Douglas Cumming, Lars Hornuf (Eds.) - The Economics of Crowdfunding - Startups, Portals and Investor Behavior-Palgrave Macmillan (2018)

The Economics of Crowdfunding
Startups, Portals, and Investor Behavior
Edited by
Douglas Cumming
and Lars Hornuf
The Economics of Crowdfunding
For academics, practitioners, and government policymakers, this book provides

a sophisticated, comprehensive analysis of this new and important means of
capital aggregation across for-profit and nonprofit sectors worldwide.
Michael Klausner,
Nancy and Charles Munger Professor of Business and Professor of Law, Stanford
University
This is an excellent book, a must-read, for anyone interested in the broad phe-
nomenon of crowdfunding.
Mingfeng Lin,
Associate Professor of Management Information Systems, University of Arizona
It is important that we recognize and respond to the opportunities and chal-

lenges arising from innovative methods of financing, such as crowdfunding.
This book provides a review of the experience to date, covering important issues
such as signaling, fraud, and regulatory models. The insights here are relevant to
academics, entrepreneurs, investors, and policymakers.
Maureen Jensen,
Chair and CEO of the Ontario Securities Commission
Douglas Cumming • Lars Hornuf
Editors
The Economics of
Crowdfunding
Startups, Portals and Investor
Behavior
Editors
Douglas Cumming Lars Hornuf
Schulich School of Business Faculty of Business Studies and Economics
York University, Toronto, Canada University of Bremen
Bremen, Germany
Max Planck Institute for Innovation and

Competition
Munich, Germany
Center of Finance, University of Regensburg

Regensburg, Germany
CESifo
Munich, Germany
ISBN 978-3-319-66118-6 ISBN 978-3-319-66119-3 (eBook)

https://doi.org/10.1007/978-3-319-66119-3
Library of Congress Control Number: 2017956103
© The Editor(s) (if applicable) and The Author(s) 2018

This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether
the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of
illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and trans-
mission or information storage and retrieval, electronic adaptation, computer software, or by similar or
dissimilar methodology now known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication
does not imply, even in the absence of a specific statement, that such names are exempt from the relevant
protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and information in this book
are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or
the editors give a warranty, express or implied, with respect to the material contained herein or for any
errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional
claims in published maps and institutional affiliations.
Cover illustration: venimo / Alamy Stock Photo
Printed on acid-free paper
This Palgrave Macmillan imprint is published by Springer Nature

The registered company is Springer International Publishing AG
The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland
To Dylan and Sasha Cumming, and Maria Christina Müller.
Foreword
The “crowd” has attracted considerable attention from many academic

fields. For good reason, crowd-based processes have gained more and
more practical relevance, for instance in problem-solving or in finance. In
this book volume on the economics of crowdfunding, Douglas Cumming
and Lars Hornuf have gathered an impressive group of contributors
exploring various facets of the phenomenon.
The definition of crowdfunding is comprehensive: Cumming and
Hornuf include reward-based and donation-based crowdfunding, equity
crowdfunding (crowdinvesting), and marketplace (peer-to-peer) lending
within the scope of the investigations presented here. Given the early
stage of the evolution of these processes, going for breadth is a compel-
ling choice.
The chapters in this volume cover a wide set of topics. In Chap. 1, the
editors provide an insightful overview of the literature regarding dona-
tion- and reward-based crowdfunding, crowdinvesting, and crowdlend-
ing models. The first part of the book then turns to the role of
crowdfunding for small companies and start-ups. Leboeuf and
Schwienbacher discuss in Chap. 2 the role of crowdfunding as a novel
financing tool for small enterprises and explore which types of firms are
most likely to benefit from widely available crowdfunding. Vismara
(Chap. 3) addresses informational inefficiencies in crowdfunding mar-
kets and identifies various forms of signals as possible solutions to these
vii
viii Foreword
problems. Lambert, Ralcheva, and Roosenboom (Chap. 4) take a close

look at the relationship between the entrepreneur who seeks to obtain
financing and the crowd, and at the informational asymmetries that may
ultimately limit the efficacy of crowdfunding. Hainz (Chap. 5) then turns
to cases of fraudulent behavior in the context of crowdfunding. Coming
to grips with such cases and possible underlying incentives for fraud will
be an important factor in strengthening crowdfunding as a new financing
tool.
Market structure aspects are studied by Fenwick, McCahery, and
Vermeulen in Chap. 6, while Mollick studies the impact of reward-based
crowdfunding on entrepreneurship in Chap. 7, employing surveys of
Kickstarter funders. The backers of projects are also at the focus of Chap.
8 where Bayus and Kuppuswamy analyze dynamics over the project
funding cycle.
The final three chapters cover regulatory aspects of crowdfunding.
Bradford (Chap. 9) presents an analysis of regulation in the USA, while
Klöhn (Chap. 10) explores the European regulatory environment. Amour
and Enriques (Chap. 11) compare regulation in the USA and the
UK. Given that countries are by now almost competing to set attractive
boundary conditions for financing via the crowd, these country-level and
comparative assessments should be highly relevant to policy makers and
researchers alike.
For any academic or practitioner who wants to have a quick and thor-
ough start into the fascinating and complex economics of crowdfunding,
this volume is an excellent point of departure. The collection of articles
tackles the phenomenon of crowdfunding comprehensively. Final answers
as to how important crowdfunding will be as a novel financing instru-
ment in the future will still have to be explored. Presently, the contribu-
tions assembled here cover major research questions, summarize the
existing literature, and offer first insights regarding regulatory responses.
The editors and the authors have undertaken an important step toward a
better understanding of a fascinating and multifaceted phenomenon.
Max Planck Institute for Innovation and Dietmar Harhoff

Competition, Munich, Germany July 2017
Preface
This book studies crowdfunding as a new financing tool in the entrepre-

neurial finance ecosystem. The analyses in the book serve multiple pur-
poses. From an academic perspective, the book attempts to give a topical
overview over the recent scholarly literature on crowdfunding. While five
years ago, very few academics started to shift their attention toward this
new topic, by the end of the decade almost no finance and certainly no
entrepreneurial finance conference goes without research findings in
crowdfunding. Even entire conferences have been dedicated to crowd-
funding. On February 8, 2013, the Crowdinvesting Symposium took place
for the first time at LMU Munich and on October 17, 2013, the Berkeley
Crowdfunding Symposium discussed the latest research on crowdfunding.
Journals like Entrepreneurship Theory and Practice as well as Small Business
Economics have dedicated special issues to crowdfunding. From a practi-
tioners’ perspective, this book summarizes what works in crowdfunding
and what does not. Portal owners and entrepreneurs looking for funding
might use the insights provided here to structure their campaigns effec-
tively. Investors learn from empirical studies about their own behavior
and potentially avoid making costly mistakes. Finally, from a policy-
maker perspective, the book provides evidence whether crowdfunding
should be fostered or prohibited as a new financing tool. To address these
questions in a rigorous and state-of-the-art manner, we have gathered
some of the most well-known scholars in the field.
ix
x Preface
The book tackles four broad topics. The first three are economic in
nature and investigate what we have learned so far about start-ups, por-
tals, as well as backers and investors in the crowdfunding realm. These
topics are covered by 19 outstanding management, finance, and econom-
ics scholars. Thereafter, based on the economic evidence, four outstand-
ing legal scholars have investigated how crowdfunding is currently
regulated and potentially ought to be regulated in the future. Their focus
is on the USA, the European Union, as well as individual member states
such as the UK and Germany.
Moreover, to make the book more readable and consistent, we decided
on the following simple terminologies. Crowdfunding encompasses four
major business models. The donation-based crowdfunding model involves,
for example, the funding of philanthropic and research projects. Under
this model, backers donate money to support a project without expecting
compensation. This differs under the reward-based crowdfunding model
in which backers are promised tangible or intangible perks, such as a sup-
porter T-shirt or having their name posted on the campaign website. At
times, the reward-based model of crowdfunding may resemble a pre-
purchase, such as when backers fund a product or service they wish to
consume and which is still to be developed by the entrepreneur. Under
these models, the crowd is referred to as backers, because they do not
invest but donate their funds or pre-purchase a product or service.
Popular examples are video games (e.g., Star Citizen) or the Pebble smart-
watch. Portals include, for example, Crowdfunder.co.uk, Indiegogo,
Kickstarter, and Startnext.
Crowdinvesting—which is also referred to as investment-based crowd-
funding, securities crowdfunding, or equity crowdfunding—is a subcat-
egory of crowdfunding and refers to an alternative form of external
finance for firms in countries that permit the solicitation of the general
public. The solicitation often takes place without or with a “light” version
of a securities prospectus (e.g., JOBS Act Title III in the USA or the
Small Investor Protection Act in Germany). The crowd participates in the
uncertain future cash flows of a firm via equity, mezzanine, or debt
finance. The crowd is referred to as investors, as they make a financial
decision and do not consume a product. Portals include, for example,
Companisto, Crowdcube, Republic, Seedrs, Seedmatch, and WiSeed.
Preface
xi
Crowdlending is another subcategory of crowdfunding where loans are

extended to an individual or firm at a fixed interest rate. The crowd is
referred to as lenders. Unlike in the crowdinvesting domain, repayment
by the borrowers starts immediately. Portals include, for example,
LendingClub, FundingCircle, and Auxmoney.
Toronto, Canada Douglas Cumming

Bremen, Germany Lars Hornuf
Acknowledgments
This book evolved as part of the research project “Crowdinvesting in

Germany, England and the USA: Regulatory Perspectives and Welfare
Implications of a New Financing Scheme,” which was supported by the
German Research Foundation (Deutsche Forschungsgemeinschaft) under
the grant number HO 5296/1-1. Lars Hornuf would also like to thank
Gerrit Engelmann for his excellent support in formatting the book con-
sistently. Douglas Cumming gratefully acknowledges the Social Sciences
and Humanities Research Council of Canada for financial support.
xiii
Contents
1 Introduction 1
Douglas Cumming and Lars Hornuf
Part I Startups 9
2 Crowdfunding as a New Financing Tool 11

Gaël Leboeuf and Armin Schwienbacher
3 Signaling to Overcome Inefficiencies in Crowdfunding

Markets 29
Silvio Vismara
4 The Crowd–Entrepreneur Relationship in Start-Up

Financing 57
Thomas Lambert, Aleksandrina Ralcheva, and
Peter Roosenboom
5 Fraudulent Behavior by Entrepreneurs and Borrowers 79

Christa Hainz
xv
xvi Contents
Part II Market Structure 101
6 Fintech and the Financing of SMEs and Entrepreneurs:

From Crowdfunding to Marketplace Lending 103
Mark Fenwick, Joseph A. McCahery, and Erik P.M.
Vermeulen
Part III Backers and Investors 131
7 Crowdfunding as a Font of Entrepreneurship: Outcomes

of Reward-Based Crowdfunding 133
Ethan Mollick
8 Crowdfunding Creative Ideas: The Dynamics of Project

Backers 151
Venkat Kuppuswamy and Barry L. Bayus
Part IV Recent Regulatory Efforts 183
9 The Regulation of Crowdfunding in the United States 185

C. Steven Bradford
10 The Regulation of Crowdfunding in Europe 219

Lars Klöhn
11 Individual Investors’ Access to Crowdinvesting:

Two Regulatory Models 255
John Armour and Luca Enriques
Index 279
List of Figures
Fig. 1.1 Global crowdfunding market by segment volume, USD

billions in 2015 2
Fig. 5.1 Moral hazard model for the crowdlending market:
payoff structure 83
Fig. 5.2 Marketplace lending 30+day delinquency 90
Fig. 6.1 Global venture capital investments in fintech start-ups 107
Fig. 6.2 Crowdfunding platforms in Europe in 2015 111
Fig. 6.3 Overview of countries in our study 121
Fig. 6.4 Year-on-year percent growth of first-time venture capital
backed fintech companies (country) 122
Fig. 6.5 Percentage growth of first-time venture capital backed fintech
companies (regulatory approach) 123
Fig. 7.1 What kind of organization created the project? 141
Fig. 7.2 Dollars in non-crowdfunding revenue per dollar in
crowdfunding pledges for completed projects 144
Fig. 7.3 Measures of innovation: percent of projects in category
reporting winning major awards or applying for patents 145
Fig. 8.1 Distribution of project-funding outcomes 158
Fig. 8.2 Average number of backers added to a project on any day 160
xvii
List of Tables
Table 2.1 Differences in motivation between professional and

nonprofessional investors 17
Table 3.1 Taxonomy of signals in crowdfunding 35
Table 3.2 Empirical evidence from crowdfunding studies 37
Table 4.1 List and description of selected crowdinvesting portals 70
Table 5.1 Default rates and expected repayments on Prosper 88
Table 7.1 Respondents’ selection of reward status options 136
Table 7.2 Percent agreeing that “my Kickstarter campaign helped me…” 141
Table 7.3 Creator job status on projects 142
Table 7.4 Organization types used by Kickstarter project creators 143
Table 7.5 Average yearly revenues (outside of Kickstarter campaign
money)143
Table 7.6 Average yearly revenues (outside of Kickstarter campaign
money) for projects that earned any income 143
Table 7.7 Responses to questions about artistic freedom (from 1,
“strongly disagree,” to 5, “strongly agree”) 146
Table 7.8 Social impact of projects 147
Table 7.9 Factors predicting campaign’s failure to deliver (Middle
failure case) 147
Table 8.1 Summary statistics for Kickstarter projects 2010–2011
(N = 14,704)157
xix
xx List of Tables
Table 8.2 Panel estimation results for the dynamics of backer support
(cluster-robust standard errors; t-statistics in parentheses) 161
Table 11.1 US and UK crowdinvesting regulations—summary 270
1
Introduction
Douglas Cumming and Lars Hornuf
Crowdfunding has experienced tremendous growth and developed into a

global multibillion-dollar business over the course of the last five years.
The most successful segment of the nascent market is crowdlending,
which is also referred to as peer-to-peer lending or marketplace lending,
and had an estimated global market volume of USD 25 billion in 2015
(Massolution 2016). Although more recent figures on the overall market
volume are not yet available, market growth has most likely continued
during the years 2016 and 2017. The portal Lending Club alone reported
to have funded loans worth USD 31 billion by the end of 2017. The
other market segments are considerably smaller and are comparable in
D. Cumming
Schulich School of Business, York University, Toronto, ON, Canada
L. Hornuf (*)
Business Studies & Economics, University of Bremen, Bremen, Germany
Max Planck Institute for Innovation and Competition, Munich, Germany
Center of Finance, University of Regensburg, Regensburg, Germany
CESifo, Munich, Germany
© The Author(s) 2018 1

D. Cumming, L. Hornuf (eds.), The Economics of Crowdfunding,
https://doi.org/10.1007/978-3-319-66119-3_1
2 D. Cumming and L. Hornuf
30
25.10
25
20
15
10
5 2.85 2.68 2.50

0.81 0.40 0.24
0
Fig. 1.1 Global crowdfunding market by segment volume, USD billions in 2015
size. According to Massolution (2016), donation-based crowdfunding

reached a global volume of USD 2.85 billion, reward-based crowdfund-
ing USD 2.68 billion, and crowdinvesting USD 2.50 billion in 2015.
New segments such as royalty-based crowdfunding, hybrid forms of
crowdfunding, and token presales or Initial Coin Offerings exhibit rela-
tively small market volumes (Fig. 1.1).
Depending on the jurisdiction under which platforms are operating,
their business models often cut out traditional financial intermediaries.
On the upside, this might reduce transaction costs and make financial
services more cost-efficient. Furthermore, crowdlending portals may be
well equipped to develop credit risk models that are geared to high-risk
loans. They may thus provide a better assessment of high-risk customers
than traditional financial intermediaries that used to refuse certain indi-
viduals and businesses access to mainstream financial services. Put differ-
ently, crowdfunding portals have identified the inability of traditional
banks to extend loans as a business opportunity and consequently seek to
fill the existing funding gaps. At the same time, many crowdfunding mar-
kets lack financial intermediaries that screen and monitor borrowers.
Portals have regularly no skin in the game and consequently have little
Introduction 3
incentives to consider the performance of their investors. Under the new

US crowdinvesting rules, the funding portals and their directors are even
prohibited to have any financial interest in the issuer. From a macroeco-
nomic and systemic risk perspective, this might be a desirable setting, as
no crowdfunding platform can become too big to fail.
Moreover, all crowdfunding platforms cater per definition to two-
sided markets. This means that platforms need not only attract borrow-
ers, start-ups, or charity beneficiaries but also individuals who are willing
to donate or put their money into a risky investment. Thus, if platforms
intend to operate in the market over a considerable period of time, they
should, in line with Rochet and Tirole (2003), have good incentives to
serve the interest of all market participants including the investors.
Whether the owners and managers of a crowdfunding platform intend to
operate a long-term business or rather engage in fly-by-night operations
is ultimately an empirical question. However, some caution is warranted.
Over the course of one and a half years, the Chinese crowdlending plat-
form Ezubao, for example, had attracted a total of USD 7.6 billion from
around 900,000 investors. In January 2016, it became obvious that the
portal operated a Ponzi scheme and senior executives had spent consider-
able amounts of investors’ money on private expenses, making very little
real investments.
Platforms are not the only market players that engage in fraud. Several
project creators in reward-based crowdfunding have been identified as
being scams (Cumming et al. 2016). For example, the Kobe beef jerky
campaign was just about being completed, when Kickstarter stopped the
USD 120,309 going to the fraudsters’ bank account. Whether the crowd
is well positioned to identify scams is not clear. Mollick and Nanda
(2015) find, for a sample of theater projects, that the financing decisions
of the crowd and professional funders are quite consistent and that there
is no difference in the quality of projects that receive funding by the
crowd and those funded by professionals. On the other hand, crowd-
funding platforms lack some of the features that Surowiecki (2004) iden-
tified as being important for the ‘wisdom of the crowd’ to emerge.
Although the crowd might be a diversified enough group to distinguish
valuable projects and scams, the decision-making process of backers and
investors on the various Internet platforms is hardly independent and
might also be driven be irrational herding. Some early contributions from

the crowdlending realm indicate that investors can, however, also engage
in strategic and rational herding (Herzenstein et al. 2011a).
If operations did not already fall under existing securities or banking
laws, policy makers have so far taken a wait-and-see approach or imple-
mented a light form of regulation that is to be adapted once regulators
have learned more about the functioning of crowdfunding markets. The
reason for the reluctant approach of many regulators is that they also
understand the potential of serving underbanked individuals and small
businesses that are at the core of economic growth. Large groups of the
population might for the first time receive funding that was not available
to them but should have been from an economic efficiency standpoint.
Furthermore, crowdfunding also has a democratizing element in the
sense that investors get access to a new asset class that was not available to
them before.
In recent years, the academic literature has also shown a growing
interest in crowdfunding. Some segments have received attention ear-
lier than others, which was mostly due to data availability and the
relevance of the respective crowdfunding segments. As noted in the
Preface of this book, crowdfunding consists of four different business
models. The funding of philanthropic and research projects is known
as the donation-based crowdfunding model, where backers donate
money to a project without subsequently receiving a monetary com-
pensation. Still, backers may derive utility from the act of donation,
for which Andreoni (1989) coined the term warm-glow effect. In an
early study, Saxton and Wang (2014) analyzed data from Facebook
Causes. They evidence that in the Internet traditional economic expla-
nations are less important for charity-giving decisions than social net-
work effect explanations are. Moreover, they revealed that health-related
causes were most appealing to donors. Crowdfunding platforms that
return donations in the event of not meeting capital goals tend to lead
to larger contributions in total according to simulations (Wash and
Solomon 2014) and empirical evidence (Cumming et al. 2015).
Further, donors often invest very early or very late in crowdfunding
and projects are more likely to be completely funded if donors invest
early (Solomon et al. 2015).
Introduction 5
Under the reward-based crowdfunding model, backers are promised a

product or a perk. In a seminal article, Mollick (2014) examined the
delivery rate in reward-based crowdfunding campaigns. Using data from
Kickstarter, he found that most project creators intend delivering the
product they promised, but many deliver it with a considerable delay.
Crowdinvesting, which is also referred to as investment-based crowdfund-
ing, securities crowdfunding, or equity crowdfunding, is an Internet-
based form of external finance for firms. Solicitation of investors often
takes place without or with a ‘light’ version of a securities prospectus.
Investors participate in the uncertain future cash flows of a firm via
equity, mezzanine, or debt finance. In one of the first articles on the
topic, Ahlers et al. (2015) examine the effectiveness of signals that start-
ups use to induce investors. They find that retaining equity and providing
more detailed information about risks are interpreted as effective signals
by the crowd. In another seminar article, Agrawal et al. (2015) find that
local funders are less responsive to information about the cumulative
funds raised during a crowdinvesting campaign. They further evidence
that this effect is largely driven by investors during the early phase of the
campaign who have an offline social relationship with the creator.
Crowdlending is another form of crowdfunding where loans are
extended to an individual or firm at a fixed interest rate. Under this
model, the crowd may adequately be referred to as lenders. Unlike in the
other crowdfunding models, repayment often starts immediately. In one
of the first articles, Lin et al. (2013) find that female borrowers secure
financing more often than men. Moreover, Herzenstein et al. (2011b)
show that a detailed loan description positively affects the probability of
financing. Recently, Iyer et al. (2015) have highlighted that soft factors
together with the rating category of the loan enable lenders to infer
approximately one-third of the variation in the creditworthiness indi-
cated in the borrower’s credit score. While a complete overview of the
literature on crowdlending goes beyond the scope of this introduction, a
worthwhile summary of the most important articles for the different
crowdfunding segments is provided by Dorfleitner et al. (2017, 85ff.).
While this book gives an overview of the current state of crowdfunding
research and partly develops it further, we also want to provide a glimpse
on what we believe are future research topics. First, while rigorous research
has developed in all segments of crowdfunding, little research exists that

takes a comparative stance. For example, one might ask whether firms
fare better when they are funding new projects through reward-based
crowdfunding, crowdinvesting, or crowdlending. On the other side of
the coin, it is not yet clear whether it is more efficient for backers to invest
in a firm, to extend a loan, or to receive a product that can later poten-
tially be resold or consumed. Second, while scholarly literature has looked
at funding success, not much is known about the ultimate success of a
venture. Future research might thus ask whether crowdfunding creates
sustainable firms and what the relevant success factors are to that respect.
Third, little is known about the motives of backers and investors. While
pure or impure altruism most likely plays a role in donation-based crowd-
funding, the warm-glow effect might to some extent even exist in crowd-
investing and crowdlending. Given that some investors might
systematically lose money from these investments and still decide to sup-
port this type of ventures for non-monetary reasons, it raises interesting
policy questions that ought to be answered in the future. The authors in
this book already answer some of them.
References
Agrawal, Ajay, Christian Catalini, and Avi Goldfarb. 2015. Crowdfunding,
Geography, Social Networks, and the Timing of Decision. Journal of
Economics and Management Strategy 24: 253–274.
Ahlers, Gerrit K., Douglas Cumming, Christina Günther, and Denis Schweizer.
2015. Signaling in Equity Crowdfunding. Entrepreneurship Theory and
Practice 39: 955–980.
Andreoni, James. 1989. Giving with Impure Altruism: Applications to Charity
and Ricardian Equivalence. Journal of Political Economy 97: 1447–1458.
Cumming, Douglas J., Lars Hornuf, Moein Karami, and Denis Schweizer. 2016.
Disentangling Crowdfunding from Fraudfunding. Social Science Research
Network. https://ssrn.com/abstract=2828919. Accessed 20 Feb 2017.
Cumming, Douglas J., Gaël Lefoeuf, and Armin Schweinbacher. 2015.
Crowdfunding Models: Keep-It-All vs. All-or-Nothing. Social Science Research
Network. https://papers.ssrn.com/abstract=2447567. Accessed 20 Feb 2017.
Dorfleitner, Gregor, Lars Hornuf, Matthias Schmitt, and Martina Weber. 2017.
FinTech in Germany. Heidelberg: Springer.
Introduction 7
Herzenstein, Michal, Utpal M. Dholakia, and Rick L. Andrews. 2011a. Strategic

