of these tensions to identify several important areas of future research.
As we noted earlier, one of the important benefits crowdfunding platforms offer to
entrepreneurs is the opportunity engage with external audiences to receive feedback and insight
into the firm’s products and business model. Yet, ventures are often unprepared for the flood of
feedback these audiences provide and it is important to understand both how entrepreneurs build
these audiences as well as how they maintain positive social engagement (Hui, Greenberg, &
Gerber, 2014). The downside of so much social engagement occurs when entrepreneurs receive
conflicting or even erroneous advice from audience members. Although undoubtedly well-
intended, such prosocial engagement often invokes reciprocity norms and expectations among
audience members resulting in expectation of a quid pro quo response from the venture. Another
consequence of building up public audiences is that on some platforms, these audience members
can also influence each other. Since the responses of the firm are transparent to members of the
general audience, a second order effects of perceived violations of such reciprocity norms and
expectations can sometimes lead to embarrassing public spats with the venture’s backers
accompanied by an escalating sense of collective outrage. Numerous well-publicized community
backlashes have impacted the crowdfunding industry in many recent years as audience and
campaign goals and expectations have failed to align effectively (i.e., see Cowley, 2014).
Understanding both the mechanisms of prosocial audience engagement as well as the most
effective tools for managing and influencing audience expectation in order to manage coordination
costs efficiently is a crucial question for future research.
Research into the problems associated with managing stakeholder and audience
engagement on crowdfunding platforms is also likely to benefit by exploring how network
governance mechanisms enable both firms and platforms to manage stakeholder and audience
relations. Network governance systems are characterized by the use of informal social systems to
manage complex inter-firm relations (Jones, Hesterly, & Borgatti, 1997). In these settings, since
hierarchical and structural control strategies are ineffective, firms and platforms can use access
controls to enforce prosocial behaviors (Belleflamme et al. 2014). By excluding or ostracizing
actors who attempt to take advantage of the system, these arrangements enable the platforms to
utilize social control mechanisms to enforce mutually beneficial behaviors. More research is
needed to explore how these mechanisms might function across digital exchange networks, but
given the various benefits associated with promoting digital exchange, it is imperative that future
research explore how these downside risks can be managed so as not to undermine the benefits.
Challenge #2: The Perils of Distributed Governance
While diffuse network ties between backers and supporters with entrepreneurial ventures
on crowdfunding platforms enable ventures to raise small amounts of financing from a wider
number individuals might indeed democratize access to these companies, such democratization
comes at a cost. A key question as to whether the supporters or backers would have the proper
incentive to monitor agency risks? Much of the finance literature emphasizes the problems
introduced into firm governance arrangement when ownership and control are separated (Bygrave,
1988; Chua & Woodward, 1993; Norton, 1996). Investors fear problems associated with moral
hazard, adverse selection, and overall shirking due to the lack of alignment goals and the
difficulties created by asymmetric information (Elitzur & Gavious 2003). In formal investment
environments, investors address these agency concerns by utilizing option-based compensation
(Arcot, 2014), deal covenants (Bengtsson, 2011), independent boards (Wijbenga, Postma, &
Stratling, 2007), CEO dismissals (Fiet, Busenitz, Moesel, & Barney, 1997), and direct and active
monitoring of the entrepreneur (Yoshikawa, Phan, & Linton, 2004). Crowdfunding platforms are
just beginning to explore the ways in which these types of governance mechanisms are
incorporated within the platform. But increasing public scrutiny and concerns about fraud will
continue to challenge these platforms to ensure that transparency and effective governance
practices and it is incumbent that future research explore how these and other mechanisms might
be contextualized for use in crowdfunding platforms to contend with the risks of the diffusion of
corporate control.