Herding Behavior in Peer-to-Peer Loan Auctions. Journal of Interactive
Marketing 25: 27–36.
Herzenstein, Michal, Scott Sonenshein, and Utpal M. Dholakia. 2011b. Tell Me
a Good Story and I May Lend You Money: The Role of Narratives in Peer-to-
Peer Lending Decisions. Journal of Marketing Research 48: 138–149.
Iyer, Rajkamal, Asim Ijaz Khwaja, Erzo F.P. Luttmer, and Kelly Shue. 2015.
Screening Peers Softly: Inferring the Quality of Small Borrowers. Management
Science 62: 1554–1577.
Lin, Mingfeng, Nagpurnanand R. Prabhala, and Siva Viswanathan. 2013.
Judging Borrowers by the Company They Keep: Friendship Networks and
Information Asymmetry in Online Peer-to-Peer Lending. Management
Science 59: 17–35.
Massolution. 2016. 2015CF. The Crowdfund Industry Report. http://reports.
crowdsourcing.org/index.php?route=product/product&product_id=54.
Accessed 7 Mar 2017.
Mollick, Ethan R. 2014. The Dynamics of Crowdfunding: Determinants of
Success and Failure. Journal of Business Venturing 29: 1–16. https://doi.
org/10.2139/ssrn.2088298.
Mollick, Ethan R., and Ramana Nanda. 2015. Wisdom or Madness? Comparing
Crowds with Expert Evaluation in Funding the Arts. Management Science 62:
1533–1553.
Rochet, Jean-Charles, and Jean Tirole. 2003. Platform Competition in Two-
Sided Markets. Journal of the European Economic Association 1: 990–1029.
Saxton, Gregory D., and Lili Wang. 2014. The Social Network Effect: The
Determinants of Giving Through Social Media. Nonprofit and Voluntary
Sector Quarterly 43 (5): 850–868.
Solomon, Jacob, Wenjuan Ma, and Rick Wash. 2015. Don’t Wait!: How Timing
Affects Coordination of Crowdfunding Donations. Paper presented at
Proceedings of the 18th ACM Conference on Computer Supported
Cooperative Work (547–556), New York, USA.
Surowiecki, James. 2004. The Wisdom of Crowds: Why the Many Are Smarter than
the Few and How Collective Wisdom Shapes Business, Economics, Societies, and
Nations. New York: Anchor Books.
Wash, Rick, and Solomon, Jacob. 2014. Coordinating Donors on Crowdfunding
Websites. Paper presented at Proceedings of the 17th ACM Conference on
Computer Supported Cooperative Work and Social Computing (38–48),
New York, USA.
Douglas Cumming is Professor of Finance and Entrepreneurship and the

Ontario Research Chair at the Schulich School of Business, York University. He
has published over 150 articles in leading refereed academic journals in finance,
management, and law and economics. He is the incoming editor-in-chief of the
Journal of Corporate Finance (January 2018), and a co-editor of Annals of
Corporate Governance, Finance Research Letters, and Entrepreneurship Theory and
Practice. He is the author and editor of over a dozen books. Cumming’s work has
been reviewed in numerous media outlets, including The Economist, the Wall
Street Journal, The New York Times, and The New Yorker.
Lars Hornuf is Professor of Finance at the University of Bremen. He was a

visiting scholar at University of California, Berkeley; Stanford University; Duke
University; and Georgetown University. From 2014 to 2017, Hornuf held a
grant from the German Research Foundation on ‘Crowdinvesting in Germany,
England and the USA: Regulatory Perspectives and Welfare Implications of a
New Financing Scheme’. In 2016, he wrote two expert reports for the Federal
Ministry of Finance on the German FinTech market and the Small Investor
Protection Act. Hornuf ’s work has been covered in newspapers like The Economist
and Foreign Policy.
Part I
Startups
2
Crowdfunding as a New Financing Tool
Gaël Leboeuf and Armin Schwienbacher
2.1 Introduction
The lack of access to finance is well recognized as being one of the main
difficulties for many start-ups, especially risky and innovative ones
(Carpenter and Petersen 2002). While much of this difficulty stems from
the severe information asymmetries and agency costs that many start-ups
face, others may be due to the lack of fit with the investors’ investment
objectives. When external finance is required, selecting the right form of
finance is crucial for successfully developing an entrepreneurial activity,
and this choice involves different trade-offs, owing to different pros and
cons for each type of financing source (Cosh et al. 2009). For example, in
general, start-ups with an intermediate level of growth prospects are not
eligible for venture capital finance, as managers seek investments in risky
G. Leboeuf
Univ Lyon, Université Lumière Lyon2, Coactis EA4161, Lyon, France
A. Schwienbacher (*)
Department of Finance and Accounting, SKEMA Business School,
Euralille, France

https://doi.org/10.1007/978-3-319-66119-3_2
12 G. Leboeuf and A. Schwienbacher
but high-growth companies. These start-ups may then receive funding

from business angels or friends and family. Similarly, while most tradi-
tional start-ups rely on bank loans (Robb and Robinson 2014), candi-
dates for bank loans need to provide collateral and sufficient cash flows to
sustain interest payments, two elements that research and development
(R&D)-intensive start-ups typically do not have.
The digital revolution, combined with social media and structured
crowdfunding platforms that act as intermediaries between fund seekers
(entrepreneurs) and small fund providers (the crowd), offers new oppor-
tunities to raise capital to develop a company or launch a project, and
sometimes even to finance risky R&D expenditures in existing entrepre-
neurial companies (Belleflamme et al. 2014; Mollick 2014). Internet-
based crowdfunding now allows even small entrepreneurs to raise funds
from a large crowd, as communication costs have virtually disappeared
with the Internet. In countries with a lack of sufficient seed and start-up
capital such as angel finance and friends and family, crowdfunding has
the potential to help fill the funding gap because it allows nonqualified
individuals to also invest in innovative start-ups (Hornuf and
Schwienbacher 2017). In the case of reward-based crowdfunding, the
amount of funds collected during the campaign may further offer valu-
able feedback on the market prospects of the product being produced by
the entrepreneur (Chemla and Tinn 2016; Schwienbacher 2014).
While research on crowdfunding still offers a largely incomplete pic-
ture of the phenomenon, existing studies indicate that crowdfunders par-
ticipate for very different reasons and that these reasons also vary across
the different types of crowdfunding. Moreover, entrepreneurs launching
a crowdfunding campaign may self-select to do so, as crowdfunding may
not be the best choice for all entrepreneurs. Therefore, in this chapter we
argue that while crowdfunding may fill a funding gap, specific types of
entrepreneurs are more likely to benefit, as they are better able to match
crowdfunders’ preferences for participating in a crowdfunding campaign
and reap the benefits of crowd participation.
In this chapter, we first discuss how crowdfunding fits into the tradi-
tional financing cycle of small businesses and start-ups. We then raise the
question as to whether crowdfunding solves a specific funding gap, a nec-
essary condition to justify crowdfunding as a viable source of entrepre-
neurial finance in the long run. Finally, we elaborate on the type of
Crowdfunding as a New Financing Tool 13
entrepreneurial activities and entrepreneurs who are more likely to benefit

from crowdfunding. Many of these issues are covered in more detail in
subsequent chapters.
2.2 The New Financing Cycle

Start-ups get financed under what is commonly described as the so-called
financial growth-cycle paradigm, proposed by Berger and Udell (1998).
This paradigm largely considers a linear relationship between sources of
funding and stages of development, in which the type of funding is a
function of the start-up’s stage of development. In this framework, each
funding source is characterized by its relative capacity to deal with infor-
mation asymmetries and moral hazard and, most crucially, by its funding
capacity in terms of size. Start-ups at their initial stage may rely on friends
and family, bootstrap finance, and business angels, all of which may pro-
vide limited amounts of capital. For larger amounts, venture capital funds
may be tapped, as they often make staged investments of several millions
of dollars or euros. Much larger and more developed companies may go
public through an initial public offering as a means to raise money on a
regulated, public stock market. These firms, however, are already at a
more mature stage, with lower technological and market risks, and thus
are prone to less information asymmetry problems. Bank finance may be
available for any amount (Schwienbacher 2013) but is not suitable for
start-ups exhibiting high levels of information asymmetry or moral haz-
ard problems or start-ups with a lack of collateral and insufficient reve-
nues to support interest payments.
A first-order question is where crowdfunding is situated in this frame-
work. We suggest that the answer depends largely on the type of crowd-
funding considered. Reward-based crowdfunding more closely resembles
supplier finance, while crowdlending resembles bank finance, an equity-
based crowdfunding angel (Hornuf and Schwienbacher 2016), and, to a
lesser extent, venture capital finance (and perhaps even an initial public
offering on smaller stock market segments, such as the Marché Libre in
Paris or the Alternative Investment Market in London, though only for
some outliers for the time being). Indeed, recently, some start-ups have
raised several millions of euros on equity-crowdfunding platforms in
Germany, making it a potentially credible alternative to venture capital

(Hornuf and Schwienbacher 2017). Donation-based crowdfunding may
at times resemble bootstrap finance, insofar as bootstrap finance some-
times involves relying on “free” resources. Considering these distinctions,
crowdfunding typically fits with early stage and expansion-stage finance
in terms of stage of development.
Still, crowdfunding needs to fill a funding gap to be a viable source of
funding (for a general discussion on funding gaps in the context of entre-
preneurial finance, see Cressy 2002). If it only substitutes for another
source such that it merely crowds out the existing source without offering
some specific benefits (either lower transaction costs or reduced contrac-
tual inefficiency), its economic value is limited. Research, however, sug-
gests that this is not the case. While crowdfunding may generate its own
transaction costs and risks (Griffin 2013; Hazen 2012; Hildebrand et al.
2016; Mollick 2013), it may provide efficient funding for some types of
entrepreneurial initiatives. One possible source of gains is the extra infor-
mation obtained in reward-based crowdfunding campaigns on possible
demand for the product (Chemla and Tinn 2016; Schwienbacher 2014).
In this type of crowdfunding, the entrepreneur typically produces the
product as a reward so that it resembles “prepurchasing.” Then, the crowd-
funding campaign gives a better view of market demand, similar to a
market analysis—except that, here, individuals do not simply claim to be
willing to buy the product but already prepurchase it, making it a more
credible source of information than a simple market analysis. Moreover,
under an all-or-nothing funding model, risk may be reduced for the
entrepreneur, because the threshold level for undertaking the project pro-
vides a call option to the entrepreneur, who will then not undertake the
project if demand does not cover costs (Cumming et al. 2016). This
model reduces operational risk of the project because no financial resources
have been engaged yet; they are only engaged if enough demand is secured
during the reward-based crowdfunding campaign. Relatedly, Hakenes
and Schlegel (2014) show that in equity-based crowdfunding, investors
are willing to reveal private information about their interest to invest if the
campaign is run under the all-or-nothing funding model, as then they are
guaranteed that their commitment will be canceled in case of lack of suf-
ficient interest by other potential investors. The generation of valuable
information through the aggregation of individual preferences is often

referred to as a manifestation of “wisdom of crowds,” which leads to infor-
mation that cannot become available with traditional sources of finance.
Crowdfunding may further help entrepreneurs access venture capital
funds. Recent studies show that successful crowdfunding campaigns tend
to attract follow-up funding more easily in the form of venture capital. In
the subsample of projects that raised more than USD 100,000 on
Kickstarter or Indiegogo, Shafi and Colombo (2016) find that these
entrepreneurs were significantly more likely to raise venture capital. This
means that crowdfunding is a valuable first step in attracting the atten-
tion of larger investors, if necessary.
A final reason for the possible viability of crowdfunding as a distinct
source of entrepreneurial funding involves the lack of seed capital avail-
able in the economy, as often argued in Europe, due to the lack of angel
finance. In this case, crowdfunding may help reduce the gap between
available seed capital and availability of valuable investment opportuni-
ties. Hornuf and Schwienbacher (2017) argue that this point makes
equity-based crowdfunding even more important in Europe than in the
United States. Considering these different arguments, it seems plausible
that crowdfunding is helping fill a funding gap.
2.3 The Crowd as Financier

In this section, we take a closer look at the crowd as fund provider. The
crowd represents a pool of potential funders, each with a different profile
and expectations but sharing the same willingness to finance a project or
an entrepreneur. While some members may be part of a specific commu-
nity of fans sharing common interests and preferences (especially for art
and music projects), most often these individuals do not know one
another. In what follows, we discuss some profiles of crowdfunders for
the different crowdfunding types (donation-/reward-based crowdfund-
ing, crowdinvesting, and crowdlending) and their motivation to
participate in crowdfunding campaigns. Then, we discuss mechanisms
offered by crowdfunding to investors to evaluate their decision to back a
project or a proposed investment opportunity, including risk sharing,
herding behavior, and informational cascade.
2.3.1 Profiles and Motivations of Crowdfunders
The main objective of an entrepreneur who relies on crowdfunding is to

raise capital from a large number of small investors. While donation- and
reward-based crowdfunding can only rely on nonprofessional partici-
pants (fans, donors, or consumers), crowdinvesting and crowdlending
offer promises of possible capital gains and dividends (for equity) or
interest payments (for loans), thus enabling professional investors to par-
ticipate as well.
An important distinction between professional and nonprofessional
participants is that the main goal of nonprofessional participants is not
purely based on profits (Bretschneider et al. 2014; Cumming and Johan
2013). For example, the backers of a Kickstarter campaign may contrib-
ute to prepurchase an object (a consumption decision), to help a known
entrepreneur (support of an entrepreneurial initiative), to support a cause
they believe in (charity), or to obtain recognition by being part of a group.
Conversely, professional investors need to generate profits from their
investing activities, especially if they manage capital for clients, even if
they may follow other goals such as promoting socially responsible invest-
ments and economic development. These latter goals will generally be of
second order, however.
It is important to distinguish between donation- or reward-based
crowdfunding and crowdinvesting and crowdlending. In donation-
based crowdfunding, backers do not receive any reward from their con-
tribution. In reward-based crowdfunding, backers may be eligible to
receive a reward, depending on the promises made by the entrepreneur
and the amount pledged during the campaign. Entrepreneurs offer
greater rewards for higher contributions. In contrast, in crowdlending
and crowdinvesting, entrepreneurs offer crowdfunders the possibility to
earn financial returns and, thus, to become an investor. The possibility
to earn financial returns is more likely to attract more traditional inves-
tors, including professional investors; for example, AngelList offers a
program for professional investors, while Lending Club recently started
with a pension fund. Table 2.1 illustrates the main motivations crowd-
funders pursue based on their profile (professional or nonprofessional
investors) and on the type of crowdfunding (donation-/reward-based
Table 2.1 Differences in motivation between professional and nonprofessional

investors
Donation- and
reward-based
crowdfunding Crowdlending and crowdinvesting
Professional – Financial returns (with or without
investors secondary objectives, such as
supporting entrepreneurial
activities, networking, and
portfolio diversification)
Nonprofessional Reward, warm glow, Financial returns, supporting
investors altruism, entrepreneurial activities, fun to
recognition, invest/participate, recognition,
reciprocity, reciprocity, identification
identification
Note: Adapted from Bretschneider et al. (2014), Cumming and Johan (2013)
crowdfunding or crowdinvesting/crowdlending). While professional

investors tend to limit contributions to profit-generating crowdfunding
types (crowdlending and crowdinvesting), we find nonprofessional par-
ticipants in both categories (profit-generating and donation-/reward-
based). Although we know that warm glow, altruism, recognition,
reciprocity, and identification have an impact on the decision to partici-
pate, the main motivation of investors is compensation in the form of
either expected final returns or the promised reward (Cholakova and
Clarysse 2015).
The overall number of backers may also affect the ultimate level of
benefits accruing to individual backers. Belleflamme et al. (2015) discuss
the different ways that network effects may affect the overall utility from
participating in a crowdfunding campaign. Such network effects may
occur between groups (cross-group effects between entrepreneurs and
crowdfunders) and within a single group (within-group effects between
entrepreneurs themselves or crowdfunders themselves). In the first case, a
network effect may arise across projects of a same category, as more
crowdfunders on the platform may attract more entrepreneurs (more
crowdfunders means greater funding capacity overall), which in turn may
attract even more crowdfunders (more entrepreneurs means a greater
variety of projects). The second case considers network effects within the
group of crowdfunders. Two opposing effects may occur. On the one
hand, more crowdfunders may make it more attractive for other indi-
viduals to join the platform because projects are more likely to be funded
and, thus, successful; on the other hand, more crowdfunders can mean
more competition for a limited number of rewards or securities. This
negative impact is most likely to be severe in crowdinvesting, in which a
limited number of securities are sold. Whether network effects have a
positive or negative impact on group participation depends on the type
of platform and its structure.
Next, it is possible to distinguish profiles of investors/backers accord-
ing to their behavior in and active contribution to the project. Lin et al.
(2014) classify crowdfunders into four groups: active backers, trend fol-
lowers, altruistic backers, and the crowd. Active backers are those who
invest early during the campaign in many projects and are less sensitive to
the number of backers who have already invested in a project. Trend fol-
lowers invest later in projects and are more sensitive to the number of
backers who have already committed; they wait to see how funding
dynamics evolve. Altruistic backers invest for reasons other than invest-
ment success; thus, they are the typical backers in donation-based crowd-
funding. Finally, the broader crowd encompasses backers with no typical
behavior of the three former groups.
It is also worth noting the presence of another class of backers: peers.
Indeed, many entrepreneurs in crowdfunding campaigns are also backers
in other projects (Zvilichovsky et al. 2015). When supporting projects of
others before starting their own campaign, entrepreneurs increase their
chances to succeed. Through reciprocity, entrepreneurs are likely to
receive pledges for their own project from other entrepreneurs they
helped before starting.
2.3.2 R
isk/Return Balance and Assessment
of Investment Opportunities
Although the backers may be motivated by various reasons and the

amount involved may be rather low in crowdfunding, the crowd remains
responsive to the relationship between risk and success (or return) of the
project. Cumming et al. (2016) show that the crowd responds to both
the level of the funding goal and the funding model used. By funding
model, the authors are referring to the two important models “all-or-
nothing” and “keep-it-all.” They investigate the context of Indiegogo, an
international crowdfunding website on which entrepreneurs can choose
between the two models. If a project requires a higher goal, the crowd
could view the project as having larger fixed costs and thus having a lower
chance to gather the amount required. In the same way, if an entrepre-
neur chooses the keep-it-all funding model, the project can be under-
funded (as the entrepreneur receives the money even if the funding goal
is not achieved), and the risk borne by backers is higher from the increased
risk of never receiving the reward or any return on their investment.
Moreover, the crowd has other mechanisms to assess the quality (and
the likelihood of success) of a crowdfunded project. As with any tradi-
tional investment, crowdfunders have access to the basic information
provided directly by the entrepreneur on the crowdfunding platform
(e.g., business plan, legal information). Depending on the platform, the
information may be closely audited and formatted or, in contrast, exhibit
great heterogeneity among projects. Still, Mollick (2013) finds that the
crowd evaluates the quality of a project by using the same signals as ven-
ture capitalists. In addition, despite the persistence of traditional biases in
investment decisions such as the home bias (Hornuf and Schmitt 2016;
Lin and Viswanathan 2015), crowdfunding allows a significant reduction
in gender and geographic bias (Agrawal et al. 2011; Mollick and Robb
2016). Compared with traditional venture capital financing, the geo-
graphic distribution is larger in crowdfunding (less limited to some spe-
cific areas such as the Silicon Valley), and recent studies show more
women leading crowdfunding campaigns. Moreover, the crowd is able to
evaluate the project quality at least as accurately as experts, with the
advantage of providing good evaluation of the target market because,
most of the time, members of the crowd are not only investors but also
the final users (Mollick 2013).
As participation of others is often visible in real time during the crowd-
funding campaign, a backer considering participating can estimate the
willingness of others to support the same project. Alternatively, for
crowdfunding platforms trying to reduce herding behavior by hiding pre-
vious participations, comments and/or testimonials are a good indicator
of crowd support. This leads to specific dynamics during the campaign in

which the contribution of one individual is determined by the behavior
of others. In this context, two effects may affect the decision to pledge:
the number of previous backers and their reputation. First, the number
of backers provides a good signal of the support gained from the crowd.
According to Kuppuswamy and Bayus (2017), the crowd will be more
prone to participate if the number of previous backers at the time of
investment is already high. Second, some backers may decide to disclose
their identity, while others keep their pledge anonymous. If an opinion
leader or an informed backer decides to disclose his or her pledge, he or
she will act as a certifier and attract other backers, in turn increasing the
probability of campaign success (Parker 2014; Ralcheva and Roosenboom
2016). By aggregating both standard financial information and soft
information about borrower quality, Iyer et al. (2015) show that the
crowd can assess the risk of a project and predict failure at least as accu-
rately as a traditional bank scoring system.
2.4 The Entrepreneur as Fundraiser

Most of the big successes in crowdfunding are closely linked to high-tech
firms. Three-dimensional printers, virtual reality glasses, and smart
watches are the most famous crowdfunded projects. Nevertheless, crowd-
funding has existed for a long time, and nonprofit organizations were the
first to use it as a financing source. With their reliance on altruism, char-
ity, or warm glow, tapping a large crowd was the best way to collect sig-
nificant amounts of money to finance their activities. When Internet-based
crowdfunding began appearing at the end of 2000 as a result of the d igital
revolution, the first firms to use it were overwhelmingly cultural firms
(e.g., film, music, games), which were then directly followed by design
and technological projects. Today, crowdfunding has become an option
for every kind of start-up. When a project may have global impact, some
platforms offer a worldwide audience. For local projects, other platforms
are available and target a specific country (or even a specific region) or
industry (platforms specialized in music, clean technology, real estate,
and even restaurant).
The first goal for an entrepreneur using crowdfunding is to raise fund-

ing, but other motivations may also be at play (Gerber et al. 2012). For
example, by using reward-based crowdfunding, an entrepreneur can raise
funding but also test the market for the future product. A lack of support
for the project may indicate a too narrow market for the final product.
Another advantage of a crowdfunding campaign is the ability to use a
cheaper marketing campaign. By taking advantage of the platform’s pop-
ularity and traffic, a new product will have an initial audience and will
benefit from a word-of-mouth effect to reach the most likely customers.
Another motivation is the willingness to replicate the successful experi-
ence of others (Gerber et al. 2012). However, using an Internet platform
to present a project publicly may also have some drawbacks. During a
traditional funding process involving banks, angel investors, or venture
capital funds, an entrepreneur can easily try to find other investors (e.g.,
another bank or venture capital fund) in case the first attempt fails. For
example, if a bank rejects a loan request, the entrepreneur can approach
another bank. Restricted by the confidentiality of bank businesses, this
second bank will not know about the first rejection or the changes the
entrepreneur made to his or her project presentation (business plan) in
response to the received feedback from the first attempt. In the case of
venture capital and angel finance, entrepreneurs typically contact many
investors at the same time to attract attention from a few of them. In
crowdfunding, entrepreneurs almost never get a second chance to make a
first good impression. The Internet is decentralized by nature, and any
information becomes rapidly replicated on many other websites, even if
this information originates from a single source. When something
becomes public on the Internet, it is very difficult to remove all traces of
that information. This rule also applies to crowdfunding campaigns.
First, many crowdfunding platforms keep track of previous campaigns
launched and often allow access to the presentation page of all previous
projects, even failed ones. Second, even when the platform removes (or
limits access to) the information about a past failed attempt, plugging the
name of the project leader into a search engine will sometimes bring to
the surface many external sources of information that may disclose the
entrepreneur’s history. Though requiring some effort on the part of the
investor/backer, the reputation of the entrepreneur leading the project
may play an important role in a second campaign success. For these rea-
sons, entrepreneurs who experience a first success are more likely to
launch second campaigns. These findings are also in line with theories on
entrepreneurial self-confidence (Bandura 1982; Hayward et al. 2010).
After a first success, the self-confidence of the entrepreneur will increase,
and he or she will more likely reenter with a new project. However, an
entrepreneur who undergoes a first failure will lose self-confidence and be
less likely to undertake a second crowdfunding campaign. Nevertheless,
recent studies show that the campaigns launched by entrepreneurs with a
first success tend to underperform the first campaign by attracting fewer
backers and collecting less money (Leboeuf 2016; Yang and Hahn 2015).
These studies argue that when the first campaign is successful, people
assume that many of the interested backers have already participated in
the new venture. However, when an entrepreneur launches a second cam-
paign shortly after the first, new participants (i.e., other than those who
participated in the first campaign already) may represent a smaller frac-
tion of the backers. Thus, the surprise effect becomes less pronounced,
making any “hype” related to the second campaign less likely.
For the entrepreneur with a first failed crowdfunding experience, the
stigma of failure (Landier 2006) plays a central role in how the nonpro-
fessional crowd will assess the opportunity to invest in a crowdfunding
campaign. Even if the number of backers and the amount pledged are
higher than those during the first attempt, and even if the entrepreneurs
try to mimic successful campaigns in terms of characteristics (e.g., size,
funding model, campaign duration) and disclosure (e.g., length of text,
number of pictures provided), the probability of success of the second
campaign will be lower than any first campaign (Leboeuf 2016). Most of
the time, these efforts are insufficient to overcome the negative reputa-
tion gained from the first failure.
A vibrant stream of research on the entrepreneurial perspective of
crowdfunding investigates the extent to which entrepreneurs rely on their
relatives, close friends, and social networks, often labeled as “social capi-
tal” and proxied by the number of LinkedIn and Facebook connections
of the entrepreneur. These studies show that the success of a crowdfund-
ing campaign strongly relies on the entrepreneur’s capability of mobiliz-
ing his or her social capital (Agrawal et al. 2011, 2015; Colombo et al.
2015; Mollick 2013; Vismara 2016). Moreover, this stream of literature

shows that the entrepreneur’s willingness to keep the crowd updated by
posting new comments and updates during the campaign helps raise
more funds (Ahlers et al. 2015; Block et al. 2017). Thus, good prepara-
tion and continuous involvement during the campaign are crucial.
2.5 Concluding Remarks

In this chapter, we demonstrate that crowdfunding is a legitimate fund-
ing source for different types of entrepreneurs and that it fills a funding
gap, ranging from seed capital to later-stage funding, depending on the
type of crowdfunding considered. Moreover, this new form of funding is
able to attract nontraditional investors thanks to its specific properties
and mechanisms. A greater number of people may be more easily tempted
to participate because of the small amounts involved for each backer,
though this may also lead to herding behavior and self-implication due to
the disintermediated nature of crowdfunding.
However, crowdfunding still needs to demonstrate strengths to become
a sustainable funding model for entrepreneurs. First, it needs to increase
the trustworthiness for investors (Cumming and Johan 2013) by reduc-
ing information asymmetry in the mechanisms of the various types of
crowdfunding (to avoid investor concerns about where their money goes,
under which legal form, liquidity issues that may arise, and so on) and by
tackling the risks of fraud (false projects, wrong usage of the funds
received by the entrepreneur) (James 2013). Second, the platforms need
to keep in mind that they face nontraditional investors and that perhaps
they should not engage in too much due diligence when the crowd is
perfectly capable of assessing the value of a project (Mollick and Nanda
2015). That is, platforms need to prevent the risks of fraud but not the
project’s market risks.
Crowdfunding is now at a specific point in time in terms of develop-
ment. During its first decade, crowdfunding experienced tremendous
growth and developed under light regulation (leading to a high degree of
freedom of actions and active experimentation). In addition, the crowd-
funding market is still highly decentralized across many platforms and
many mechanisms. This form of decentralized development is similar to

the situation the Internet faced upon its establishment some decades ago.
Today, however, the Internet is mostly centered on big players (often
called GAFAM, or Google, Apple, Facebook, Amazon.com, and
Microsoft) that control much of the market and are suspected of reduc-
ing freedom (e.g., Google filters search results, Facebook censors some
messages posted by users, Apple is highly restrictive of application devel-
opers, and Microsoft licenses prohibit some usages of its own software).
A threat to crowdfunding as it is known today is the overregulation of the
market and the overconcentration of platforms that will begin appearing
as the market starts consolidating. An increase of regulations will mechan-
ically enhance participants’ protection; however, by tightening the restric-
tions imposed on investor profiles, overregulation may lead to a negative
effect on investors’ freedom. Concentration, for its part, will lower trans-
action costs at the price of reducing options for entrepreneurs to tap the
right crowd. Fewer platforms mean fewer choices for specialized or local
platforms. The next big challenge for crowdfunding will be to find a suit-
able equilibrium as it begins consolidating as a market.
References
Agrawal, Ajay K., Christian Catalini, and Avi Goldfarb. 2011. The Geography
of Crowdfunding. National Bureau of Economic Research. http://www.nber.
org/papers/w16820.pdf. Accessed 17 Mar 2017.
———. 2015. Crowdfunding: Geography, Social Networks, and the Timing of
Investment Decisions. Journal of Economics & Management Strategy 24:
253–274.
Ahlers, Gerrit K.C., Douglas J. Cumming, Christina Gunther, and Denis
Schweizer. 2015. Signaling in Equity Crowdfunding. Entrepreneurship Theory
and Practice 39: 955–980.
Bandura, Albert. 1982. Self-Efficacy Mechanism in Human Agency. American
Psychologist 37: 122–147.
Belleflamme, Paul, Thomas Lambert, and Armin Schwienbacher. 2014.
Crowdfunding: Tapping the Right Crowd. Journal of Business Venturing 29:
585–609.
Belleflamme, Paul, Nessrine Omrani, and Martin Peitz. 2015. The Economics
of Crowdfunding Platforms. Information Economics and Policy 33: 11–28.
Berger, Allen N., and Gregory F. Udell. 1998. The Economics of Small Business
Finance: The Roles of Private Equity and Debt Markets in the Financial
Growth Cycle. Journal of Banking and Finance 22: 613–673.
Block, Jörn, Lars Hornuf, and Alexandra Moritz. 2017. Which Updates During
an Equity Crowdfunding Campaign Increase Crowd Participation? Small
Business Economics. Forthcoming.
Bretschneider, Ulrich, Katharina Knaub, and Enrico Wieck. 2014. Motivations
for Crowdfunding: What Drives the Crowd to Invest in Start-ups? Paper
presented at European Conference on Information Systems (ECIS), Tel Aviv,
Israel, June 9–11.
Carpenter, Robert E., and Bruce C. Petersen. 2002. Is the Growth of Small
Firms Constrained by Internal Finance? Review of Economics and Statistics 84:
298–309.
Chemla, Gilles, and Katrin Tinn. 2016. Learning Through Crowdfunding.
Social Science Research Network. https://papers.ssrn.com/abstract=2804541.
Cholakova, Magdalena, and Bart Clarysse. 2015. Does the Possibility to Make
Equity Investments in Crowdfunding Projects Crowd Out Reward-Based
Investments? Entrepreneurship Theory and Practice 39: 145–172.
Colombo, Massimo G., Chiara Franzoni, and Cristina Rossi-Lamastra. 2015.
Internal Social Capital and the Attraction of Early Contributions in
Crowdfunding. Entrepreneurship Theory and Practice 39: 75–100.
Cosh, Andy, Douglas J. Cumming, and Alan Hughes. 2009. Outside
Entrepreneurial Capital. Economic Journal 119: 1494–1533.
Cressy, Robert. 2002. Funding Gaps: A Symposium. Economic Journal 112:
F1–F16.
Cumming, Douglas J., and Sofia A. Johan. 2013. Demand Driven Securities
Regulation: Evidence from Crowdfunding. Venture Capital: An International
Journal of Entrepreneurial Finance 15: 361–379.
Cumming, Douglas, Gaël Leboeuf, and Armin Schwienbacher. 2016.
Crowdfunding Models: Keep-It-All versus All-Or-Nothing. Social Science
Research Network. https://papers.ssrn.com/abstract=2447567. Accessed 28
Feb 2017.
Gerber, Elizabeth, Julie Hui, and Pei-Yi Kuo. 2012. Crowdfunding: Why People
are Motivated to Post and Fund Projects on Crowdfunding Platforms. Paper
presented at ACM Conference on Computer Supported Cooperative Work,

February 11–15.
Griffin, Zachary J. 2013. Crowdfunding: Fleecing the American Masses. Case
W. Reserve Journal of Law, Technology & the Internet 4: 375.
Hakenes, Hendrik, and Friederike Schlegel. 2014. Exploiting the Financial
Wisdom of the Crowd—Crowdfunding as a Tool to Aggregate Vague
Information. Social Science Research Network. https://papers.ssrn.com/
abstract=2475025. Accessed 28 Feb 2017.
Hayward, Mathew L.A., William R. Forster, Saras D. Sarasvathy, and Barbara
L. Fredrickson. 2010. Beyond Hubris: How Highly Confident Entrepreneurs
Rebound to Venture Again. Journal of Business Venturing 25: 569–578.
Hazen, Thomas L. 2012. Crowdfunding or Fraudfunding? Social Networks and
the Securities Laws—Why the Specially Tailored Exemption Must Be
Conditioned on Meaningful Disclosure. North Carolina Law Review 90:
1735–1807.
Hildebrand, Thomas, Manju Puri, and Jörg Rocholl. 2016. Adverse Incentives
in Crowdfunding. Management Science 63: 587–608.
Hornuf, Lars, and Matthias Schmitt. 2016. Does a Local Bias Exist in Equity
Crowdfunding? The Impact of Investor Types and Portal Design. Max Planck
Institute for Innovation & Competition Research Paper No. 16-07.
Hornuf, Lars, and Armin Schwienbacher. 2016. Crowdinvesting—Angel
Investing for the Masses? In Handbook of Research on Venture Capital: Volume
3. Business Angels, ed. Hans Landström and Colin Mason, 381–397.
Cheltenham, UK: Edward Elgar.
———. 2017. Should Securities Regulation Promote Equity Crowdfunding?
Small Business Economics 49: 579–593.
Iyer, Rajkamal, Asim I. Khwaja, Erzo F.P. Luttmer, and Kelly Shue. 2015.
Science 62: 1554–1577.
James, Thomas G. 2013. Far from the Maddening Crowd: Does the Jobs Act
Provide Meaningful Redress to Small Investors for Securities Fraud in
Connection with Crowdfunding Operations. Boston College Law Review 54:
Art.7.
Kuppuswamy, Venkat, and Barry L. Bayus. 2017. Does My Contribution to
Your Crowdfunding Project Matter? Journal of Business Venturing 32: 72–89.
Landier, Augustin. 2006. Entrepreneurship and the Stigma of Failure. Social
Science Research Network. https://papers.ssrn.com/abstract=850446. Accessed
28 Feb 2017.
Leboeuf, Gaël. 2016. Does the Crowd Forgive? Social Science Research Network.
https://papers.ssrn.com/abstract=2788483. Accessed 28 Feb 2017.
Lin, Mingfeng, and Siva Viswanathan. 2015. Home Bias in Online Investments:
An Empirical Study of an Online Crowdfunding Market. Management
Science 62: 1393–1414.
Lin, Yan, Wai F. Boh, and Kim H. Goh. 2014. How Different are Crowdfunders?
Examining Archetypes of Crowdfunders and Their Choice of Projects.
Academy of Management Proceedings: 1–13309.
Mollick, Ethan R. 2013. Swept Away by the Crowd? Crowdfunding, Venture
Capital, and the Selection of Entrepreneurs. Social Science Research Network.
https://papers.ssrn.com/abstract=2239204. Accessed 28 Feb 2017.
———. 2014. The Dynamics of Crowdfunding: An Exploratory Study. Journal
of Business Venturing 29: 1–16.
Mollick, Ethan R., and Ramana Nanda. 2015. Wisdom or Madness? Comparing
1533–1553.
Mollick, Ethan R., and Alicia Robb. 2016. Democratizing Innovation and
Capital Access: The Role of Crowdfunding. California Management Review
58: 72–87.
Parker, Simon C. 2014. Crowdfunding, Cascades and Informed Investors.
Economics Letters 125: 432–435.
Ralcheva, Aleksandrina, and Peter Roosenboom. 2016. On the Road to Success
in Equity Crowdfunding. Social Science Research Network. https://papers.
ssrn.com/abstract=2727742. Accessed 28 Feb 2017.
Robb, Alicia M., and David T. Robinson. 2014. The Capital Structure Decisions
of New Firms. Review of Financial Studies 27: 153–179.
Schwienbacher, Armin. 2013. Financing the Business. In The Routledge
Companion to Entrepreneurship, ed. Ted Baker and Friederieke Welter,
193–206. Abingdon, Oxon: Routledge.
———. 2014. Entrepreneurial Risk-Taking in Crowdfunding Campaigns.
Accessed 28 Feb 2017.
Shafi, Kourosh, and Massimo G. Colombo. 2016. Does Reward-Based
Crowdfunding Help Firms Obtain Venture Capital and Angel Finance?
Vismara, Silvio. 2016. Equity Retention and Social Network Theory in Equity
Crowdfunding. Small Business Economics 46: 579–590.
Yang, Lusi, and Jungpil Hahn. 2015. Learning from Prior Experience: An
Empirical Study of Serial Entrepreneurs in IT-enabled Crowdfunding. Paper
presented at International Conference on Information Systems (ICIS), Fort
Worth, TX. Conference paper available at http://aisel.aisnet.org/icis2015/
proceedings/HumanBehaviorIS/21/
Zvilichovsky, David, Yael Inbar, and Ohad Barzilay. 2015. Playing Both Sides of
the Market: Success and Reciprocity on Crowdfunding Platforms. Social
Science Research Network. https://papers.ssrn.com/abstract=2304101.
Gaël Leboeuf is Assistant Professor of Finance at the Université Lumière Lyon

2. He holds a Ph.D. in Corporate Finance from SKEMA Business School and
Lille University. After eight years in the retail banking industry, he graduated
from Lille University in 2013 with a master’s degree in International Financial
Analysis and is working on reward-based crowdfunding research questions. He
is also a long-time defender of the open-source movement.
Armin Schwienbacher is Professor of Finance at SKEMA Business School

since 2010. He previously worked at the Université Lille 2 (France), Louvain
School of Management (Université catholique de Louvain, Belgium), and
Universiteit van Amsterdam (the Netherlands), and as a guest lecturer at
Duisenberg School of Finance (the Netherlands), Rotterdam School of
Management (the Netherlands), and the European School of Management and
Technology (Germany). He was a visiting scholar at the Haas School of Business
(UC Berkeley, USA) in 2001–2002 and a visiting professor at Schulich School
of Business (York University, Canada) in 2014–2015. Schwienbacher regularly
teaches courses in corporate finance and entrepreneurial finance. He is the
Director of the Ph.D. Program in Finance and Accounting at SKEMA Business
School.
3
Signaling to Overcome Inefficiencies
in Crowdfunding Markets
Silvio Vismara
3.1 Introduction
George Akerlof, Michael Spence, and Joseph Stiglitz received the 2001
Nobel Prize in Economics for their work in information economics
(Akerlof 1970). Previously, most economic studies simply ignored infor-
mation asymmetries and assumed that markets would behave substan-
tively the same as markets with perfect information (Stiglitz 2000, 2002).
The signaling theory (Spence 1973, 2002) is perhaps the most widely
used approach to study markets with incomplete and asymmetrically dis-
tributed information in finance, entrepreneurship, and management
(Bergh et al. 2014; Connelly et al. 2011). Essentially, proponents send
signals, or observable actions that provide information about unobserv-
able attributes and likely outcomes, to reduce the gap between stakehold-
ers’ knowledge of them and their enterprise.
S. Vismara (*)
Department of Economics and Technology Management, University of
Bergamo, Bergamo, Italy

https://doi.org/10.1007/978-3-319-66119-3_3
30 S. Vismara
This theory is particularly adaptive to the study of crowdfunding mar-

kets. The signal’s effectiveness also depends on the characteristics of the
receiver, and specifically its costs of accessing and processing information.
Crowdfunding decreases the costs of access to information, but targets
receivers (i.e., the “crowd”) with presumably high information-processing
costs. Crowdfunding platforms allow fundraising from a pool of online
backers, and must cope with collective action problems, as crowd-funders
have neither the ability nor the incentive to devote substantial resources
to due diligence. This might be so because they have invested meager
amounts, making due diligence economically inefficient. Moreover, it
might be individually efficient for crowd-funders to conduct due dili-
gence if they invest higher amounts and consequently expect higher
returns. However, they still cannot coordinate who pays for the due dili-
gence due to collective action problems, or they simply have incentives
for a free ride. This may generate a reluctance to invest in crowdfunding
projects, with potential investors willing to do so only if compensated by
a discount, which could eventually produce an Akerlof-type market fail-
ure, resulting in vanishing markets because the only equilibrium price
would be zero. It is particularly important for the future of these markets
to demonstrate signals’ validity, as once receivers have received a signal
and have used it to successfully make an informed choice, they are more
likely to attend to similar signals in the future.
In this chapter, I first briefly position a study of signals in crowdfund-
ing within the broader literature on signaling in entrepreneurial finance.
Second, I deliver a theoretical discussion and define signals in crowd-
funding, including examples of penalty and handicap signals, and dif-
ferentiate them from passive characteristics and cheap talk. I propose a
taxonomy of signals that matches the senders—namely, such organiza-
tions as firms and nongovernmental organizations (NGOs), and indi-
viduals, both proponents and fellow crowd-funders—and receivers, such
as backers, lenders, and investors. Existing studies are classified in this
taxonomy based on the definitions of reward- and donation-based crowd-
funding, crowd-investing, and crowd-lending (Chap. 1). Third, I provide
a review of the few studies on signal certification and post-signal perfor-
mance, and suggest that such studies are central in identifying effective
signals. I conclude by identifying future research directions.
Signaling to Overcome Inefficiencies in Crowdfunding Markets 31
3.2 Signaling in Entrepreneurial Finance

In a Modigliani–Miller world without informational asymmetries, tax
bankruptcies, or agency costs, capital structure is irrelevant to a firm’s
total value. However, capital structure matters in the real world, and
companies in need of new financing face an important question regard-
ing how to overcome information asymmetries with potential backers.
Self-financing is a source of entrepreneurial capital that is less subject to
problems caused by information asymmetries, as entrepreneurs contrib-
ute their own money. However, the ability to rapidly grow will be con-
strained with these limited resources if external sources of capital are not
used. When a firm determines a need for external funds, it must then
gain access to capital markets.
The existence of asymmetric information in capital markets means
that external investors might not adequately assess their investment proj-
ects. This effect is most important in the case of a small and innovative
business, due to a lack of reliable information about its actual status and
performance. It is indeed difficult to provide convincing signals regarding
an innovation project’s quality, although this is a key growth determinant
in any new technology-based firm. Many discussions have revolved
around the unsuitability of debt for early stage financing (Stiglitz and
Weiss 1981). Debt holders bear a downside risk, but do not share the
upside of successful innovation. Further, debt-financing prospects are
limited for start-ups, as most of their resources are intangible and tend to
have limited salvage value because of their highly specific nature (Hubbard
1998).
For these reasons, most entrepreneurial finance literature focuses on
external equity (Carpenter and Petersen 2002). This represents a bias, as
evidence indeed exists that even early stage entrepreneurial firms rely
extensively on bank debt (Cassia and Vismara 2009; Robb and Robinson
2014; Hanssens et al. 2016). Broadly, start-ups raise funds from multiple
sources (Hanssens et al. 2015), and central to the present study, new
forms of debt capital are quickly developing for entrepreneurial firms;
one such form is the mini-bond. It is currently unclear whether the trad-
ing of mini-bonds will primarily occur in traditional, regulated markets
32 S. Vismara
(e.g., ExtraMOT in Italy) or new crowdfunding platforms (e.g.,

Crowdcube in the United Kingdom). Cumming and Vismara (2016)
note that it is unclear as to what will happen when or if interest rates
increase, making traditional bank lending less appealing than at present.
Another form of debt capital for entrepreneurial firms includes crowd-
lending, a debt-based transaction between individuals and existing busi-
nesses (mostly small firms), with many individual lenders contributing to
one loan. The study of these financing mechanisms offers a promising
way to contribute to entrepreneurial finance literature.
Information asymmetry, and its related adverse selection problems in
an entrepreneurial setting, is particularly pronounced due to the diffi-
culty that entrepreneurs face in conveying their new ventures’ quality to
firm outsiders, resulting in potentially severe agency issues and moral
hazard problems. Young technology firms’ dilemma involves potential
investors’ problems in evaluating the focal firm’s prospects, as the cost of
exchange increases when a firm cannot be reliably evaluated (Williamson
1985). Many public policies have limited such problems by adopting an
explicit goal to develop risk capital markets for small firms. For instance,
several stock exchanges have established market segments dedicated to
small firms with lower listing barriers (Vismara et al. 2012). Crowdfunding
markets are, to some extent, another extreme of loosely regulated public
markets.
3.3 Signals in Crowdfunding