At the same time, the costs of deploying such governance mechanisms to resolve agency
costs must be balanced with the overall amount of financing risk each backer or supporter of a
crowdfunding project is taking. For example, if a backer is providing $25 to help support an
emerging venture or to buy a few shares of a new venture through an equity crowdfunding
platform, will the transactional costs of utilizing complex governance mechanisms or direct active
monitoring of management exceed the amount of risk the investor is taking? One of the key
questions of future research is to explore how the introduction of various disclosure requirements
and governance technologies and tools might help to mitigate these problems. Perhaps these
platforms might draw inspiration from Canadian experiments with a functional, early-stage capital
market for young ventures to explore how investment risks are managed in these settings
(Carpentier, L’her, & Suret, 2010)? Given transnational nature of many crowdfunding platforms
(Mollick, 2014), understanding how these platforms facilitate better governance mechanisms is an
important avenue for future research (see Cumming, Schmidt, & Walz, 2010).
Challenge #3: The Unintended Risks of Disintermediation
Classically conceived, the funding rationale of external investments in new ventures is
based on risk-adjusted returns (Cochrane 2005). By seeking rates of return that reflect the
perceived risks attendant to a nascent-stage venture, angels, venture capitalists, and even friends,
families, and “fools” seek to be compensated for the unproven aspects of a new business. Angel
networks and venture firms act as intermediaries, applying experience and industry-based
expertise to the challenge of identifying and mitigating the information asymmetries that
characterize novel technologies, organizational forms and business models (Zott & Amit 2010).
Limited partners investing in venture funds pay significant management fees to the managing
partners precisely for their expertise in overcoming the inherent knowledge gaps that confront
investors seeking diversification into new and small firms (Gompers & Lerner 2001). In a sense,
the management fees are an information cost paid by the limited partners as insurance against
unforeseen risks that professional intermediators can partially or wholly mitigate. Analogous
forms of these information costs can be found in the due diligence performed by banks
contemplating the issuance of a loan, or the road shows orchestrated by investment bankers
underwriting an initial public offering. In each of these cases, intermediaries incur the information
costs of others with an eye towards offering an investment opportunity with a rate of return that is
properly adjusted for the investment-specific risks.
In marked contrast, the world of crowdfunding pays relatively scant attention to risk. Since
crowdfunding platforms are distributed and disintermediated, digital-exchange networks, the role
of professionals who would otherwise be paid handsomely for mitigating venture-specific
information asymmetries is largely irrelevant. There are three primary reasons for this. First, many
of the individuals offering financial support for a given venture are not “investors” in the normal
sense of the term. Better word would be “funders” or “backers,” insofar as financial resources are
made available, but the expectations of each individual may or may not resemble the sophistication
of a financial investor. In fact, across the wide assortment of crowdfunding models, numerous
forms of financial and non-financial compensation can be observed, including: intrinsic
satisfaction from donations, customer rewards, pre-purchase rights, lending-related interest
payments, and owner’s equity (Mitra 2012). Even returns involving crowdfunding equity defy
simple categorization because there is no clear equivalent for the classically conceived risk-
adjusted rates of return of seen in traditional funding vehicles. Thus, while the mass aggregation
that occurs in crowdfunding takes on the appearance of an investment vehicle, the individual
funders may or may not perceive the financial transaction as being an investment. For this reason,
it would be erroneous to juxtaposition crowdfunding alongside traditional forms of venture
investing as though they constitute a menu of funding alternatives. Venture capital investments in
a given firm are an aggregation of the underlying risk-adjusted expectations of the investors;
however, no such claim can be made about the aggregation of crowdfunders’ expectations, which
are comprised of a vast array of highly personal, idiosyncratic justifications.