Problems in information asymmetries are more severe in crowdfunding
than in other entrepreneurial finance markets. Projects on the capital
demand side are typically proposed by first-time entrepreneurs, which
might actually be favorable, as this might confirm that this new activity
acts to close funding gaps. Individuals with previously no access to finan-
cial resources can now gain access for the first time. To this extent, crowd-
funding may help democratize entrepreneurial finance. On the capital
supply side, crowd-funders are less equipped to overcome information
asymmetry, as they lack the experience and capability to evaluate differ-
ent opportunities, as well as the incentives to do so, due to fixed costs that
limit the opportunities to perform ex ante due diligence and ex post moni-
toring. Signals play a crucial role in such a context.
Signals are an economic actor’s activities—not passive characteris-
tics—that positively relate to an unobserved attribute that an exchange
partner values, and whose cost inversely relates to the quality of the sender
(i.e., some signalers are in better positions than others to absorb associ-
ated costs).1 Differential costs provide the basis for a selection process
whereby receivers can use the signal to select a sender from among a
larger set of signalers. Effective signals are those that create a separating
equilibrium, in which low-quality firms find it more costly or risky to
signal than high-quality firms. A costly signal, but one that is not differ-
entially so for imitative signalers, does not create a separating equilib-
rium. When signaling costs are the same for different quality groups, this
generates a pooling equilibrium, by which receivers are left unsure as to
which signals to believe; one cannot prevent low-quality providers from
imitating the signals of high-quality providers under such conditions. To
be effective, dishonest signals should not pay off.
The same rationale applies to risk, which is the danger of being caught
for false signaling. To be effective, the risk must be stronger for lower-
quality senders. Penalty costs are a form of negative feedback that could
serve as a substitute for signal costs. Signal costs differ in that they occur
by implementing the signal, whereas penalty costs occur only from false
signaling. Ownership stakes offer a conventional example. Retained
equity is typically interpreted as a signal of entrepreneurial intentions,
and strongly correlates with the probability of success in an initial or
follow-on offer in stock markets (Leland and Pyle 1977). Consistent with
corporate finance literature, if growth is the primary goal of crowd-
funders committed to long-term goals, then they should be expected to
retain control of a firm after an offering. As confirmation of this informa-
tion’s importance, the percentage of equity offered is clearly reported on
the home page of projects posted on crowdfunding platforms. Ahlers
et al. (2015) and Vismara (2016) demonstrate that previous results from
different financial settings hold in equity crowdfunding, in that a larger
percentage of equity offered by founders reduces the probability of equity
crowdfunding campaigns’ success.
34 S. Vismara
A related type of signal, based on bonding mechanisms, is handicap

signaling. For example, lockup clauses are used in initial public offerings
(IPOs), which produce liquidity costs for the firm’s original shareholders.
Insiders in high-quality firms are more willing to “lock in” to the firm’s
ownership, thereby signaling their commitment. The handicap is more
burdensome in low-quality firms, thus creating a separating equilibrium.
A similar bonding option comes from the structure of tax incentives in
the United Kingdom. Benefit occurs in an enterprise investment scheme
(EIS) when shares are held for at least three years from the date of issue;
otherwise, the tax relief will be withdrawn. Opting for such a mechanism
provides a form of a priori confirmation, whereby the signaler will self-
damage if the signal proves to be false.
Stiglitz (2000) highlights two broad information types in which asym-
metry is particularly important: information about quality and informa-
tion about intent. High-quality firms intend to act in a manner that
receivers desire, while low-quality firms do not. However, intentions are
credible signals only when they are binding, and repercussions occur if
the signal’s senders do not follow through on their intended behavior. As
signalers and receivers have partially competing interests, lower-quality
signalers have an incentive to deliver false signals to entice receivers to
select them. Examples of such “cheap talk” come from the IPO markets
(Farrell and Rabin 1996; Almazan et al. 2008). It is unsurprising that
IPO prospectuses are enticing, as these are created with a perspective
toward promoting newly listed ventures. Entrepreneurs and hired inter-
mediaries are indeed keen to create prospectuses that illuminate their
firms.2 With few exceptions, all companies going public declare that they
raise capital to pursue positive net present value (NPV) projects (Paleari
et al. 2008). Unfortunately, many of them use IPO proceeds to repay
debt and rebalance their capital structures. A similar example of cheap
talk in crowdfunding could include the exit intentions (e.g., IPO acquisi-
tions) that proponents declare at listing, which will not suffer costs in the
case of different post-campaign behavior.
Table 3.1 illustrates a taxonomy of signals that matches the senders—
such organizations as firms and NGOs, and individuals, both proponents
and fellow crowd-funders—and receivers, such as backers, lenders, and
investors. Subsequently, existing studies are classified in this taxonomy
Table 3.1 Taxonomy of signals in crowdfunding

Crowd-
Crowdfunding lending Crowd-investing
Receiver/sender Backers Lenders Investors
Organizations NGOs ? NO NO
Firms Burtch et al. Lin et al. Ahlers et al.
(2013), (2013) (2015),
Burtch et al. Ralcheva and
(2014), Roosenboom
Ordanini (2016), Vismara
et al. (2011), (2016)
Individuals Proponents Mollick Hildebrand NO
(2014), et al.
Kuppuswamy (2016)
and Bayus
(2014)
Crowd- Burtch et al. Collier and Moritz et al.
funders (2013), Hampshire (2015), Hornuf
Colombo (2010), and
et al. (2015), Yum et al. Schwienbacher
Kuppuswamy (2012) (2017), Vismara
and Bayus (2017)
(2014)
along the definitions of reward- and donation-based crowdfunding,

crowd-investing, and crowd-lending (Chap. 1). The proponent in crowd-
investing is by definition a company, but reward- and donation-based
campaigns are mostly launched by individuals. The governance and orga-
nizational implications of the capital-raising process through crowdfund-
ing arguably differ (Cumming et al. 2016b).
It can be noted before proceeding that signals benefit the sender by
reducing information asymmetries with the receiver; however, signals
may also provide intrinsic, substantive value. It is beyond the scope of
this chapter to quantify and discern the purely information-based certifi-
cation effect from signals’ intrinsic, substantive values (Colombo et al.
2016).3
Finally, while signaling theory provides the best theoretical lens
through which to study crowdfunding of the motivations discussed in
this chapter, other theories may complement our understanding of these
36 S. Vismara
markets. Bergh et al. (2014) propose that sense-making (Weick 1995)
and the information-processing theory (Thomas and McDaniel 1990)
have the advantage of using a behavioral perspective that could overcome
the signaling theory’s rational-actor assumption. These two concepts
could help decipher why a signal assumes different meanings among
receivers, or how different signals interact.
3.3.1 Signals from Proponents to Crowd-Funders
This section reviews various papers that focus on the determinants of

crowdfunding campaigns’ success, as summarized in Table 3.2. Some of
these studies explicitly focus on signals, while others more broadly
describe the factors associated with crowdfunding campaigns’ increased
chances of success. Studies on donation- or reward-based crowdfunding
argue that motivations other than potential monetary returns are impor-
tant for funders. Research on donation-based crowdfunding communi-
ties draws from extensive literature on charitable giving (e.g., Burtch
et al. 2014) and public goods (e.g., Burtch et al. 2013; Kuppuswamy and
Bayus 2014). This literature examines principles that are unlikely to apply
to investors in financial markets, such as crowd-investing or crowd-
lending. Cholakova and Clarysse (2015) and Vismara (2016) coherently
discover that offering rewards to investors does not increase crowd-
investing campaigns’ probability of success.
Different motivations to bid are likely to require different signals.
Mollick (2014) used a sample of reward-based projects posted on
Kickstarter to demonstrate that a founder’s number of social network con-
nections positively associates with the capital raised for a project.
Belleflamme et al. (2014) documented that entrepreneurs use their social
networks and established platforms on the Internet to directly interact
with the crowd. Colombo et al. (2015) examined the same platform to
discover that the founder’s social capital plays a crucial role in attracting
backers in a campaign’s early days, which consequently mediates the offer’s
success. Social capital’s role in donation-based crowdfunding has also been
confirmed (Ordanini et al. 2011). However, research is still lacking on the
role of entrepreneurs’ social capital in a crowd-investing context.
Table 3.2 Empirical evidence from crowdfunding studies
Signal/type of Crowdfunding Crowdfunding

crowdfunding (donations) (rewards) Crowd-investing
Early A high number A high number Early contributions are
investments of of fundamental in increasing
contributions contributions success of funding; positive
in the early in the early correlation (Vismara 2017)
days of days of
offering offering
increases the increases the
probability of probability of
crowdfunding crowdfunding
campaigns’ campaigns’
success success
(Burtch et al. (Colombo
2013) et al. 2015)
Other investors Prior investors Raising Contributions in the early
negatively substantial days of offering are
affect later amounts of fundamental in attracting
participants; capital in the other investors (Vismara
likely early days of a 2017)
connected to campaign is a
the idea of predictor of
self-relevance success in a
(Burtch et al. “success
2013) breeds
success”
self-reinforcing
pattern
(Colombo
et al. 2015)
Venture quality ? Social capital A positive correlation exists
and between venture quality
preparedness (specifically, human and
are associated intellectual capital) and
with an success (Ahlers et al. 2015).
increased Consistent evidence exists
chance of for the strong positive
project success, impact of intellectual
suggesting property rights protections
that quality in equity crowdfunding’s
signals play a success (Ralcheva and
role in project Roosenboom 2016)
outcomes
(Mollick 2014)
(continued )
38 S. Vismara
Table 3.2 (continued)
Social capital ? Both personal Public profile investors attract

social contacts other investors (Vismara
and those built 2017). A founder’s greater
within number of social connections
crowdfunding will increase the probability
communities of an equity crowdfunding
may be campaign’s success (Vismara
vehicles to 2016)
attract seed
financing
(Colombo
et al. 2015).
Between two
founders that
linked their
Facebook
profiles, the
one with more
Facebook
friends has a
higher
probability of
success;
nevertheless,
having no
Facebook
account is
better than
having few
online
connections
(Mollick 2014)
Top ? ? The number of TMT members
Management positively relates to
Team (TMT) campaign outcome,
size reflecting perception by
outside investors as a
positive signal of a firm’s
ability to cope with market
uncertainty (Ahlers et al.
2015; Vismara 2017)
(continued )
Geography ? Geography may A location in a larger city

play an positively impacts funding
important role success (Ralcheva and
in Roosenboom 2016). The
crowdfunding geographic distance
efforts’ success between the start-up and
(Mollick 2014). investors, as well as learning
Investment effects and sniping, do not
patterns over affect the backers’
time are willingness to pay (Hornuf
independent of and Neuenkirch 2017)
the geographic
distance
between the
entrepreneur
and investor,
even if the role
of family and
friends is quite
important in
early stages. It
can be
considered that
this study has
been made on a
crowdfunding
platform for
musical artists,
or in a particular
environment
(Agrawal et al.
2011)
Campaign A charitable- Duration A negative correlation exists
duration giving project decreases the between duration and
is more chances of success, possibly because
influential the success, possibly duration is fixed and can
longer it lasts because longer only change during the
(Burtch et al. durations are a campaign; it can be shorter
2013) sign of a lack of if it is already successful, or it
confidence can be extended in some
(Mollick 2014) cases (Vismara 2017)
(continued )
40 S. Vismara

Number of ? Correlation of The number of investors

investors 0.10 (with p should correlate with an
< 0.05) equity crowdfunding
between the campaign’s probability of
number of success (Ahlers et al. 2015).
backers and a The mean of the number of
crowdfunding investors is much higher for
campaign’s successful projects (Ralcheva
success and Roosenboom 2016)
(Mollick 2014)
Target size ? Increasing goal The mean target amounts of
size is successful projects are
negatively significantly higher than
associated unsuccessful ones (Ralcheva
with success and Roosenboom 2016).
(Mollick 2014) Campaign characteristics
play a meaningful role in
backers’ willingness to pay.
Both the funding goal and
pre-valuation serve as signals
for potentially lucrative
investments, as an increase
in these variables is
associated with a higher
premium (Hornuf and
Neuenkirch 2017)
Awards, ? ? The most economically
grants, or significant impact to reach
patents success, according to our
specifications, is associated
with previously winning a
grant or an award (Ralcheva
and Roosenboom 2016). No
evidence exists for grants/
awards’ positive impact,
possibly due to the sample size
(Ahlers et al. 2015). Vismara
(2017) discovers an impact for
patents held at listing
(continued )

Presentation ? Such signals as Posting an update

and updates videos and significantly and
frequent positively affects the
updates are number of investments
associated made by the crowd and
with greater the investment amount
success, and collected by the start-up.
spelling errors This effect does not occur
reduce the immediately in its
chance of entirety; rather, it lags
success behind the update by a
(Mollick 2014) few days. The positive
effect increases with the
number of words in the
update. Regarding the
update’s content, a
positive effect can be
attributed to updates
about new funding and
business developments, as
well as updates on
promotional campaigns
operated by the start-up
(Block et al. 2017). Investors
making investment
decisions consider
information updates on a
portal website, other
investors’ comments, and
more sophisticated
investors’ investment
decisions. They refrain
from investing when
observing withdrawals
(Hornuf and Schwienbacher
2017)
(continued )
42 S. Vismara

Privacy ? Reducing access ?
to information
controls
induces a net
increase in
fundraising,
yet this
outcome
results from
two competing
influences:
treatment
increases the
willingness to
engage with
the platform (a
4.9% increase
in the
probability of
contribution)
and
simultaneously
decreases the
average
contribution (a
USD 5.81
decline) (Burtch
et al. 2014)
Nonfinancial ? The results The results indicate that
motives indicate that nonfinancial motives play no
nonfinancial significant role, both in the
motives play decision to pledge and to
no significant invest in the project for
role, both in product-based campaigns
the decision to (Cholakova and Clarysse
pledge and to 2015)
invest in the
project for
product-based
campaigns
(Cholakova
and Clarysse
2015)
(continued )

Due diligence The data The data further The data further indicate that
further indicate that the application of due
indicate that the application diligence generally has a
the of due strong, positive influence on
application of diligence the fundraising success rate
due diligence generally has a and amount in the platform,
generally has strong, controlling for all services a
a strong, positive platform offers (Cumming
positive influence on et al. 2017)
influence on the
the fundraising
fundraising success rate
success rate and amount in
and amount the platform,
in the controlling for
platform, all services a
controlling for platform offers
all services a (Cumming
platform et al. 2017)
offers
(Cumming
et al. 2017)
Equity / / A larger percentage of equity
retention offered by founders will
reduce the probability of
equity crowdfunding
campaign success (Ahlers
et al. 2015; Vismara 2016)
Ahlers et al. (2015) used a sample of 104 projects from the Australian
Small Scale Offerings Board (ASSOB), a business-matching platform, to
identify which characteristics of the business (e.g., risk factors or pre-
planned exit intentions) and of its top management team (e.g., its size or
level of education) affect the probability of a proposal’s success. The use
of insider equity is a widely explored version of this signaling type in
strategy literature. Insiders affirm their strategies’ potential in the stock
market via their own investments; financial commitment reflects their
private knowledge, and their willingness to assume risk serves as a bond
to suffer personal loss if the firm does not perform well. Thus, managerial
44 S. Vismara
ownership serves as an important signal, wherein a separating equilib-

rium is created not by differential signal costs, but by differential penalty
costs; Ahlers et al. (2015) and Vismara (2016) discover supportive evi-
dence. Finally, other possible signals currently under research or to be
investigated include quality and the length of the text describing the proj-
ect, video, quality of reward, and pictures.
3.3.2 Other Types of Signals
The previous section addressed signals from proponents to crowd-funders.

Another way to create a separating equilibrium would be to involve a
third party in the signaling process that is willing to assume the costs of
signaling. Sociological evidence (Podolny 1993) notes that reputable
actors enhance the prestige through which one is viewed; similarly, third-
party endorsements have been studied as signals of a firm’s quality to
uninformed external investors. The underlying idea includes prestigious
players that highly value their reputations, and will carefully guard against
tarnishing it. The third party in this case bears the signaling costs, as it is
their reputational capital at stake.
Affiliation with a prestigious underwriter or venture capitalist has been
shown to be associated with better firm performance in an IPO context
(Beatty and Ritter 1986; Carter and Manaster 1990; Carter et al. 1998;
Megginson and Weiss 1991; Migliorati and Vismara 2014). The IPO
literature has also considered other financial intermediaries involved in
going public, such as top-quality auditors (Beatty 1989), universities
(Bonardo et al. 2011), and rating agencies (Khurshed et al. 2014), but
has discovered that they are less effective certification mechanisms.
Crowdfunding investors cannot rely on reports issued by financial ana-
lysts or on such formal intermediaries as IPO underwriters. One possible
exception includes certifications by pre-crowdfunding investors. Ralcheva
and Roosenboom (2016) find that offerings in Crowdcube backed by
venture capitalists have a higher probability of success, but it is difficult
to discern whether the substantial benefit delivered by such an affiliation
increases the chance per se, or if this occurs due to a reduction in infor-
mation asymmetries. Further, it is indiscernible whether the affiliation
with a venture capitalist is the firm’s action or characteristic.
Signals delivered by other investors become essential with a lack of

third-party endorsement. Their bids are clearly observable, or highly vis-
ible to potential investors, and costly; if investors bid for low-quality
projects, they earn low or no returns. As information cascades
(Bikhchandani et al. 1992) among investors play a prominent role in
finance (Welch 1992), they are likely to do so in crowdfunding. IPOs
with a high level of institutional demand in the first days of bookbuilding
also see high levels of bids from retail investors in the later days (Khurshed
et al. 2014).
Regardless of whether regulatory differences across platforms are sig-
nals, or the countries themselves, entrepreneurs select where to list as a
signal. For instance, the platform structure may denote a “keep-it-all”
versus “all-or-nothing” choice as a signal. Two papers use the similarities
and differences between German crowdfunding platforms to deliver new
insights: in an exploratory study of 23 interviews in Germany, Moritz
et al. (2015) report that investors’ decision-making processes in crowd-
investing are influenced by other market participants. Most new ventures
posted on the Companisto platform use prior investors’ statements as
external credentials in the ventures’ presentation videos. Hornuf and
Neuenkirch (2017) analyze the pricing of cash flow rights in start-up
companies using a unique data set of 44 crowd-investing campaigns on
Innovestment. In contrast with all other European crowd-investing por-
tals, Innovestment operates a multi-unit, second-price auction in which
backers themselves can specify the price of an investment ticket. They
exploit this unique auction mechanism to analyze backers’ willingness to
pay for cash flow rights, and discover that campaign characteristics, inves-
tor sophistication, progress in funding, herding, and stock market volatil-
ity influence backers’ willingness to pay in an economically meaningful
manner, while geographic distance, learning effects, and sniping at an
auction’s end have no effect.
Vismara (2017) contributes to this nascent literature by extending the
study from signals sent by project proponents, to encompass the signal-
ing dynamics between investors. Some of these studies predict previous
bids’ positive effect on the campaigns’ outcome. Reciprocity, a shared
identity, the desire to support a cause, and social image are their primary
motivations. In contrast, if individuals primarily care about the end result
46 S. Vismara
(i.e., the provision of goods), they are less likely to help in the actual or
perceived presence of other supporters. Theory predicts that pure altru-
ism leads to crowding out, with each new contribution decreasing the
appeal of subsequent contributions. Hence, the likelihood of bidding
would negatively relate to the number of previous backers. Depending on
the perspective and empirical setting, some non-crowd-investing studies
discover a positive linear effect of other community members’ funding
decisions on individual contributions (e.g., Colombo et al. 2015), while
others discover a negative effect (e.g., Burtch et al. 2013, 2015) or a non-
linear relationship (e.g., Kuppuswamy and Bayus 2014). In their work,
Kuppuswamy and Bayus (2014) use a sample of Kickstarter projects to
reveal that a project’s additional backer support negatively relates to its
past backer support, but this effect subsides as the project-funding cycle
approaches its closing date.
Hornuf and Schwienbacher (2016) derive an additional key difference
between reward-based crowdfunding and crowd-investing. While propo-
nents in the former raise as much as possible, crowd-investing involves a
maximum number of shares that entrepreneurs are willing to sell. They
also note that the funding goal itself might be a signal sent by the founder.
3.4 S
ignal Confirmation and Post-Signal
Performance
Most crowdfunding studies have investigated signals as determinants of
campaigns’ success. The next step involves demonstrating why it is
optimal for high-quality firms to signal, and why low-quality firms
would not. A confirmation mechanism enables a determination of
whether the beliefs in the signal are indeed realized for both the signal
sender and receiver. Further, a signal’s value is confirmed if the senders
subsequently outperform their peers who did not send the signal.
Beliefs, in other words, must be confirmed by subsequent experience
(Spence 2002). A test for separating equilibrium consecutively requires
moving beyond the receiver’s reaction to a signal, as well as studying
whether the expectation associated with a signal’s presence is confirmed,
with post-signal findings (Colombo et al. 2016). These arguments
can also be found in the theoretical literature on signaling theory and

market equilibria. For example, Cadsby et al. (1990) note how high-
quality firms can exploit the opportunity to use a signal to break a
pooling equilibrium and generate a separating equilibrium in financial
markets. In this section, I first discuss the theories proposed to explain
the IPOs’ long-term performance, and then summarize the few
papers on the long-term performance of firms that raised funds via
crowdfunding.
Companies tend to perform below the market’s benchmark during the
first few years after an IPO. This anomaly was first identified by Ritter
(1991), and numerous international studies have thus far conducted con-
sequent research. Literature, starting with Jain and Kini (1994), has most
recently even pointed to post-issue underperformance, in terms of oper-
ating measures. The explanations proposed for this phenomenon revolve
around three primary theories (Khurshed et al. 2003): (1) market timing;
(2) window dressing; and (3) asymmetric information.
The first explains underperformance in terms of a timing decision in
entering the market, whether exogenous or endogenous to the floated
company. One exogenous reason involves the “window of opportunity”
theory (Loughran and Ritter 1995), which states that companies go pub-
lic or generally raise equity capital not when the growth prospects are
good and financing is required, but when the control shareholder finds it
optimal. The incentive to go public is particularly strong in periods in
which a specific sector indicates large market ratios. For instance, con-
sider the Internet bubble in the late 1990s, or the recent consideration
reserved for the energy share market. Market timing may otherwise
endogenously originate in the issuing company so it is inclined to go
public at a time of maximum performance, namely, when it can exploit
the market’s favorable valuation.
The window-dressing theory is similarly based on this consideration,
in that, before the IPO, companies are subject to strong incentives to
“embellish” their balance sheets. These firms may evoke “creative”
accounting in the form of earnings management, which leads to greater
pre-IPO profitability that cannot be maintained post-issue. This results
in deteriorating post-issue operational performance due to a simple mean
reversion effect (Fama 1998).
48 S. Vismara
A third reason for long-term underperformance arises from the asym-

metric information theory, which discusses the opportunism (moral haz-
ards) derived from changes in ownership structure at the time of
IPO. Indeed, the decision to go public increases agency costs by dispers-
ing the share ownership. Therefore, this changes the relationship between
the principal (shareholders) and agent (manager). This decline in perfor-
mance could be caused by both an ex ante adverse selection effect by
companies that decide to go public (Leland and Pyle 1977) and ex post
opportunistic behavior (Jensen and Meckling 1976), such as the com-
pany management’s pursuit of private benefits once public (perquisite
consumption).
Some papers have investigated crowdfunding after campaigns have
closed. Mollick’s (2014) study of Kickstarter finds that less than 5% of
projects fail to deliver their products, and 75% deliver with a delay. Small
projects are more likely to fail in delivering rewards, while the propo-
nent’s characteristics do not affect the probability of a project’s success.
Cumming et al. (2016a) offer examples of documented cases of fraudu-
lent behavior in reward-based crowdfunding in the United States.
By providing a first market assessment of the project and evidence of
connection with active supporters, firms are expected to benefit from a
successful crowdfunding campaign, not only with the product, but also
in the financial market. However, the only available study thus far on the
“success after the success” in (reward-based) crowdfunding is that by
Mollick and Kuppuswamy (2014).4
Signori and Vismara (2016) first quantify the return on investments in
equity crowdfunding. The authors use an augmented dataset with com-
bined information from Crowdcube, Crunchbase, and the Companies
House to study a population of 212 successfully funded initial equity
offerings on the crowdfunding platform Crowdcube from their 2011
inception to 2015. This study reveals that 10% of these firms failed, while
30% pursued one or more seasoned equity offerings, either in the form
of private equity injection (10%), follow-on offerings in the same plat-
form (22%), or as targets in a merger or acquisition (1%). The expected
annualized return for an initial crowdfunding investor is 8.8%, implying
an annual value creation of GBP 25 million. Among the determinants of
post-campaign outcomes, the presence of nonexecutives, patents, and tax
incentives are associated with seasoned offerings, while none of the com-
panies initially backed by professional investors have subsequently failed.
One way to identify whether equity crowdfunding closes an important
funding gap is to look at insolvency rates; if these are comparatively high,
this might provide evidence that these firms should not have initially
received funding. Hornuf and Schmitt (2016) discover that, on average,
firms started crowd-investing campaigns three years after their establish-
ment. The authors further note that equity crowd-funded campaigns
have somewhat higher survival rates in the United Kingdom than in
Germany. Nevertheless, 70% of the German campaigns funded between
September 1, 2011, and December 31, 2015, were still operating as
active businesses four years after the campaign ended.
I conclude this review on post-campaign outcomes with a few sug-
gested research directions. Can we differentiate whether signals refer to
campaign success (i.e., successful funding) and venture success (i.e., a
successful exit with no insolvency)? What is crowdfunding’s impact on
different performance indicators, such as exits, employment, patents,
angel or VC finance, or sales growth, among others?
3.5 Conclusions
The cornerstone of entrepreneurial finance is that properly functioning
financial systems can reduce the information and transaction costs in a
world in which writing, issuing, and enforcing contracts consumes
resources; information is asymmetric; and its acquisition is costly. Recent
financial innovations, such as crowdfunding markets, promise to be a
step in this direction, and signaling theory provides a privileged angle by
which to investigate these markets. The present manuscript has proposed
a taxonomy of signals in crowdfunding that will hopefully guide future
research on this topic. Specifically, I again stress that among the future
directions identified in this study, an analysis of post-signal performance
is central not only to the correct use of signaling theory, but to the future
of crowdfunding markets. As crowdfunding’s ultimate goal is to build an
enduring business, a successful campaign is therefore a beginning, and
not an end.
50 S. Vismara
Notes
1. In this section, I adopt a strict definition of “signal” coherent with Spence’s
original economic model. Literature has used less strict definitions, and
has also included an actor’s inherent characteristics. When I review the
current literature on signaling in crowdfunding in the next section, I will
specifically identify how individual papers address signals.
2. I discuss the window-dressing theory later, in the section on signal confir-
mation and post-signal performance, in which I draw conclusions on the
parallelism between crowdfunding offerings and initial public offerings by
discussing the evidence and theories on IPOs’ long-term performance. I
provide a definition and examples of cheap talk in this section that con-
form to Stiglitz’s original economic model; literature has used less strict
definitions. When I review the current literature on signaling in crowd-
funding in the following sections, I will specifically identify how individ-
ual papers address signals.
3. Additionally, some papers take a comparative perspective across platforms
(Cumming and Zhang 2016; Cumming et al. 2017), or focus on specific
topics, such as gender issues (Mohammadi and Shafi 2017; Vismara et al.
2017).
4. A survey of 158 successfully funded Kickstarter projects reveals that
approximately 18% of the respondents raised outside risk capital in the
forms of venture capital (VC) or business angel (BA) investing, while 8%
through additional reward-based crowdfunding campaigns. The propo-
nents’ specific industry experience and the presence of “a substantially
complete business plan before fundraising” are the main predictors of out-
side funding (Mollick and Kuppuswamy 2014, 12).
References
Agrawal, Ajay K., Christian Catalini, and Avi Goldfarb. 2011. The Geography
of Crowdfunding. National Bureau of Economic Research. http://www.nber.
org/papers/w16820. Accessed 20 Feb 2017.
2015. Signaling in Equity Crowdfunding. Entrepreneurship: Theory and
Practice 39: 955–980.
Akerlof, George A. 1970. The Market for Lemons: Quality Uncertainty and the
Market Mechanism. Quarterly Journal of Economics 84: 488–500.
Almazan, Andres, Sanjay Banerji, and Adolfo de Motta. 2008. Attracting

Attention: Cheap Managerial Talk and Costly Market Monitoring. Journal of
Finance 63: 1399–1436.
Beatty, Randolph P. 1989. Auditor Reputation and the Pricing of Initial Public
Offerings. Accounting Review 64: 693–709.
Beatty, Randolph P., and Jay R. Ritter. 1986. Investment Banking, Reputation
and the Underpricing of Initial Public Offerings. Journal of Financial
Economics 15: 213–232.
585–609.
Bergh, Donald D., Brian L. Connelly, David J. Ketchen, and Lu M. Shannon.
2014. Signaling Theory and Equilibrium in Strategic Management Research:
An Assessment and Research Agenda. Journal of Management Studies 51:
1334–1360.
Bikhchandani, Sushil, David Hirshleifer, and Ivo Welch. 1992. A Theory of
Fads, Fashion, Custom, and Cultural Change as Informational Cascades.
Journal of Political Economy 100: 992–1026.
Bonardo, Damiano, Stefano Paleari, and Silvio Vismara. 2011. Valuing
University-Based Firms: The Effects of Academic Affiliation on IPO
Performance. Entrepreneurship Theory and Practice 35: 755–776.
Burtch, Gordon, Anindya Ghose, and Sunil Wattal. 2013. An Empirical
Examination of the Antecedents and Consequences of Contribution Patterns
in Crowd-Funded Markets. Information Systems Research 24: 499–519.
———. 2014. Cultural Differences and Geography as Determinants of Online
Pro-Social Lending. MIS Quarterly 38: 773–794.
———. 2015. The Hidden Cost of Accommodating Crowdfunder Privacy
Preferences: A Randomized Field Experiment. Management Science 61:
949–962.
Cadsby, Charles B., Murray Frank, and Vojislav Maksimovic. 1990. Pooling,
Separating, and Semiseparating Equilibria in Financial Markets: Some
Experimental Evidence. Review of Financial Studies 3: 315–342.
Carpenter, Robert E., and Bruce C. Petersen. 2002. Capital Market
Imperfections, High-Tech Investment, and New Equity Financing. Economic
Journal 112: 54–72.
52 S. Vismara
Carter, Richard B., Frederick H. Dark, and Ajai K. Singh. 1998. Underwriter
Reputation, Initial Returns, and the Long-Run Performance of IPO Stocks.
Journal of Finance 53: 285–311.
Carter, Richard, and Steven Manaster. 1990. Initial Public Offerings and
Underwriter Reputation. Journal of Finance 45: 1045–1067.
Cassia, Lucio, and Silvio Vismara. 2009. Suppliers as Fund Suppliers: Firms’
Trade Credit and the Local Level of Development of the Banking System in
Europe. Investment Management and Financial Innovations 6: 46–58.
Cholakova, Magdalena, and Bart Clarysse. 2015. Does the Possibility to Make
Equity Investments in Crowdfunding Projects Crowd Out Reward-Based
Investments? Entrepreneurship Theory and Practice 39: 145–172.
Colombo, Massimo G., Michele Meoli, and Silvio Vismara. 2016. Signalling in
Science-Based IPOs: The Combined Effect of Affiliation with Prestigious
Universities, Underwriters, and Venture Capitalists. Social Science Research
Collier, Benjamin C., and Robert Hampshire. 2010. Sending Mixed Signals:
Multilevel Reputation Effects in Peer-To-Peer Lending Markets. Paper presented
at Proceedings of the 2010 ACM Conference on Computer Supported
Cooperative Work (197–206), Savannah, USA.
Connelly, Brian L., S. Trevis Certo, R. Duane Ireland, and Christopher
R. Reutzel. 2011. Signaling Theory: A Review and Assessment. Journal of
Management 37: 39–51.
Cumming, Douglas J., Lars Hornuf, Moein Karami, and Denis Schweizer.
2016a. Disentangling Crowdfunding from Fraudfunding. Max Planck
Institute for Innovation and Competition Research Paper, No. 16-09. https://
Cumming, Douglas J., Michelle Meoli, and Silvio Vismara. 2016b. Investors’
Choice Between Cash and Voting Rights: Evidence from Dual-Class Equity
Crowdfunding. Working Paper, University of Bergamo.
Cumming, Douglas J., Alice Rossi, and Silvio Vismara. 2017. What Do
Crowdfunding Platforms Do? A Comparison Between Investment-Based
Platforms in Europe. Working Paper, University of Bergamo.
Cumming, Douglas J., and Silvio Vismara. 2016. A Research Journey Into
Entrepreneurial Finance. In The Routledge Companion to makers of modern
entrepreneurship, ed. D.B. Audretsch and E.E. Lehmann, 64–73. London,
UK: Routledge.
Cumming, Douglas J., and Yelin Zhang. 2016. Are Crowdfunding Platforms
Active and Effective Intermediaries? Social Science Research Network. https://
Fama, Eugene F. 1998. Market Efficiency, Long-Term Returns, and Behavioral
Finance. Journal of Financial Economics 49: 283–306.
Farrell, Joseph, and Matthew Rabin. 1996. Cheap Talk. Journal of Economic
Perspectives 10: 103–118.
Hanssens, Jürgen, Marc Deloof, and Tom Vanacker. 2015. Underexplored Issues
in Entrepreneurial Finance. In The Concise Guide to Entrepreneurship,
Technology and Innovation, ed. D.B. Audretsch, C.S. Hayter, and A.N. Link,
219–222. New York, NY: Edward Elgar.
———. 2016. The Evolution of Debt Policies: New Evidence from Business
Startups. Journal of Banking and Finance 65: 120–133.
in Crowdfunding. Management Science 63 (3): 587–608.
Hornuf, Lars, and Matthias Neuenkirch. 2017. Pricing Shares in Equity
Hornuf, Lars, and Matthias Schmitt. 2016. Success and Failure in Equity
Crowdfunding. CESifo DICE Report 14: 16–22.
3. Business Angels, ed. H. Landström and C. Mason, 381–397. Cheltenham,
UK: Edward Elgar.
Hubbard, R. Glenn. 1998. Capital Market Imperfections and Investment.
Journal of Economic Literature 36: 193–225.
Jain, Bharat A., and Omesh Kini. 1994. The Post-Issue Operating Performance
of IPO Firms. Journal of Finance 49: 1699–1726.
Jensen, Michael C., and William H. Meckling. 1976. Theory of the Firm.
Managerial Behavior, Agency Costs and Ownership Structures. Journal of
Financial Economics 3: 305–360.
Khurshed, Arif, Stefano Paleari, Alok Pandè, and Silvio Vismara. 2014.
Transparent Bookbuilding, Certification and Initial Public Offerings. Journal
of Financial Markets 19: 154–159.
Khurshed, Arif, Stefano Paleari, and Silvio Vismara. 2003. The Operating
Performance of Initial Public Offerings: The UK Experience. Social Science
Research Network. https://ssrn.com/abstract=439240. Accessed 20 Feb 2017.
Kuppuswamy, Venkat, and Barry L. Bayus. 2014. Crowdfunding Creative Ideas:
The Dynamics of Project Backers in Kickstarter. Social Science Research
54 S. Vismara
Leland, Hayne E., and David H. Pyle. 1977. Informational Asymmetries,
Financial Structure, and Financial Intermediation. Journal of Finance 32:
371–387.
Lin, Mingfeng, Nagpurnanand R. Prabhala, and Siva Viswanathan. 2013.
Judging Borrowers by the Company They Keep: Friendship Networks and
Information Asymmetry in Online Peer-to-Peer Lending. Management
Science 59: 17–35.
Loughran, Tim, and Jay R. Ritter. 1995. The New Issues Puzzle. Journal of
Finance 50: 23–51.
Megginson, William L., and Kathleen A. Weiss. 1991. Venture Capitalist
Certification in IPOs. Journal of Finance 46: 879–903.
Migliorati, Katrin, and Silvio Vismara. 2014. Ranking Underwriters of European
IPOs. European Financial Management 20: 891–925.
Mohammadi, Ali, and Kourosh Shafi. 2017. Gender Differences in the
Contribution Patterns of Equity-Crowdfunding Investors. Small Business
Economics. Forthcoming.
Mollick, Ethan. 2014. The Dynamics of Crowdfunding: An Exploratory Study.
Journal of Business Venturing 29: 1–16.
Mollick, Ethan, and Venkat Kuppuswamy. 2014. After the Campaign: Outcomes
of Crowdfunding. Social Science Research Network. https://ssrn.com/
Moritz, Alexandra, Jörn Block, and Eva Lutz. 2015. Investor Communication
in Equity-Based Crowdfunding: A Qualitative-Empirical Study. Qualitative
Research in Financial Markets 7: 309–342.
Ordanini, Andrea, Lucia Miceli, Marta Pizzetti, and Anantharanthan
Parasuraman. 2011. Crowd-Funding: Transforming Customers Into Investors
Through Innovative Service Platforms. Journal of Service Management 22:
443–470.
Paleari, Stefano, Enrico Pellizzoni, and Silvio Vismara. 2008. The Going Public
Decision: Evidence from the IPOs in Italy and in the UK. International
Journal of Applied Decision Sciences 1: 131–152.
Podolny, Joel M. 1993. A Status-Based Model of Market Competition. American
Journal of Sociology 98: 829–872.
in Equity Crowdfunding. Social Science Research Network. https://ssrn.com/
Ritter, Jay R. 1991. The Long-Run Performance of Initial Public Offerings.
Journal of Finance 46: 3–27.
Robb, Alicia M., and David T. Robinson. 2014. The Capital Structure Decisions
of New Firms. Review of Financial Studies 27: 153–179.
Signori, Andrea, and Silvio Vismara. 2016. Returns on Investments in Equity
Crowdfunding. Social Science Research Network. https://ssrn.com/
Spence, Michael. 1973. Job Market Signaling. Quarterly Journal of Economics
87: 355–379.
———. 2002. Signaling in Retrospect and the Informational Structure of
Markets. American Economic Review 92: 434–459.
Stiglitz, Joseph E. 2000. The Contributions of the Economics of Information to
Twentieth Century Economics. Quarterly Journal of Economics 115:
1441–1478.
———. 2002. Information and the Change in the Paradigm in Economics.
American Economic Review 92: 460–501.
Stiglitz, Joseph E., and Andrew Weiss. 1981. Credit Rationing in Markets with
Imperfect Information. American Economic Review 71: 393–410.
Thomas, James B., and Reuben R. McDaniel. 1990. Interpreting Strategic
Issues: Effects of Strategy and the Information Processing Structure of Top
Management Teams. Academy of Management Journal 33: 286–306.
Vismara, Silvio. 2016. Equity Retention and Social Network Theory in Equity
———. 2017. Information Cascades Among Investors in Equity Crowdfunding.
Entrepreneurship Theory and Practice. Forthcoming.
Vismara, Silvio, Davide Benaroio, and Federica Carne. 2017. Gender in
Entrepreneurial Finance: Matching Investors and Entrepreneurs in Equity
Crowdfunding. In Gender and Entrepreneurial Activity, ed. Albert Link.
Cheltenham: Edward Elgar.
Vismara, Silvio, Stefano Paleari, and Jay R. Ritter. 2012. Europe’s Second
Markets for Small Companies. European Financial Management 18: 352–388.
Weick, Karl E. 1995. Sensemaking in Organizations. Thousand Oaks, CA: SAGE
Publications.
Welch, Ivo. 1992. Sequential Sales, Learning, and Cascades. Journal of Finance
47: 695–732.
Williamson, Oliver E. 1985. Economic Institutions of Capitalism. New York: Free
Press.
Yum, Haewon, Byungtae Lee, and Myungsin Chae. 2012. From the Wisdom of
Crowds to My Own Judgment in Microfinance Through Online Peer-to-Peer
Lending Platforms. Electronic Commerce Research and Applications 11:
469–483.
56 S. Vismara
Silvio Vismara is Professor of Entrepreneurial Finance at the University of

Bergamo, Italy; an adjunct professor at the University of Augsburg, Germany;
and a research fellow at Indiana University, USA. He is the associate editor of
Small Business Economics and of the Financial Review, and a member of the edi-
torial review board of Entrepreneurship Theory and Practice and Journal of
Technology Transfer. His research on initial public offerings (IPOs) and crowd-
funding has been covered by The Economist, Financial Times, and Investors’
Chronicle. He is a scientific consultant for the Italian Stock Exchange.
4
The Crowd–Entrepreneur Relationship
in Start-Up Financing
Thomas Lambert, Aleksandrina Ralcheva,
and Peter Roosenboom
4.1 Introduction
After raising USD 2.4 million from a crowdfunding campaign on
Kickstarter in 2012, Oculus VR, LLC, a California-based manufacturer
of a virtual reality headset, generated large media attention when only
two years later it got taken over by Facebook for USD 2 billion in cash
and stock.1 Many of the original backers were not only surprised but also
disappointed by this outcome. The Oculus Rift enthusiasts, who backed
the project on Kickstarter, expected “something else” from their partici-
pation in the crowdfunding campaign, as testified by this backer: “Maybe
I was naive [about Oculus]. I thought it was more just like someone
doing it for a hobby and just wanted to do something fun for the com-
munity. I didn’t know it was going to turn into a USD 2 billion deal.”2
On Kickstarter, one of the biggest pre-ordering/reward-based
crowdfunding portals, backers are not entitled to the company’s revenues
T. Lambert (*) • A. Ralcheva • P. Roosenboom

Rotterdam School of Management, Erasmus University Rotterdam,
Rotterdam, The Netherlands

https://doi.org/10.1007/978-3-319-66119-3_4
58 T. Lambert et al.
or profits. Nevertheless, many of the Oculus supporters felt “betrayed.”

In this case, participation in a crowdinvesting campaign, in which entre-
preneurs sell shares of their start-up companies to investors through the
Internet, would have allowed the backers to benefit from the acquisition
of the company.
For the crowd of contributors, participating in a crowdfunding cam-
paign may be a valuable social activity, as it is associated with a community-
based experience that generates community benefits for contributors
(Belleflamme et al. 2014). The case of Oculus, however, like many other
cases reveals that the nature of these community benefits may vary
between crowdfunding vis-à-vis crowdinvesting. Backers in crowdfund-
ing campaigns mostly derive consumption value from their experience,
while crowdinvesting offers an investment experience to investors who
are primarily interested in the financial prospects of the start-up.
Understanding the characteristics and motivations of the crowd and how
they influence funding success is important. Indeed, crowdfunding and
crowdinvesting have both demonstrated potential in financing start-ups
as shown by their startling rise. In 2015 alone, the global crowdfunding
market raised more than USD 34 billion, thus doubling the amount of
USD 16.2 billion raised in 2014.3
In this chapter, we first discuss the characteristics and motivations of
the crowd and how they relate to success in crowdfunding. In particular,
Belleflamme et al. (2014) look more closely at the relationship that the
entrepreneur builds with his or her crowd by modeling the entrepreneur’s
choice between crowdfunding, which includes the pre-ordering scheme,
and crowdinvesting. Their model stresses the role and importance of
community benefits in order to “tap” the right crowd for funding success;
that is, understanding the motivations of the crowd given the capital
requirements. Their main finding is that entrepreneurs prefer the pre-
ordering scheme if the amount of capital they need is relatively small as
compared to the market size and prefer crowdinvesting otherwise.
An interesting implication of their theoretical framework is that the
crowd–entrepreneur relationship is also subject to the typical asymmetric
information problems of start-up financing well documented in the case
of venture capital and business angel financing (see also Agrawal et al.
2014; Belleflamme et al. 2015). First, before the financing takes place,
The Crowd–Entrepreneur Relationship in Start-Up Financing 59
the crowd often lacks the necessary information to assess the true ability
of the entrepreneur or the intrinsic quality of the start-up or product,
which could lead to an adverse selection problem. In other words, portals
only manage to attract low-quality entrepreneurs because high-quality
entrepreneurs anticipate that they will not be identified as such by the
crowd. Second, after financing takes place, the crowd may also find it dif-
ficult to induce ex post effort on the side of the entrepreneur: delays in
product delivery are commonplace, and outright frauds are the most
extreme cases though much less frequent (Mollick 2014). These are forms
of moral hazard. Both adverse selection and moral hazard may stifle
welfare-enhancing transactions between the crowd and the entrepreneur.
Belleflamme et al. (2014) further show that the choice of the “right” busi-
ness model (crowdfunding vs. crowdinvesting) is one important decision
entrepreneurs need to make in order to overcome these potential market
failures. In particular, they demonstrate that when quality uncertainty
and information asymmetry are prevalent, entrepreneurs are induced to
opt for crowdinvesting.
In the second part of this chapter we continue our discussion on how
these two typical asymmetric information problems affect the crowd–
entrepreneur relationship in the crowdinvesting context. We focus on
crowdinvesting because it represents the business model for which infor-
mation problems are inherently the most significant. We argue that
entrepreneurs in crowdinvesting may want to supplement their crowd of
contributors with other types of contributors to mitigate information
asymmetry concerns. In particular, the decision to take on board a sophis-
ticated investor (business angel or venture capitalist) or to make use of a
syndicate of investors is an important strategy to reduce them. First,
sophisticated investors with their expertise, knowledge and skills provide
quality signals that contribute to mitigating the adverse selection prob-
lem entrepreneurs resorting to crowdinvesting face. Second, once invest-
ment has taken place, sophisticated investors are in a better position to
bear the cost of monitoring entrepreneurs and to write investment con-
tracts setting special decision-making rights (e.g. veto power on firm
decisions, appointment of directors), reducing in turn moral hazard
problems. Third, because these sophisticated investors co-contract with
the crowd on the same terms without being compensated for their efforts,
they may find it less attractive to engage in ex ante expertise and ex post
monitoring. This would in turn limit the benefits for the crowd. We close
the second part with a discussion on how syndication, in which a lead
investor has face-to-face interaction with the entrepreneur and is com-
pensated using carried interest, further mitigates information problems
of early stage investments.
4.2 Tapping the Crowd to Get Financed4