The cause of this divergence, and the second reason crowdfunding treats risk so differently
from traditional investors, is due to the distributed nature of crowdfunding. By spreading the
funding burden across hundreds or even thousands of individuals, the aggregate risk becomes
parsed beyond recognition. That is, the amount that each backer incurs is sufficiently small that
the opportunity cost is no longer compared to investment alternatives, but rather to lifestyle
alternatives. Lifestyle alternatives, such buying a discretionary product or service, eating out, or
enjoying some form of entertainment, are financed through ongoing expenses, not investment
capital, which fundamentally changes the perception of value and risk. Since the risk attendant to
crowdfunding is parsed to the point that it bears an opportunity cost resembling daily expenditures,
the risks associated with information asymmetries are subordinate to the intrinsic benefits as a
backer of the venture. Under such conditions, there is no role for a professional intermediary
because no one is willing to individually pay the information costs. The risks have been parsed to
a trivial level even though the costs of mitigating the information asymmetries remain as high as
they would be for investors seeking risk-adjusted returns. For this reason, crowdfunders are willing
forego the value of institutional intermediaries when the transactional risk becomes an
afterthought. This development is not without consequences. In time, the disintermediation of paid
experts means that more bad ideas will be brought to market. Backers will provide resources for
goods and services that may or may not have an addressable market, supporting ideas touted as
being “novel” when they are only imitations of existing ventures. The difference from traditional
investing, however, is that backers ultimately do not care because the funding is not precipitated
by a desire or need for risk-adjusted returns.
Theories of investment returns that are built upon pre-crowdfunding conceptions of risk
fail to capture this dynamic because crowdfunding is not so much an alternative to traditional
funding as it is a manifestation of technology-driven sociological change that embraces a digital
democratization that is already occurring. This is the third reason that crowdfunding views risk so
differently from traditional forms of venture investing and why it is so problematic to compare
crowdfunding as a sortable decision-choice logic, one among several potential funding vehicles
for new ventures. The reason research attempting to conceptualize crowdfunding through the lens
of traditional venture financing faces such difficulties is that crowdfunding is not simply a diffuse
version of traditional debt or equity modes; instead, it brings to the table an entirely new premise
and digital model for funding. Since the cultural heritage of crowdfunding is not the grounded in
investment theory and rates of return, but rather the modern-day confluence of society and
technology in the form of crowd-sourcing (Schwienbacher & Larralde, 2010), the dominant ethos
of crowdsourcing remains one of shared commitment and distributed labor. In its earliest form,
venture aspirants posed work-related challenges that were solved through crowd-sourced efforts.
For this reason, crowdfunding is not the cause of democratized platforms, they are the financial
manifestation of that which was had already come to pass socially and technologically. Therefore,
using management tools and financial theories pre-dating crowd-sourcing is unlikely to capture
the full dynamic of crowd-funding. Instead, the effort requires new theoretical approaches and
perspectives that acknowledge the unique challenges created by the digitization of finance through
"Early-stage financing has both technical and colloquial meanings in entrepreneurial finance research.
Early-stage venture capital financing, for example, technically refers to funding rounds invested into
ventures who have functioning products and/or business models but have not yet become profitable. In
contrast, the colloquial use of the term “early-stage financing” refers to resource mobilization processes in
young, startup ventures who have not yet started to grow exponentially and are beset by numerous
uncertainties. In this chapter, our use of “early-stage capital” is based on the colloquial use of the term.
In this chapter, we treat traditional venture capital and corporate venture capital as a single asset class to
simplify our discussion since these funding mechanisms are categorically similar relative to the other
forms of early-stage finance.
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Table 6.1: Crowdfunding & External Early-Stage Financing Vehicles
Bank Financing
Reward, equity, loan
Equity, Loan
Equity, Loan
Equity, Loan
Small increments of
capital raised via the
internet from
Small increments of
capital raised via
strong and weak
network ties from
individuals within an
entrepreneur’s local
increments of capital
raised via formal
bank lending.
increments of capital
raised via wealthy
informal investors
or quasi-syndicated
investor groups.
increments of capital
raised via
professional or
corporate venture
capital funds.
Direct exchange of
rewards, equity, or
charitable (micro-)
loans, through crowd-
based cash
Generally, cash
infusion with informal
Generally, direct
financing with
formal contracts
based on
securitization of
personal or corporate
Generally, direct
informal financing
with equity or
convertible debt
Generally, direct
formal financing
with equity or
convertible debt
$0- Unbounded
~ $<10,000
Unbounded; based
on collateral value
$250k to $1 M
$2 M - $5 M
Mostly informal, if
they exist at all
Formal, contractual
Ranging from semi-
formal, incomplete
contract to formal
Mostly formal, but
contracts. Formal
Financial Returns
Mostly financial;
some socio-
Financial Returns
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