Crowdfunding is an umbrella term that refers to different business mod-
els allowing entrepreneurs to raise capital: crowdfunding (including pre-
sales), crowdinvesting (including profit sharing) and crowdlending. For
each business model, better understanding the characteristics of the
crowd of contributors—being either backers, investors or lenders—is
crucial for entrepreneurs and portal managers because it determines
crowdfunding successes and failures. One such important characteristic
is the so-called community benefits that the crowd enjoys by participat-
ing in the crowdfunding mechanism. These extra benefits are likely to
vary across business models. Because entrepreneurs perceive all business
models as different, a key issue is to understand what drives entrepreneurs
to choose among the different business models.
Belleflamme et al. (2014) build a stylized model to address this ques-
tion. They consider an entrepreneur who intends to “tap the crowd” to
meet a certain capital requirement for setting up her start-up and there-
fore starting production. For unmodeled reasons, the entrepreneur has
not been successful in attracting sufficient external finance to cover this
amount of capital. In their model, the entrepreneur can choose between
two business models that dominate nowadays, namely crowdfunding and
crowdinvesting. To make the comparison as clear as possible, the authors
assume, without loss of generality, that (1) launching a crowdfunding
campaign or a crowdinvesting campaign is equally costly for the entrepre-
neur, and (2) participating in one or the other business model is a priori
the same for the crowd.
By “freezing” the cost and the participation dimensions, the authors
want to focus on another dimension of crowdfunding that they see as cru-
cial, namely the relationship that crowdfunding allows the entrepreneur to
establish with the crowd. The key argument developed in their article is
that this relationship differs across business models. That is, when choosing
one or the other business model, the entrepreneur also chooses what she
can learn about the crowd and what she can extract from them through the
pricing of her product.
Indeed, the crowdfunding model that the authors develop is based on
pre-ordering: the backers are consumers who have a strong taste for the
announced product and who therefore decide to pre-order it, that is, they
pay for it before it is actually produced.5 The entrepreneur can reward the
crowd in various ways, but what matters is that these rewards (called
community benefits) increase the backers’ willingness to pay for the
product. It is assumed that this increase in willingness to pay is propor-
tional to the backers’ taste for the product, which means those consumers
who like the product the most are also those who value the rewards the
most. As a result, this business model allows the entrepreneur to segment
her product consumers into two groups: the backers who signal them-
selves as high-paying consumers (and whose willingness to pay is further
enhanced by the value that they attach to the rewards), and the other
(regular) consumers who wait for the product to be put on the market
before considering to buy it. The entrepreneur is, thus, able to price-
discriminate between both consumer groups, which gives her the oppor-
tunity to raise her profits, as she is assumed to be in a monopoly position
for her product.6 However, the optimal price discrimination scheme may
not be feasible if the initial capital requirement is too high. The obliga-
tion to finance the capital through pre-sales puts a constraint on the price
that can be charged to those consumers who choose to pre-order the
product. Therefore, the profitability of this crowdfunding model decreases
with the size of the capital requirement.
The alternative business model (crowdinvesting) that the authors con-
sider is based on profit sharing.7 Crowdinvesting (here profit sharing) dif-
fers from crowdfunding based on two dimensions. First, the nature of
contributions and compensations is different: instead of pre-ordering the
product, the crowd is invited to directly provide a fixed sum of money to
the entrepreneur and is promised a share of the future profits in exchange.
Second, contributors also enjoy community benefits but it is assumed here
that these benefits are independent of the contributor’s taste for the prod-
uct. This assumption makes sense as the crowd is seen here as investors,
who may well decide to finance the start-up without purchasing the prod-
uct. The implications of these differences are the following. On the minus
side, the entrepreneur is no longer able to segment the crowd and to single
out the high-paying consumers. On the plus side, all individuals value
community benefits in the same way, which makes it easier for the entre-
preneur to capture this extra value. Moreover, this ability to capture the
value that the crowd attaches to community benefits is not impaired by
the size of the capital requirement.
The comparison of the profits that the entrepreneur can achieve under
the two business models yields the main result of the analysis: the entre-
preneur prefers the pre-ordering model when the capital requirement is
relatively small and the profit-sharing model otherwise. The intuition
behind this result has been outlined earlier: pre-ordering allows the entre-
preneur to practice price discrimination, which should give her a higher
profit than in the profit-sharing scheme (in which she is bound to set a
uniform price for her product). However, price discrimination is con-
strained, and hence less profitable, when the initial capital requirement
grows larger than some threshold. Above this threshold, the profit-sharing
model, which allows the entrepreneur to turn all individuals into inves-
tors, becomes the best option.8
Belleflamme et al. (2014) report consistent results when they intro-
duce some uncertainty about the true quality of the product, which may
only be known after production has taken place. In this case, both the
entrepreneur and the crowd face the same (lack of ) information. In
another extension, the authors introduce information asymmetry
between the entrepreneur and the crowd about product quality and find
that information asymmetry tends to favor profit-sharing schemes. Since
the uncertainty about product quality directly influences the decision
(utility) of consumers to pre-order the product or not, the entrepreneur
is constrained when she tries to screen backers and to induce them to pre-
order. However, the inability of the crowd to ascertain the quality of the
product constrains the entrepreneur less when she tries to attract inves-
tors. Indeed, under profit sharing, investors (who eventually may not
consume) care about product quality only insofar as it affects the expected
profitability of their investment.
These theoretical underpinnings have implications for both entrepre-
neurs and portal managers. First, they highlight the importance of self-
revelation mechanisms in the course of the crowdfunding process. Since

entrepreneurs cannot ex ante identify consumers with a high willingness
to pay for their product, entrepreneurs may opt for pre-ordering as a
screening device that induces high-paying consumers to reveal themselves
as such.9 For example, the singer Verity Price managed to crowdfund her
first album by appealing to her fans through her own website. While her
album is now released on the market at a price of ZAR (South African
Rands) 116, at the time of the crowdfunding campaign her fan base pre-
ordered it at ZAR 150—that is, about 30% more of what regular con-
sumers pay today.
Second, the crowd enjoys community benefits arising from the crowd-
funding experience, the nature of which varies with the business model
considered.10 Under the crowdinvesting (pre-ordering) mechanism, com-
munity benefits are linked to the consumption experience. This can be
understood as the feeling of belonging to the entrepreneurial initiative, or
the feeling of being part of a group of special/privilege consumers of the
product. For example, backers may participate in the ideation and design
of the product, as in the case of Pebble, whose creator announced the fol-
lowing during the Kickstarter campaign: “Without further ado, I’d like
to present the Voter’s Choice color … Orange! It won with almost 2000
out of more than 10,000 qualified votes.”11 Another post by Pebble’s cre-
ator further testifies the involvement of backers in the ideation of the
product: “Today, we’d like to announce that your enthusiasm has helped
convince us to move the entire Pebble roadmap forward and bring you a
brand new feature. Bluetooth 4.0—inside every Pebble! All Pebble
watches will support Bluetooth 2.1 (as before) as well as Bluetooth 4.0
(Low Energy).”12 In addition, Mollick (2014) points out the importance
of updates and comments to create and maintain a relationship between
the entrepreneur and the crowd in Kickstarter. Under the crowdinvesting
(profit-sharing) mechanism, community benefits are, however, related
more to the investment than the consumption experience since the crowd
might not eventually be consumers of the product. Indeed, investors
derive value of having financed and thus contributed to the very existence
of the start-up or product. An investor on FundedByMe, a Stockholm-
based crowdinvesting portal, comments: “Most of all I want experience
from different lines of business and to observe the operations from a close
distance. It becomes interesting in a different way when you have some of
your own money in it. […The] dream is that at least one of them [proj-
ects] would turn out to be a big success.”
Third, Belleflamme et al. (2014) highlight that choosing the “right”
business model crucially depends on the ability of the entrepreneur to cor-
rectly estimate her capital needs. The authors predict that pre-ordering
(profit sharing) is preferred when the capital needs of the entrepreneurs are
low (high). This is consistent with empirical observations: From data pro-
vided by Crowdcube and Kickstarter, two market leaders in crowdinvesting
and crowdfunding respectively, one easily understands that entrepreneurs
resorting to crowdinvesting collect on average more capital than those rely-
ing on crowdfunding (including pre-ordering). At the time of writing, suc-
cessful entrepreneurs on Crowdcube raised on average GBP 421,707
(approx. USD 554,123), whereas entrepreneurs on Kickstarter generated
on average USD 8,086.13 A similar insight applies to the target goal.
Fourth, Belleflamme et al. (2014) show that when the uncertainty and
information asymmetry regarding the quality of the product are high,
investors tend to favor profit sharing over pre-ordering schemes. This
implies that profit sharing may be more suitable for early stage ventures,
as they inherently suffer from more information asymmetries and because
pre-ordering typically requires more developed projects/products at the
time of the campaign—namely, the existence of a prototype or even the
existence of the very product. In what follows we address these
information-related concerns in crowdinvesting and discuss potential
remedies; in particular, the need in some circumstances to tap other types
of investors beside the crowd.
4.3 Tapping Other Types of Investors

4.3.1 C
rowdfunding and the Information Problems
of Start-Up Financing
The inherently uncertain nature of crowdfunding campaigns and the lack

of information surrounding start-ups make it particularly difficult for the
entrepreneurs to gain the crowd’s trust in order to be successful in raising
their funds. However, information problems are less pronounced in the
cases of crowdfunding and crowdlending than in the case of crowdinvest-

ing for several reasons. First, crowdfunding proponents believe in the
“wisdom of the crowd” and its ability to efficiently make collective invest-
ment decisions. Research on reward-based crowdfunding has indeed
found support for the “wise” crowd argument, for example, theater proj-
ects on Kickstarter selected by the crowd perform as well as projects
selected by experts (Mollick and Nanda 2015). Second, crowdfunding
portals worldwide advertise the capital campaigns raise as a strong signal
of quality. Mollick (2014) argues that projects which have already
attracted funding from backers more easily accumulate further funding
success through a so-called Matthew Effect (“success breeds success”;
Merton 1957). Similar dynamics seem to be dominating crowdlending
portals (e.g. Prosper), in which well-funded borrowers attract more lend-
ers, who in turn infer the creditworthiness of borrowers by observing
peer-lending decisions (“observational learning”; Zhang and Liu 2012).
Also, by taking into account observable soft information, lenders in this
market substantially outperform unobservable credit scores in terms of
predicting default (Iyer et al. 2016). Third, in crowdfunding and
crowdlending, the relationship between the entrepreneur and the crowd
is more transactional by definition: backers in crowdfunding receive their
products and/or rewards shortly after the fund-raising, while borrowers
in crowdlending hold a fixed claim and thus receive interest and their
money back.14
In contrast, in crowdinvesting, contributors (i.e. investors) make an
investment decision that makes them a residual claimant in typically
early stage companies, a large proportion of which fails.15 The investors
have to rely on the entrepreneur to share part of her subsequent revenues
or profits (in the case of revenue or profit sharing) and only see some of
their money back when there is a dividend paid or an exit event such as
the sale or public offering of the venture (in the case of equity).16
Information problems are thus inherently more pressing in crowdinvest-
ing. One can distinguish two main information problems. The first is
that of hidden information or adverse selection, which occurs before the
financing takes place (ex ante).17 To mitigate this problem, some crowd-
investing portals perform an elaborate screening, in the process of which
each venture undergoes due diligence, to assess whether it meets the
necessary quality standards. For example, from a sample comprising

about 70% of Canadian portals over the years 2013–2016, Cumming
and Zhang (2016) find a positive association between due diligence and
funding success. The authors conclude that active due diligence (i.e.
background checks, site visits, credit checks, cross checks, monitoring
accounts and third-party proof ) represents an important value for portals
in limiting the number of lower-quality projects.18 The second informa-
tion problem is that of hidden action or moral hazard, which occurs after
investment has taken place (ex post). After the capital raising the entre-
preneur can decide to invest the money in a way that does not benefit the
backers or the entrepreneur might not keep her promises. Some portals
reduce moral hazard by playing a monitoring role after the investment or
by facilitating information disclosure of firms to investors after invest-
ment. For example, in the case of Seedrs, a crowdinvesting portal in the
United Kingdom, the portal acts as the nominee shareholder on behalf of
investors and offers some degree of investor protection under the sub-
scription agreement they have with each company that crowdfunds on
their portal. Symbid, a Dutch crowdinvesting portal, offers a monitoring
function on which company information is provided on a regular basis to
investors who invested in that company.
Last, many leading crowdinvesting portals rely on third parties to miti-
gate either the ex ante or the ex post information problem. In particular,
they introduce a mix of different types of investors (both naive and
sophisticated investors) or have a syndicate of investors among whom a
lead investor engages in due diligence and monitoring on behalf of the
other investors (and gets compensated for that). The following sections
aim at discussing the role and importance of sophisticated investors and
syndicates in the crowdinvesting context, respectively.
4.3.2 The Role of Sophisticated Investors
As technology and online networks continue to develop, sophisticated

investors such as business angels and venture capitalists are starting to
turn to crowdinvesting portals to gain access to relatively new steady deal
flow and even invest alongside the crowd. Crowdinvesting portals are
compelling to both business angels and venture capitalists, as they lever-

age technology to offer a wider range of investment opportunities and to
facilitate more efficient information transfer, as compared to traditional
means for sourcing deal flow.19 The structure and standardized format of
crowdinvesting campaigns allow for much quicker due diligence process
and provide the necessary information to ease the investment decision
process. Crowdinvesting portals are also a competitive marketplace that
requires entrepreneurs to publicly demonstrate their potential and the
strength of their team.
Although these traditional investors find interest in crowdinvesting,
the reverse is also true: traditional investors play a key role in the online
solicitation of funds for early stage ventures by yielding entrepreneurs
both ex ante and ex post benefits. First, the important role of these more
sophisticated investors comes into play when the question is raised as to
whether the crowd alone is able to deal with the high levels of uncertainty
and information asymmetry. Being more informed and experienced,
sophisticated investors have the ability to lower the risk of funding, in
that the projects they invest in are likely to be perceived by the crowd of
naive contributors as higher-quality and, thus, less risky investments.
Empirical research has already addressed the role of traditional investors
in crowdfunding campaigns’ outcomes. Block et al. (2017) document
that the strategic release of updates about receiving funding from busi-
ness angels or venture capitalists attracts additional investors, and also has
a positive effect on the amount of funding accumulated during crowdin-
vesting campaigns launched on the German portals Seedmatch and
Companisto. Ralcheva and Roosenboom (2016) show that companies
are more successful in raising their target amount on the UK-based portal
Crowdcube when they are backed by a business angel. These more sophis-
ticated investors have done the needed screening and due diligence before
deciding to invest in a given company, which is an action small armchair
(crowd)investors can easily free ride on. Other studies consider informa-
tion cascades and confirm that investors indeed follow more informed
and sophisticated fellow investors with public profiles when deciding in
which campaigns to invest (see Hornuf and Schwienbacher 2017, for
evidence from German portals; Vismara 2016, for evidence from
Crowdcube).
Second, crowdinvesting can lead to moral hazard, meaning that the

actions of the entrepreneur may change to the detriment of the crowd
after the investment has taken place. Traditionally, business angels and
venture capitalists deal with moral hazard problems via investment con-
tracts. These investment contracts give them special decision-making
rights, such as the right to appoint one or more directors on the board
and the right to veto company decisions (e.g. the issuance of additional
equity, large investments and the sale of the company or its assets).
Moreover, business angels and venture capitalists often sit on the board of
directors to monitor what the entrepreneur does with the money they
invested. In contrast, none of the (naive) investors engaging in crowdin-
vesting feel individually compelled to start monitoring the entrepreneur
or write an investment contract. This is because they would have to bear
all the costs involved in doing so but would only benefit to the extent of
their fractional ownership in the firm, leaving the vast majority of the
benefits from their efforts to be shared among the other non-monitoring
investors, who would simply free ride on their efforts. By attracting a bal-
anced mix of both naive and sophisticated investors, entrepreneurs might
be able to at least partially address these crowd’s concerns, as sophisti-
cated investors are very likely to engage in monitoring activities. Business
angels and venture capitalists alike have strong incentives to invest time
and resources in systematically reviewing the progress of their portfolio
companies, as they not only put their wealth at stake but also face serious
reputational consequences in case their investees fail. At the same time,
they are more experienced and have high expertise in monitoring, from
which the portion of naive investors can reap significant benefits. What
is more, once traditional investors have invested in a company, they pull
their resources (industry knowledge, networks and services) to help their
investee companies succeed (Gorman and Sahlman 1989). At the time of
writing, there are only a few studies that look into the ex post perfor-
mance of crowdinvesting campaigns and the role of sophisticated inves-
tors. One early study is that of Signori and Vismara (2016) who examine
the expected return on investments of 212 successful equity raisings on
Crowdcube and find that in one out of ten cases investors lose their
money soon after the offering. However, the authors report that none of
the companies backed by a business angel or venture capitals have
s ubsequently failed. This suggests that the monitoring and value-adding

role of traditional investors positively impacts subsequent performance.
In a study of the realized return on investments on German crowdinvest-
ing portals, Hornuf and Schmitt (2016) find that investors’ returns have
been meager (even negative according to their calculations from the
entire German crowdinvesting market between 2011 and 2015) when
compared to the earnings of venture capital funds and the average profits
of a well-diversified crowdlending portfolio. Questioning the viability of
the crowdinvesting market in Germany, Hornuf and Schmitt (2016)
observe, however, that many German portals have now established pool-
ing contracts encouraging the coexistence of the crowd and venture capi-
tal funds to overcome these performance issues.
4.3.3 The Role of Syndication
There are many crowdinvesting portals that have been successful in

attracting a crowd of different types of investors (e.g. AngelList,
Crowdcube, Crowdfunder, MyMicroInvest, SyndicateRoom; see
Table 4.1 for a list of (selected) examples of existing types of portals with
a description of the type of investments they offer). While there is evi-
dence that business angels and venture capitalists actively engage in
crowdinvesting, on portals such as Crowdcube (UK-based) and
MyMicroInvest (Belgium-based), they usually co-invest with the crowd
on the same terms, which means that they do not get compensated for
bringing in their knowledge and expertise. This could, in turn, reduce
their incentives to get sufficiently involved in ex post mentoring and
monitoring, and hence limit the benefits for the other investors. However,
some portals have thought of a unique portal design feature, which
enables them to address this issue by formalizing the relationship between
the entrepreneurs and the different types of investors. For example,
SyndicateRoom (UK-based) facilitates a syndicate-like crowdinvesting,
which necessitates the involvement of an experienced business angel in
every round of investment. On such type of portals, individuals, business
angel groups and/or venture capital funds can form syndicates and invite
other investors to participate in their deals. AngelList, a US-based
Table 4.1 List and description of selected crowdinvesting portals

Portal Description
AngelList US-based website for start-ups that facilitates syndicate
investments by accredited investors, among other things.
Syndicates are brought to the portal and led by experienced
angel investors who have vetted the target investment and
personally invest in the deal they offer, thus demonstrating
their confidence in the investment’s potential. AngelList has
over 200 syndicate leads who are actively bringing deals to
the portal. Source: https://angel.co/
Crowdcube UK-based crowdinvesting portal that offers individuals
(everyday investors as well as professional investors) the
opportunity to invest in start-up, early stage and growth
businesses through equity and debt investment options.
Source: https://crowdcube.com/
Crowdfunder US-based crowdinvesting portal that connects
entrepreneurs to investors online. It manages the
Crowdfunder VC Index Fund, which invests into start-ups
backed by top VCs at their same terms. Selected Fund
investments are then shared with their online investor
network. Source: https://www.crowdfunder.com/
MyMicroInvest Belgium-based crowdinvesting portal that offers
investment opportunities after validating the submitted
portal projects, for which legal information and due
diligence have been completed. In the majority of cases,
one or several professional investors participate in the
financing. It issues Participative Notes upon investment
which mirror a loan or a participation in the capital of the
underlying company in economic terms and give the
owner the right to the same return (interest in case of
loans or capital gains in the case of shares). Source:
https://www.mymicroinvest.com/
Seedrs UK-based crowdinvesting portal that facilitates equity
investments by friends, family, customers, angels and
other independent investors for early stage businesses.
Investors receive protection through a unified nominee
structure. Source: https://www.seedrs.com/
SyndicateRoom UK-based crowdinvesting portal that promotes an investor-
led crowdfunding model by necessitating the
participation of an experienced business angel in every
round of investment. These lead investors play an active
role in evaluating the strengths of the deals they back
and invest their own money. Individual investors are
offered to invest alongside these angel investors on the
same economic terms. Source: https://www.
syndicateroom.com/
investor matchmaking website, offers investment syndicates in which

start-ups raise money from accredited investors investing alongside
prominent angel investors. Even Crowdcube, a portal focused on build-
ing a large base of small investors, is currently introducing different roles
(e.g. a lead role) for investors.
Crowdinvesting syndicates are particularly useful for reducing both
the ex ante and ex post information problems we discussed earlier. Here
a (professional) lead investor posts a deal on the portal seeking the crowd
to co-invest in the company together with her. The lead investor has face-
to-face interaction with the entrepreneur and is compensated using car-
ried interest (i.e. a share of the profits of the investment in excess of the
amount that the lead investor contributes) by the crowd of investors for
value-adding and monitoring services (such is the case of AngelList). This
“carry” plays a key role in that it provides strong motivation for the lead
investors to put in the hard work of correctly evaluating the entrepre-
neurial venture and helping it raise the funds it needs.
In the world of early stage equity financing, syndicates have been tra-
ditionally used by venture capital firms to make investments together
with other venture capital firms, thus sharing a joint pay-off. There are
many benefits associated with venture capital syndication. For example,
syndication can be used as a mechanism to resolve information asymme-
tries and combine knowledge and expertise to make better investment
decisions (Lerner 1994). In addition, by forming syndicates venture capi-
tal firms are able to pull together more capital, but also share the high risk
inherent in early stage investments. Business angels use similar tools to
overcome the information problem and benefit from an improved deal
flow. They organize themselves in angel groups or business angel net-
works in order to collectively evaluate and invest in entrepreneurial
ventures. These groups and networks offer several advantages: they make
larger investments possible, while at the same time reducing the burden
for individual angels; they provide more visibility, which results in receiv-
ing superior deal flow; and they usually include the most sophisticated
and active investors, which allows for superior decision-making (Kerr
et al. 2014). In other words, syndication encourages information flows
and provides opportunities for investors to source high-quality deal flow,
to benefit from additional due diligence and diversify their portfolios.
This syndicate system may prove to be especially effective in crowdin-

vesting in that it encourages information transfer from the more knowl-
edgeable and sophisticated investors to the more naive-type investors
composing the crowd. More importantly, crowdinvesting syndicates con-
fer strong incentives for lead investors to conduct thorough due diligence
and active monitoring.20 Agrawal et al. (2016) coin syndication the “killer
app” of crowdinvesting because they can potentially augment the role of
professional investors, thus allowing for more efficient capital allocation
and enhancing aggregate economic activity.
4.4 Conclusion
In this chapter, we have examined some key features of the crowd and
how they relate to success in crowdfunding and crowdinvesting. In both
business models, the crowd of backers/investors enjoys some extra utility
(the so-called community benefits) over more traditional investors/cus-
tomers. The nature of these community benefits varies across business
models: community benefits are linked to the consumption experience
under crowdfunding and to the investment experience under crowdin-
vesting. Belleflamme et al. (2014) unveil that this difference in the nature
of community benefits is key in determining the entrepreneurial choice
of business model. They show, consistent with empirical observations,
that when the initial capital requirement is relatively small, entrepreneurs
favor crowdfunding and resort to crowdinvesting otherwise.
Their theoretical framework has several entrepreneurial implications.
One implication, well illustrated by the case of Oculus, is the importance
for the entrepreneur to select the right business model given what she can
learn about/from the crowd and what she can extract from the crowd
through the pricing mechanism. Another key implication is that the
crowd–entrepreneur relationship is not foreign to the typical asymmetric
information problems of start-up financing and that when information
asymmetries are more pressing, entrepreneurs tend to opt for crowdin-
vesting, rather than crowdfunding or even crowdlending, in which the
crowd–entrepreneur relationship is by nature more transactional.
Crowdinvesting may thus necessitate complementing entrepreneurs’
relationship with the crowd by implementing various mechanisms miti-

gating more acute information problems. In particular, we have high-
lighted that the backing of sophisticated investors and the formation of
a syndicate of investors do reduce information asymmetries regarding
pre- and post-campaign outcomes.
Notes
1. See, for example, “Facebook to Buy Virtual Reality Firm Oculus for
USD 2 Billion” by Reed Albergotti and Ian Sherr, Wall Street Journal,
March 25, 2014, “Facebook Plays Platform Catch-Up with USD
2 Billion Oculus Deal” by Hannah Kuchler and Tim Bradshaw, Financial
Times, March 26, 2014, or “Facebook Buys VR Startup Oculus for
USD 2 Billion” by Cade Metz, Wired, March 25, 2014.
2. “When Crowdfunding Goes Corporate: Kickstarter Backers Vent over
Facebook’s Oculus Buy” by Victor Luckerson, Time, March 26, 2014.
3. These numbers of the crowdfunding market are sourced from the
Massolution Crowdfunding Industry Report (2015), available at: http://
reports.crowdsourcing.org/index.php?route=product/product&product_
id=54 (last consulted on July 12, 2016).
4. This section partly draws from Belleflamme and Lambert (2014).
5. Cumming et al. (2015) consider different types of crowdfunding models
(i.e. Keep-It-All vs. All-Or-Nothing) and show that they allow to allo-
cate the risk differently between the crowd and the entrepreneur.
Without loss of generality, the discussion in Belleflamme et al. (2014)
does not account for this variation of crowdfunding models.
6. We have here a form of behavior-based price discrimination as consum-
ers self-select into one group and are then charged a specific price cor-
responding to their choice; see Fudenberg and Miguel Villas-Boas (2006)
for a general analysis of behavior-based price discrimination and
Belleflamme and Peitz (2015) for a textbook treatment.
7. See also Sahm et al. (2014), who slightly correct the analysis on profit
sharing and, thereby, simplify it.
8. Ellman and Hurkens (2015) also examine a crowdfunding model that
allows the crowd to pre-order the product and in which entrepreneurs can
commit to produce only if aggregate funding exceeds a defined threshold.
Yet, in their model, pre-ordering does not confer any additional commu-
nity benefit. Their objective is to determine the optimal crowdfunding

mechanism in the presence of two conflicting forces: a high threshold
allows the entrepreneur to set higher prices for high-type buyers, while a
low threshold raises the probability of production. Kumar et al. (2016) also
model threshold choice, but they consider a continuum of consumers.
9. See Chemla and Tinn (2016) whose model emphasizes the importance
of learning about demand as an essential reason why entrepreneurs
engage in the pre-ordering mechanism.
10. Community benefits do not have to be confused with the rewards that
are often offered by entrepreneurs to the participating crowd. Rewards
simply represent, in both business models, a materialization of these
community benefits.
11. See https://www.kickstarter.com/projects/597507018/pebble-e-paper-
watch-for-iphone-and-android/posts/273665 (last consulted on July 11,
2016).
12. This quote is also stressed by Agrawal et al. (2014). See https://blog.get-
pebble.com/2012/05/08/and-one-more-thing/ (last consulted on July
11, 2016).
13. See www.crowdcube.com and www.kickstarter.com/help/stats (last con-
sulted on July 11, 2016).
14. In most cases the products/rewards promised by the entrepreneur are
delivered (see Mollick 2014) in part because a failed delivery history
would also establish a negative reputation of the entrepreneur which
decreases funding success when returning to raise money on Kickstarter
(Li and Martin 2016).
15. According to the Small Business Administration (SBA), only about 50%
of businesses survive five years or longer. See https://www.sba.gov/sites/
default/files/advocacy/SB-FAQ-2016_WEB.pdf (last consulted on
November 28, 2016).
16. Such an exit event might only occur several years after the original invest-
ment, if at all. Hornuf and Schmitt (2016) report that until the end of
2015 only seven start-ups that equity crowdfunded in Germany offered
exit opportunities to their investors.
17. The problem of adverse selection, introduced by Akerlof (1970), can be
illustrated with a simple example. Assume the venture is of either a low-
quality (worth USD 100) or a high-quality type (worth USD 200).
Investors know that there is an equal chance that they are dealing with a
low-quality or high-quality venture but cannot distinguish between the
two. In that case, backers would rationally price the venture at the aver-
age value of (50%*USD 100+50%* USD 200=) USD 150. This implies
an undervaluation of USD 50 for the high-quality venture and an over-

valuation of USD 50 for the low-quality venture. As a result, low-quality
ventures would quickly start to flood the market for early stage finance,
which in the extreme case could lead to a market breakdown where no
venture successfully gets financed.
18. Portals are of course not the only actors capable of mitigating such infor-
mation asymmetries. We refer to Ahlers et al. (2015), Ralcheva and
Roosenboom (2016) and Vismara (2016), among many others, whose
work focuses on entrepreneurs and stresses the role of certification and
quality signals.
19. Traditionally, both business angels and venture capitalists would use their
personal connections and networks, and attend local start-up events or
dedicated start-up conferences as means to access new potential invest-
ment opportunities. The typical way to source vital information would be
through various documents and/or face-to-face communication.
20. Hildebrand et al. (2016) consider incentive effects for group leaders on
the crowdlending portal Prosper. Their results suggest that similarly to
crowdinvesting, group leaders on Prosper much more carefully screen
and choose the listings to be funded when they have sufficient “skin in
the game.”
References
Agrawal, Ajay, Christian Catalini, and Avi Goldfarb. 2014. Some Simple
Economics of Crowdfunding. Innovation Policy and the Economy 14: 63–97.
———. 2016. Are Syndicates the Killer App of Equity Crowdfunding?
California Management Review 58: 111–124.
Ahlers, Gerrit, Douglas Cumming, Christina Günther, and Denis Schweizer.
2015. Signaling in Equity Crowdfunding. Entrepreneurship Theory and
Practice 39: 955–980.
Akerlof, George. 1970. The Market for Lemons: Quality Uncertainty and the
Market Mechanism. Quarterly Journal of Economics 84: 488–500.
Belleflamme, Paul, and Thomas Lambert. 2014. Crowdfunding: Some Empirical
Findings and Microeconomic Underpinnings. Revue Bancaire et Financière 4:
288–296.
585–609.
Belleflamme, Paul, and Martin Peitz. 2015. Industrial Organization: Markets
and Strategies. Cambridge: Cambridge University Press.
Block, Jörn, Lars Hornuf, and Alexandra Moritz. 2017. Which Updates During an
Equity Crowdfunding Campaign Increase Crowd Participation? Small Business
Economics. https://link.springer.com/article/10.1007/s11187-017-9876-4.
Chemla, Gilles, and Katrin Tinn. 2016. Learning Through Crowdfunding.
Crowdfunding Models: Keep-It-All Versus All-Or-Nothing. Social Science
Feb 2017.
Cumming, Douglas, and Yelin Zhang. 2016. Are Crowdfunding Platforms
Active and Effective Intermediaries? Social Science Research Network. https://
papers.ssrn.com/abstract=2882026. Accessed 20 Feb 2017.
Ellman, Matthew, and Sjaak Hurkens. 2015. Optimal Crowdfunding Design.
Fudenberg, Drew, and J. Miguel Villas-Boas. 2006. Behavior-based Price
Discrimination and Customer Recognition. In Handbook on Economics and
Information Systems, ed. T.J. Hendershott, 377–436. Amsterdam: Elsevier.
Gorman, Michael, and William A. Sahlman. 1989. What Do Venture Capitalists
Do? Journal of Business Venturing 4: 231–248.
Hornuf, Lars, and Armin Schwienbacher. 2017. Market Mechanisms and
Funding Dynamics in Equity Crowdfunding. Journal of Corporate Finance.
http://www.sciencedirect.com/science/article/pii/S0929119916302450.
Science 62: 1554–1577.
Kerr, William R., Josh Lerner, and Antoinette Schoar. 2014. The Consequences
of Entrepreneurial Finance: Evidence from Angel Financings. The Review of
Financial Studies 27: 20–55.
Kumar, Praveen, Nisan Langberg, and David Zvilichovsky. 2016. (Crowd)

Funding Innovation: Financing, Constraints, Price Discrimination and
Welfare. Social Science Research Network. https://papers.ssrn.com/
Lerner, Joshua. 1994. The Syndication of Venture Capital Investments. Financial
Management 23: 16–27.
Li, Emma, and J. Spencer Martin. 2016. Capital Formation and Financial
Intermediation: The Role of Entrepreneur Reputation Formation. Journal of
Corporate Finance. http://www.sciencedirect.com/science/article/pii/
S0929119916300487. Accessed 20 Feb 2017.
Merton, Robert K. 1957. Priorities in Scientific Discovery: A Chapter in the
Sociology of Science. American Sociological Review 22: 635–659.
Mollick, Ethan, and Ramana Nanda. 2015. Wisdom or Madness? Comparing
1533–1553.
in Equity Crowdfunding. Social Science Research Network. https://papers.
Sahm, Marco, Paul Belleflamme, Thomas Lambert, and Armin Schwienbacher.
2014. Corrigendum to “Crowdfunding: Tapping the Right Crowd”. Journal
of Business Venturing 29: 610–611.
Crowdfunding. Social Science Research Network. https://papers.ssrn.com/
Vismara, Silvio. 2016. Information Cascades among Investors in Equity
Crowdfunding. Entrepreneurship Theory and Practice. http://onlinelibrary.
wiley.com/doi/10.1111/etap.12261/full. Accessed 20 Feb 2017.
Zhang, Juanjuan, and Peng Liu. 2012. Rational Herding in Microloan Markets.
Management Science 58: 892–912.
Thomas Lambert is an Assistant Professor of Finance at Rotterdam School of

Management, Erasmus University. His research interests are in banking, corpo-
rate finance, entrepreneurial finance and political economy. His work has been
presented at major conferences around the world and has been published in
leading academic journals, including the Economic Journal and Management
Science. Lambert holds a Ph.D. degree in Finance jointly from the Université
catholique de Louvain and Université Lille 2, for which he has received several
awards, including the Banque de France Foundation Prize for the Best Thesis in
Monetary and Financial Economics.
Aleksandrina Ralcheva is a Ph.D. candidate at the Rotterdam School of

Management, Erasmus University. Her interests and research efforts are targeted
towards the financing of young and innovative ventures. She is particularly pas-
sionate about financial technology (FinTech), i.e. crowdfunding, blockchain,
and peer-to-peer transactions in general. She carries the technological curiosity
to explore creative solutions to complex issues surrounding big data, machine
learning and the Internet of Things.
Peter Roosenboom is a Professor of Entrepreneurial Finance and Private

Equity at the Rotterdam School of Management, Erasmus University. His work
has been published in leading finance and accounting journals such as the
Review of Financial Studies, Journal of Financial and Quantitative Analysis, Review
of Finance and Contemporary Accounting Research. Roosenboom is an associate
editor for the Journal of Banking & Finance and the Multinational Finance
Journal. He is a regular advisor to the Dutch government on private equity and
the financing of small- and medium-sized enterprises (SMEs).
5
Fraudulent Behavior by Entrepreneurs
and Borrowers
Christa Hainz
5.1 Introduction
The crowdfunding market is a child of the digital revolution and, although
still in its infancy, it is growing rapidly. Prosper.com, one of the first
crowdfunding platforms to engage in peer-to-peer lending, was founded
in 2006. Just like new products new markets have to demonstrate that
they satisfy needs that would otherwise be unmet. The need addressed by
crowdfunding platforms is to bring supply and demand of capital
together.1 As funding decisions involve significant risks, the platforms
need to build up the reputation that transactions take place in a fair and
trustworthy manner. Otherwise investors are not willing to invest.
To build up this reputation it is important to limit fraudulent behav-
ior. From other financial markets we know that fraud has severely nega-
tive repercussions on the market. There is evidence from the United
States that households in states that are also home to firms involved in
corporate fraud cases reduce their stock market participation (Giannetti
and Wang 2016). In Germany the so-called Neuer Markt (a stock market
C. Hainz (*)
Ifo Institute for Economic Research, Munich, Germany

https://doi.org/10.1007/978-3-319-66119-3_5
80 C. Hainz
for small- and medium-size innovative growth firms) was dissolved in

2003 only a few years after its launch in 1997. One of the main reasons
was that some major corporate scandals, such as misstatement of turn-
over and insider trade, eroded its reputation (Burghof and Hunger 2004).
A similar effect could occur in the crowdfunding market in case of fraud.
As the market is still very young, the negative effects of fraud cases might
be very strong and potentially unfold a destructive power. Fraud by plat-
forms will exert similar negative externalities.
In this chapter we investigate fraud by borrowers and entrepreneurs.
Fraud has many different faces. We use the definition provided by
Cummings et al. (2016, 4) for reward-based crowdfunding and formu-
late it for crowdfunding in general. The investor must verify that the fol-
lowing five different elements are present in order to prove fraud on the
part of a firm: (1) the firm must have made a false statement related to a
material fact, (2) the firm must have known that the statement was
untrue, (3) it must have been the firm’s intention to deceive the investor,
(4) the investor must have reasonably relied on the statements of the firm,
and (5) the investor must have been injured, which is most likely the case
if funds are lost.2
We will begin this chapter by taking an economic perspective on
fraudulent behavior. We use the sketch of a model with asymmetric
information to highlight the role of uncertainty and discuss mechanisms
to reduce the underlying incentives problem. We then review the existing
evidence on potentially fraudulent behavior in the three different crowd-
funding markets and highlight their limitations. We subsequently discuss
those factors that influence the detection of fraud and conclude by offer-
ing some policy implications.
5.2 Asymmetric Information and Fraud

The behavior of agents and the relationship between agents and their
principals is studied in contract theory. The idea underlying the models
in contract theory is that the agents, or in the case of financial services the
firms represented by their managers, have better information than their
principals, the financiers; and that the former use the information asym-
metry for their own benefit. The contract theoretical models deal with
Fraudulent Behavior by Entrepreneurs and Borrowers 81
fraudulent behavior without calling it fraud. As the definition of fraud

has shown, the challenge is to demonstrate that an agent’s behavior is
fraudulent and that the agent took his actions by intent. Contracts can
specify variables that can be observed and verified. However, the agent’s
behavior cannot be stipulated in a contract because it cannot be observed
and verified. At the point in time at which the contract is written there is
uncertainty about the outcome of a project. In the context of finance this
means that the capital that is invested in a project does not generate a
return with certainty, but that there is a distribution of returns. The ulti-
mate return is, in contrast to the agent’s behavior, observable and verifi-
able and therefore can be the subject matter of a contract. We will discuss
two problems of fraud depending on the point in time when it takes
place; the agent can deceive the principal before or after the contract is
concluded.
5.2.1 Adverse Selection
At the point in time before the principal and the agent enter into a con-
tractual relationship the principal cannot observe the agent’s type, that is
whether the agent has a high- or low-risk production technology. The
agent’s type will influence the distribution of the returns and ultimately
returns are observable.
An example of adverse selection from crowdfunding is Kobe beef jerky.
In a Kickstarter campaign Magnus Fun Inc. offered Kobe beef jerky
shortly after the import of Kobe beef to the United States was allowed,
but still heavily regulated. The original goal was to raise USD 2,374. In
fact more than 3,000 backers offered over USD 120,000. A team of
filmmakers detected inconsistencies in the figures of Magnus Fun Inc.
and the campaign stopped briefly before it would have been completed
and the money of the principals could have been lost.3
5.2.2 Moral Hazard
The second problem of asymmetric information arises after the contract

is concluded because the agent cannot commit to a certain behavior, such
as investing the money as promised or exerting effort in managing the
82 C. Hainz
project. This problem can be referred to as moral hazard.4 By exerting

effort the agent increases the probability that the project generates a high
return, enabling the agent to make payments to its principal. Similarly
the agent can divert the funds instead of investing them appropriately,
meaning that the project stands a relatively low chance of proving
successful.
There are two fraud cases from crowdfunding that can serve as exam-
ples for moral hazard. Jen Hintz raised USD 26,000 on Kickstarter for
FibroFibers, an indie yarn-dyeing business. In reality she did not spend
the money on her business, but instead used it to finance her move from
North Carolina to Massachusetts. Another example comes from
GoFundMe. A mother raised money for paying the cancer treatments for
her daughter. The daughter, however, was healthy and the money was
spent otherwise (Fredman 2015).
We want to use the following simple model to illustrate the moral
hazard model for the crowdlending market. Therefore the contracting
parties are called borrower and lender. We study credit contracts in which
borrowers first receive credit and then decide on where to invest the
money. If the borrower invests the money in the proposed project the
probability of success, that is of being able to repay the loan, is pH. If he
does not invest the money as proposed, but uses it for his own purposes,
he will get a private benefit b with certainty, but the project will never
succeed. The borrower has a return of X in the case of success and zero in
the case of failure; returns are assumed to be verifiable. Furthermore, we
assume that investment I is efficient from a social welfare perspective only
if the borrower decides to invest the money instead of taking the private
benefit, that is pH X − I > b. However, the choice of the borrower is not
observable and causes a moral hazard problem. We assume that the bor-
rower possesses assets totaling the amount of A that can be liquidated by
the lender in the case of failure. Thus, the borrower’s liability is limited to
A (<I). The payoffs are depicted in Fig. 5.1. It is worth noting that in the
case of investing as proposed, the payoff might be 0 whereas it is certainly
0 in the case of fraud. Thus, for the investor it is impossible to distinguish
between fraudulent and non-fraudulent behavior in this case because the
agent’s investment decision is not observable. But the lender gets an
imperfect signal as to the borrower’s behavior. Therefore, the contract
Invest
1− 0
Do not Invest 1 0 +b
Fig. 5.1 Moral hazard model for the crowdlending market: payoff structure
terms are the means of solving the moral hazard problem; they must be
set such that they give the borrower an incentive to behave
non-fraudulently.
The principals offer a contract {R; A} to the borrower, in which R is the
repayment in the successful state and A is the liability in case of default.
Although crowdfunding contracts do not specify collateral, borrowers are
liable with all their assets in case of default and A measures the borrower’s
liability.5 In order to solve the moral hazard problem, the credit contract
must satisfy an incentive compatibility constraint (1), which states that
the net payoff for the borrower must be higher when investing in the
project than when taking the money and spending it on for its own pri-
vate benefit. When investing the money the borrower will be successful
with probability pH, generating a return of X and repaying R to the lender.
If the project fails, the borrower will lose all of his assets totaling the
amount of A. When the borrower spends the money for its own benefit,
he gains a private benefit of b, but will certainly lose its assets A.
pH ( A + X − R ) + (1 − pH ) ( A − A ) ≥ A − A + b (1)

pH ( X − R + A ) ≥ b (2)

This equation helps us to understand the problems that may arise

because a project is credit financed. As we assumed that pH X − I > b,
nobody would undertake a fraudulent project with its own means.
However, if it is possible to find a lender that provides a loan, the bor-
84 C. Hainz
rower does not have to bear all the costs of his (non-)investment and
therefore may have an incentive to take the money from the lender and
spend it on its own purposes, getting a private benefit of b. Equation (2)
states the condition a credit contract has to fulfill so that the borrower
will opt for the investment. Comparative statistics provide interesting
insights. The higher the private benefits from diverting the funds, the
higher the incentive to opt for diverting the funds. On the other hand,
the more profitable the investment project, that is the higher the proba-
bility of success pH and the return in case of success X, the lower the
incentive to divert the funds. Most importantly, the terms of the credit
contract influence the borrower’s incentives. The higher the repayment R
and the lower the liability A, the more attractive it is for the borrower to
divert the funds. The lower the liability of the borrower, the more diffi-
cult it will be to write an incentive-compatible contract. Here it is impor-
tant to bear in mind that the lower the difference between (R−A), the
higher the incentive not to divert the funds and invest them as
proposed.
Ultimately there are two ways to address problems of asymmetric
information. The first way is to reduce the information asymmetry. The
second way is to write a contract that gives the borrower an incentive not
to exploit its information advantage. The simple model above has shown
that in the case of moral hazard the difference between the repayment in
the case of success and failure, that is (R−A), should be low.
In the banking context, reducing information asymmetry after the
contract is signed is reached by monitoring the borrower. To this end the
borrower has to document the development of his business regularly by
showing balance sheet and other data to the loan officer. However, moni-
toring imposes a fixed cost on the bank, making it unattractive for small
loan sizes. For microcredit new contractual forms have emerged as a
result. The first microfinance bank, the Grameen bank in Bangladesh,
initially only granted microloans to groups of borrowers with joint liabil-
ity. The idea was to exploit the knowledge that individual borrowers have
about their peers. Thus borrowers would exert pressure on their peers to
repay the loan because otherwise the well-performing borrowers would
have to repay for their defaulting peers.
The microfinance loans have another important feature to improve

incentives. Borrowers can build up a credit history. A good credit history
gives them access to future loans and the size of those loans increases over
time. This means that default leads to a loss of reputation. In our simple
model above this could be captured as a higher liability whereby borrow-
ers do not lose physical assets, but their reputation. The same mecha-
nisms exist when a borrower and a bank have a longer-term relationship
and when information-sharing devices exist in a credit market.
We have just discussed the mechanisms that could solve the moral
hazard problem. Similar mechanisms exist for adverse selection. For
crowdfunding to be successful it must develop ways to solve the problems
created by asymmetric information, as otherwise it will attract fraudulent
projects that are not financed by financial intermediaries that have mech-
anisms in place that solve these problems. An adverse selection problem
therefore exists between different lenders, that is, between platforms and
more generally between the more traditional financial market and the
crowdfunding platforms. In the end there are several adverse selection
problems, one between the lender and the borrower and another one
between different lenders.
5.3 Empirical Evidence on Fraud

No systematic evidence on cases of fraud in crowdfunding has been col-
lected to date. We will provide some evidence on (what we will call)
performance problems in the three different areas of crowdfunding, such
as non-deliveries and defaults.
5.3.1 Reward-Based Crowdfunding
Reward-based crowdfunding differs in several aspects from crowdlending

and crowdinvesting. Firstly, it does not necessarily give a monetary payoff
to the backers, but does provide them some other reward, such as the
product or a giveaway which, for example, may be a documentary of how
a product is made or a project t-shirt. Perhaps as a result it is often not
86 C. Hainz
perceived as an investment by the backers. Legal scholars argue that the

backers’ motivation to provide money is not to finance the development
of the product, but rather to buy rewards or goods. This argument is
illustrated by the Pebble Smartwatch project in which most backers (96
percent of the 68,929) pledged at least USD 99 which was the threshold
above which one obtained the product. If backers wanted to see the
Pebble Smartwatch to be developed, the fraction of contributions below
the threshold should have been (much) higher. From a legal point of view
the parties enter a contract for the design and manufacture of a specific
good. But the important difference to other contracts for purchasing
products on- or off-line is that the goods in reward-based crowdfunding
have not been produced at the point in time the contract is concluded
(Moores 2015).6 This means that there is more uncertainty involved
when purchasing a good via reward-based crowdfunding, which might
often not be fully acknowledged by the parties of the contract, and par-
ticularly by the buyer.
Mollick (2014) studies data on performance problems on Kickstarter.
He uses data on Kickstarter projects from its start in 2009 until July
2012. During that period over 23,000 projects were successfully funded
on the platform (which equals a 48.1 percent share of all proposals sub-
mitted). To see how the projects perform over time the author analyzes
the final outcome of the 471 projects in the categories of Design and
Technology, which had specified delivery dates before July 2012. Among
these 471 projects 381 had outcomes that were clearly identifiable.
Within this group there were 14 projects that failed (or 3.6 percent)
either issuing a refund (3 projects) or stopping to respond to backers
(11). However, among the better-performing projects delivery on time is
not the rule, as only 24.9 percent of the projects were not delayed.
Another 33 percent did not deliver as promised until the end of the sam-
ple period. The projects with a delay (126 projects or 33 percent) deliv-
ered on average 2.4 months later.7
These figures provide some evidence on the performance problems in
reward-based crowdfunding. However, the reasons underlying these
problems can be manifold and range from intentionally deceiving inves-
tors to slipping into such deception, or even a mixture of both.8 Fraud is
only one possible explanation. If a project grants a refund, technical
problems are more likely to explain non-delivery than fraud. If an indi-

vidual stops responding, it could well be that “he ran away with the
money.” This happens in 2.9 percent of the cases in the sample. It is
important to bear in mind that these projects operate under greater
uncertainty than traditional sales, as products have not been produced at
the point in time when they are sold. As a result, Mollick (2014) finds
that delays are more likely if products are promised as compared to
giveaways. The other factors increasing the risk of a delay are the size of
the project and the degree of overfunding. These findings may provide
some indication that performance problems increase with the complexity
of the project as the latter results in uncertain outcomes.
Alternatively, one could look at fraud directly. The challenge here is
that fraud—in contrast to delivery—is not readily observable. Cumming
et al. (2016) search for fraud cases for projects on the two most popular
platforms (Kickstarter and Indiegogo) in nine countries during the period
2010–2015. They not only collect data from the websites of the two plat-
forms but complement it by searching for fraud cases themselves. They
find only 207 fraud cases (which corresponds to a rate of 0.01 percent).
The figures on fraud cases (0.01 percent) and non-deliveries (about 3
percent when deducting the refunds from the non-deliveries) could act as
lower and upper bounds for fraudulent behavior in reward-based crowd-
funding. As fraud is not readily observable, the fraud cases that this figure
is based on are only the tip of the iceberg (we will discuss the detection of
fraud cases below). By contrast, non-deliveries will exaggerate fraudulent
behavior because in an uncertain world non-fraudulent projects also fail.
5.3.2 Crowdlending
There are no figures on fraud in crowdfunding available to date. However,

default rates are observable and are used for research. Just as for non-
deliveries there are many different reasons that lead to a default, and one
of them is fraud.
To determine the performance of a loan it is optimal to study loans
that have matured. Therefore the evidence on loan performance is mostly
on loans that were granted relatively early in the life of the platforms and
88 C. Hainz
have matured already. Iyer et al. (2015) provide a very rich analysis of
peer-to-peer lending on prosper.com (henceforth Prosper). They use data
for the period February 12, 2007 until October 16, 2008. All loans are
unsecured personal loans, with a duration of three years and a fixed inter-
est rate. During this period 194,033 funding proposals were listed, of
which 17,212 were eventually funded (representing 8.9 percent).
The following Table 5.1 from Iyer et al. (2015) provides data on default
for the loans that received funding (funded listings). Default occurs when
the loan is three or more months late at the end of the three-year loan
term. For the entire loan portfolio the default rate is 30.6 percent. Not
surprisingly, the default rate depends strongly on the credit category of
the borrower. Credit categories are assigned by the platform based on the
borrower’s credit score from Experience ScoreX PLUS; they are observ-
able for the lenders. The (Experian ScoreX Plus) credit score uses numer-
ous hard financial variables in its default prediction model. In the lowest
credit category (HR) over half of the borrowers (51.6 percent) default on
Prosper. But even in credit category AA with the best borrowers the
default rate is 14.7 percent.
Table 5.1 Default rates and Funded
expected repayments on listings
Prosper
Mean SD
Loan outcomes
Annual lender interest rate 0.166 0.068
Default dummy 0.306
Credit category HR 0.516
Credit category E 0.424
Credit category D 0.356
Credit category C 0.318
Credit category B 0.305
Credit category A 0.234
Credit category AA 0.147
Fraction of loan repaid 0.797 0.334
Credit category HR 0.625 0.406
Credit category E 0.708 0.377
Credit category D 0.762 0.352
Credit category C 0.793 0.334
Credit category B 0.798 0.329
Credit category A 0.852 0.292
Credit category AA 0.910 0.235
Source: Iyer et al. (2015, 1559)
When considering these figures one has to make several qualifications.

The loans were granted in the United States just before and during the
great recession. This means that borrowers faced a significant macroeco-
nomic shock with a doubling of the unemployment rate. The following
figure shows developments in the rate for repayments that are overdue for
over 30 days among the three major peer-to-peer lending platforms in the
United States over time. This rate is measured on a daily basis and there-
fore is much lower than default rates in Iyer et al. (2015). Moreover, this
rate is calculated taking the delinquencies relative to the loans outstand-
ing at a platform.9 However, the graph shows some interesting dynamics
over time. A short while after the start of the platforms, which was when
the financial crisis hit the real economy, the default rates increased con-
siderably. But in 2010 they fell again and have not changed dramatically
since. It is also interesting to note that although delinquency rates vary
strongly between the different platforms, the differences are much lower
now than in the first few years. Not only the macroeconomic conditions,
but also changes in the way borrowers and lenders interact on the plat-
form in terms of which kind of information borrowers are required to
reveal, for instance, could explain this development.
To put the figures from Iyer et al. (2015) into perspective, one might
compare them to the delinquency rates reported by commercial banks to
the Federal Reserve Board (see Fig. 5.2). Here again the rates are com-
puted as the ratio of delinquent loans to total loans. The highest delin-
quency rates of around 10.5 percent were observed among residential real
estate loans in 2010. The delinquency rate among credit card loans
peaked as early as 2009 at 6.8 percent. By comparison, the current delin-
quency rates (first quarter 2016) are 4.8 percent for residential real estate
and 2.2 percent for credit card loans (Federal Reserve Board 2016). Of
course, these figures depend on the whole population of borrowers and
how it is composed of borrowers of different creditworthiness. Borrowers
in the high-risk loan categories of Prosper are most likely to find it very
difficult, or even impossible, to obtain loans in the formal banking sector.
Indeed, borrowers at Prosper have lower average credit scores than the
general population (610 versus 680, with higher numbers indicating
higher creditworthiness). The detailed data from Prosper makes it possi-
ble to compare default rates for individual loan categories. Here the
90 C. Hainz
0.12
0.10
0.08
0.06
0.04
0.02
0
Jul-07
Jul-12
Jan-10
Jun-10
Jan-15
Jun-15
Dec-07
May-08
Mar-09
Nov-10
Apr-11
Dec-12
May-13
Mar-14
Nov-15
Aug-09
Sep-11
Aug-14
Feb-12
Oct-08
Oct-13
Lending Club 30+ Day Deliquency
Blended 30+ Day Deliquency
Prosper 30+ Day Deliquency
Fig. 5.2 Marketplace lending 30+day delinquency
default rate of 14.7 percent of the best borrowers is higher than the aver-
age figure in the market. Thus borrowers at Prosper were less likely to
repay than their credit rating may have suggested. But we do not know
whether the default happened by intent, or whether the borrowers slipped
into difficulties repaying the loan.
When interpreting this finding we have to acknowledge that the
potential lenders only observe the loan category (as reported in the table),
but not the actual credit score. However, the lending rate the borrowers
are willing to accept may be another important measure from which one
can infer the lenders’ risk evaluation of the loan. It is worth noting that
borrowers on Prosper had to announce the interest rate they are willing
to accept until 2009 when interest rates were determined in a (Dutch
style) auction. Iyer et al. (2015) compare different measures for risk and
find that the predictive power of this announced interest rate outper-
forms that of the credit score: the interest rate is 45 percent more accurate
in predicting default than the credit score. This result provides evidence
that the lenders in peer-to-peer lending make informed choices. They not
only use the hard financial information contained in the credit category
(which is based on the credit score), but they also have soft information
about the borrower that helps them to predict how the loan will perform.
The results also indicate that soft information is particularly helpful for
evaluating the future performance of the borrowers in the lower credit
categories. The most important piece of soft information that influences
the lenders’ evaluation is the maximum interest rate a borrower posts that
s/he is willing to pay.10
Knowing the risk they are taking, lenders should be compensated for
the risk they are bearing. To calculate the expected repayment one needs
to know what the lenders would receive in case of default. If a borrower
does not repay for four months or more, his/her loan is sold to a collec-
tion agency. The proceeds from selling the loan are distributed among the
lenders. As shown in the Table 5.1 in the “fraction of loan repaid” col-
umn, which is calculated from the probability of repayment and the
recovery value Prosper gets from selling defaulting loans to a collecting
agency, the lenders in expected terms get 79.7 percent of the principal.
Thus, in expected terms, the defaults are too high and the recovery rates
too low to be compensated by an interest rate of 16.6 percent. The puz-
zling result of this analysis is that while the lenders seem to be quite good
at rating the risks of loans in relative terms, they do not get enough com-
pensation in absolute terms.
5.3.3 Crowdinvesting
Compared to the other two forms of crowdfunding, crowdinvesting is

relatively new. Unlike for the two other forms, we do not have any evi-
dence from the United States as Title III of the JOBS Act, which sets the
rules for crowdinvesting, did not take effect until May 2016. But there is
some evidence about the performance of firms financed by crowdinvest-
ing from the United Kingdom and Germany. Again, there are no studies
on fraudulent behavior in this market.
In the United Kingdom, the world’s first and largest platform for
crowdinvesting, Crowdcube, was launched in 2011. By the end of 2015
318 equity offerings had been successfully funded. Signori and Vismara
92 C. Hainz
(2016) study 212 initial offerings, the other offerings were left out because
they were too small or were follow-up campaigns. Out of these firms 22
have failed (10.4 percent). Such a failure rate may not seem too surprising
among start-up firms. An investment in the crowdinvesting market
would pay off if the losses could be offset by high returns on successful
firms. The figures available seem to suggest that this is indeed the case.
For the 64 firms (30.2 percent) that are involved in an equity deal after
raising equity by Crowdcube, the average return on the deal is 63.5
percent.
Hornuf and Schmitt (2016) provide similar figures for Germany, but
unlike Signori and Vismara (2016), they calculate actual returns. For
nearly the same period of time, September 2011 until December 2015,
303 campaigns were started on German equity crowdfunding platforms.
210 of these campaigns successfully obtained funding, 54 did not reach
their funding goal and publicly available information is missing for 39
campaigns due to the intransparency of the platform. Among the firms
financed, 85 percent are still operating three years after their incorpora-
tion. This is a higher rate than for the general population of start-ups in
Germany for which the survival rate is 70 percent. This may be due to the
fact that crowdinvesting platforms screen firms and select which firms are
allowed on the platform. Through this process the majority of “appli-
cants” is denied access to the platform (Hornuf and Schwienbacher
2018).
5.4 Fraud and Detection

Data on fraud is scarce because it is not readily observable. The number
of fraud cases observed depends on the prevalence of fraudulent behavior
and on the probability of fraud being detected; and there is even an inter-
action between the two processes (Wang 2013).
The model outlined in Sect. 5.2 shows the parameters that influence
whether an agent chooses a fraudulent project. Basically, the higher the
private benefit of diverting the funds are relative to the net return of a
project, the more likely fraud is to occur. This formulation does not take
behavioral aspects into account like preferences for truthfulness or self-
concept maintenance (Gibson et al. 2013; Hornuf and Haas 2014).11
Although the behavioral aspects might change the trade-offs for part of
the population, and thereby the number of fraud cases, the comparative
statistics of the model still provide important insights. The model has
shown that the net payoff received by the agent in cases with success rela-
tive to failure influences the choice. Thus, it depends on the contract, in
the case of crowdlending on the loan contract, what the incentives are.
Ultimately the contract should be such that the agent’s payoff in case of
success is high relative to the case of failure. In the contracts offered by
banks or microfinance organizations, this is achieved through the collat-
eralization of physical assets, through social collateral, group contracts or
reputation effects.
Thus, the challenge for crowdfunding platforms is (1) to reduce infor-
mation asymmetries themselves and (2) to offer contracts that give incen-
tive for non-fraudulent behavior. To reduce asymmetric information,
either the platform itself or the principal (the backer, the lender or the
investor depending on the type of crowdfunding) needs to collect infor-
mation about the agent. There seem to be very different attitudes towards
the involvement of the platforms depending on the type of crowdfunding
in question. In crowdinvesting platforms screen firms ex ante and reject a
large share of the proposed offers (Hornuf and Schwienbacher 2018). For
potential investors too, the widespread availability of information made
possible by the digital revolution provides new possibilities for screening
and monitoring projects (for more details see, Morse (2015) and Vismara
(2017), in Chap. 3 of this book). Agents, for instance, can describe their
projects on the platform and even show videos of their products.12
Ultimately, there is a lot of soft information in their appearance: text
features, for instance, can help to predict default (Gao and Lin 2015).
However, as research shows which features are more often used by failing
or fraudulent projects, the dishonest agents can adjust their behavior
(Morse 2015).
The design of the contracts plays a crucial role for the agent’s incentives.
This is demonstrated for crowdlending on Prosper. Hildebrand et al.
(2017) study the incentives of group leaders in lending. On Prosper every-
body can become a group leader or member. The group leader has the
right to allow new members into the group and to deny access. Moreover,
94 C. Hainz
the group leader can request additional information from members, as

well as reviewing the members’ new listings. The group leader used to be
able to decide whether to offer its service for free or to demand a reward.
These rewards were eliminated by Prosper at some point in time. The
authors use this change in the platform’s policy and show in a difference-
in-difference-analysis that the rewards had adverse effects on group leader
incentives, leading to higher default rates (and lower interest rates). This
example demonstrates how important the policies of platforms are for the
outcomes of the contracts that are concluded.
We have acknowledged that evidence on fraud cases is scarce. This
should be due to the fact that fraud has not been detected to date. The
wave of corporate scandals in the United States since the turn of the mil-
lennium inspired researchers to investigate corporate fraud. Dyck et al.
(2013) estimate that the probability that a firm in the United States com-
mits fraud is 14.5 percent. In their estimation they use the fact that after
the demise of the auditing company Arthur Anderson, firms had to
change their auditor. In these firms three times more fraud cases were
detected. Based on these figures, the authors conclude that three out of
four fraud cases remain undetected; and they use this figure to estimate
the total fraud from observed fraud.
The relationship between detected and undetected fraud cases depends
on whether there are incentives for reporting fraud. Therefore it is instru-
mental to know who reports fraud cases. Dyck et al. (2010) study a sam-
ple of 216 corporate fraud cases taking place between 1996 and 2004 in
the United States. They find that the SEC and auditors account for 17
percent of the detected cases, debt and equity holders for 3 percent, short
sellers for 11 percent, equity holders’ agents (analysts and auditors) for 24
percent, employees for 17 percent, non-financial-market regulators for
13 percent and the media for 13 percent. The crowd is missing in the
enumeration, but might be relevant as the following example suggests:
“[…] Mythic: The Story of Gods and Men was a 2012 Kickstarter cam-
paign for a videogame. Research by potential backers revealed that the
creators plagiarized nearly all of the components of the campaign. With
this information revealed to the public, the project creator withdrew the
campaign before reaching the funding goal and backers did not lose any
money” (Moores 2015, 406).
Generally, the incentive to report fraud will depend on the cost of

gathering the information relevant for detecting fraud and the rewards
that could result from a legal obligation, from a residual claim or from
reputation. On the one hand, one would argue that the widespread avail-
ability of information, in particular for firms that operate mainly online,
which is often the case for firms seeking crowdfunding, implies that the
(monetary) costs of gathering information are low. On the other hand,
the return on exerting this effort for the individual investors is also low if
they have invested a small amount, which is often the case. Thus, there is
a coordination problem between the large number of investors. Unless
there are other mechanisms, like reputation, which increase the benefit of
a single investor, incentives for fraud detection should be low among
investors. As crowdfunding firms differ in many respects like size, age and
sector from the larger corporations, some of the groups listed above that
may possibly detect fraud like non-financial-market regulators or equity
holders’ agents might simply drop out as potential fraud detectors.
5.5 Conclusions and Policy Implications

Although fraud certainly exists in crowdfunding, evidence is scarce. This
chapter discusses the incentive to engage in fraud and identifies that the
terms of the underlying contract influence the incentives. The reduction
of information asymmetries can also help to limit fraud. The fact that we
observe hardly any fraud cases may be due to low incentives to detect
fraud. Although the costs of gathering information leading to the detec-
tion of fraud in crowdfunding might be lower than in the corporate
world in general, the benefits could be lower as well. If only a small
amount of money is at risk, the low costs in absolute terms might be high
in relative terms.
As the crowdfunding markets are young, they need to establish a repu-
tation for being a “fair market place.” Therefore, market-based mecha-
nisms that try to avoid fraud are essential. One important measure is
suggested by the financial analysts’ roundtable: “Crowdfunding platforms
must develop and adopt disclosure standards that make identifying and
tracking issuers easy. Such standards may include unique identifiers for
96 C. Hainz
both individuals and companies that seek financing, and they should
require issuers to provide full legal names and brief biographies of all
principals” (Conrad et al. 2016). This may help to reduce asymmetric
information between different platforms and between other financial ser-
vice providers more generally; and thereby makes collecting information
cheaper. It also allows the agent to build up a reputation as a trustworthy
contracting party that acts as social collateral. Another important aspect
is that platforms need to carefully design the rules that determine how
contracts are formed and the incentives they provide for different groups
of participants. Finally, a potential drawback of transparency must be
mentioned: “The problem with uncovering success cues is of course once
they are disclosed, their predictive power disappears” (Morse 2015, 469).
Acknowledgment I would like to thank Manuel Wiegand for helpful discus-

sions and comments. Of course, all remaining errors are my own.
Notes
1. Note that crowdfunding platforms usually do not offer services tradi-
tional financial intermediaries like banks offer (e.g. screening or moni-
toring in the case of crowdlending).
2. Cumming et al. (2015) provide an overview on the literature on finan-
cial market misconduct in general.
3. See http://money.cnn.com/2013/06/17/technology/kickstarter-scam-kobe-
jerky/ and http://www.digitaltrends.com/cool-tech/biggest-kickstarter-
and-indiegogo-scams/.
4. We do not study the third problem of asymmetric information, costly
state verification. It arises after the returns of the project to be financed
are realized. The entrepreneur could claim that the project was not prof-
itable although it was and he diverted the project’s return of this own
purposes.
5. In countries with a well-functioning legal system the claims can be
enforced. The crowdlending platform Prosper, for example, sells its out-
standing debt to a collection agency (see Sect. 5.3.2).
6. Note that there might be a tension between timely delivery and the qual-
ity of the product (Moores 2015).
7. The literature does not always acknowledge this difference. For example,
Moores (2015, 402) gives the following reference to Mollick (2014):
“Recent figures suggest that less than five percent of crowdfunding proj-
ects result in fraud” (highlight by CH).
8. The mini drone Zano raised EUR 3 million on Kickstarter in the United
Kingdom. When they stopped responding Kickstarter asked a journalist
to investigate the case. He found that the firm was surprised by its large
funding success and the huge demand. At the same time the firm did not
describe the state of development properly initially (Nezik 2016).
9. Note that therefore we cannot directly compare the default rates.
10. Prosper changed the design and now determines the interest rates itself.
11. Other behavioral economic effects are not modeled either. Schwartz
(2015, 566) argues that “Crowdfund investors with negative returns will
not simply have lost their money, but rather they will have spent it (at
least in part) on nonpecuniary benefits, including entertainment, politi-
cal expression, and community building.” While investors may derive
utility from these benefits, they may also suffer from being deceived.
12. This gives rise to another type of fraudulent behavior, namely stealing of
ideas, as the example of a smartphone case selfie-stick shows that was
posted on Kickstarter and copied by a Chinese manufacturer (Horwitz
2016).
References
Burghof, Hans-Peter, and Adrian Hunger. 2004. The Neuer Markt—An
(Overly) Risky Asset of Germany’s Financial System. In The Rise and Fall of
Europe’s New Stock Markets (Advances in Financial Economics Vol. 10), ed.
Giancarlo Giudici and Peter Roosenboom, 295–327. Bingley: Emerald
Group Publishing Limited.
Conrad, Jennifer, Jonathan Karpoff, Craig Lewis, and Jay R. Ritter. 2016.
Statement of the Financial Economists Roundtable: Crowdfunding. Financial
Analysts Journal 72: 14–16.
Cumming, Douglas, Robert Dannhauser, and Sofia Johan. 2015. Financial
Market Misconduct and Agency Conflicts: A Synthesis and Future Directions.
Journal of Corporate Finance 34: 150–168.
Cumming, Douglas, Lars Hornuf, Moein Karami, and Denis Schweizer. 2016.
Disentangling Crowdfunding from Fraudfunding. Max Planck Institute for
98 C. Hainz
Innovation and Competition Research Paper, No. 16-09. https://ssrn.com/

Dyck, Alexander, Adair Morse, and Luigi Zingales. 2010. Who Blows the
Whistle on Corporate Fraud? Journal of Finance 65: 2213–2253.
Dyck, Alexander, Adair Morse and Luigi Zingales. 2013. How Pervasive is
Corporate Fraud? Rotman School of Management Working Paper No.
2222608. doi: https://doi.org/10.2139/ssrn.2222608
Federal Reserve Board. 2016. Charge-Off and Delinquency Rates on Loans and
Leases at Commercial Banks. https://www.federalreserve.gov/releases/char-
geoff/delallsa.htm. LAst modified 18 May 2016.
Fredman, Catherine. 2015. Fund Me or Fraud Me? Crowdfunding Scams are on
the Rise. Consumer Reports, October 5. http://www.consumerreports.org/
cro/money/crowdfunding-scam. Accessed 22 Mar 2017.
Gao, Qiang, and Mingfeng Lin. 2015. Lemon or Cherry? The Value of Texts in
Debt Crowdfunding. Working Paper. doi: https://doi.org/10.2139/
ssrn.2446114
Giannetti, Mariassunta, and Tracy Yue Wang. 2016. Corporate Scandals and
Household Stock Market Participation. Journal of Finance 71: 2591–2636.
Gibson, Rajna, Carmen Tanner, and Alexander F. Wagner. 2013. Preferences for
Truthfulness: Heterogeneity Among and Within Individuals. American
Economic Review 103: 532–548.
Hornuf, Lars, and Georg Haas. 2014. Regulating Fraud in Financial Markets:
Can Behavioral Designs Prevent Future Criminal Offences? Journal of Risk
Management in Financial Institutions 7: 192–201.
Hornuf, Lars, and Armin Schwienbacher. 2018. Internet-Based Entrepreneurial
Finance: Lessons Form Germany. California Management Review. Forthcoming.
Horwitz, Josh. 2016. Your Brilliant Kickstarter Idea Could be on Sale in China
Before you’ve Even Finished Funding It. http://qz.com/771727/chinas-facto-
ries-in-shenzhen-can-copy-products-at-breakneck-speed-and-its-time-for-
the-rest-of-the-world-to-get-over-it/. Accessed 22 Mar 2017.
Science 62: 1554–1577.
Mollick, Ethan R. 2014. Delivery Rates on Kickstarter. Social Science Research

Moores, Christopher. 2015. Kickstart My Lawsuit: Fraud and Justice in
Rewards-Based Crowdfunding. UC Davies Law Review 49: 383–424.
Morse, Adair. 2015. Peer-to-Peer Crowdfunding: Information and the Potential
for Disruption in Consumer Lending. Annual Review of Financial Economics
7: 463–482.
Nezik, Ann-Kathrin. 2016. Sauercrowd. Spiegel 34: 64–66.
Schwartz, Andrew. 2015. The Nonfinancial Returns of Crowdfunding. Review
of Banking and Financial Law 34: 565–580.
Crowdfunding. Social Science Research Network. http://ssrn.com/
Vismara, Silvio. 2017. Signaling to Overcome Market Inefficiencies. In The
Economics of Crowdfunding Startups, Portals and Investor Behavior, ed. Douglas
Cumming and Lars Hornuf. London: Palgrave Macmillan.
Wang, Tracy. 2013. Corporate Securities Fraud: Insights from a New Empirical
Framework. Journal of Law, Economics and Organization 29: 535–568.
Christa Hainz is Senior Researcher and Deputy Head of the Ifo Center for
International Institutional Comparisons and Migration Research. She was assis-
tant professor at the University of Munich and guest professor at the University
of Augsburg and visited the New York University and SITE at the Stockholm
School of Economics. Her research focuses on banking, corporate finance and
institutions. Her work has been published in the Economic Journal, the Journal
of Public Economics and the Journal of Comparative Economics. She recently wrote
an expert report for the Federal Ministry of Finance on the Small Investor
Protection Act.
Part II
Market Structure
6
Fintech and the Financing of SMEs
and Entrepreneurs: From Crowdfunding
to Marketplace Lending
Mark Fenwick, Joseph A. McCahery,
and Erik P.M. Vermeulen
6.1 Introduction
Bank lending to small and medium sized enterprises (SMEs) has changed
dramatically since the time of the financial crisis of 2008. That shouldn’t
be too surprising. Banks’ lending capacity shrank between 2008 and
2013 due to higher risk aversion in a time when economic growth had
slowed. The higher sensitivity to external market shocks led to changes in
the supply of short- and long-term financing to SME borrowers. In the
Netherlands, for example, we observed a 6–8% year-on-year decline in
M. Fenwick (*)
Kyusha University – Graduate School of Law, Fukuoka, Japan
J.A. McCahery
Faculty of Law and Tilburg Law and Economics Center, Tilburg University,
Tilburg, The Netherlands
E.P.M. Vermeulen
Tilburg Law and Economics Center, Tilburg University,
Tilburg, The Netherlands

https://doi.org/10.1007/978-3-319-66119-3_6
104 M. Fenwick et al.
bank loans to SMEs and the highest loan rejection rate in Europe (OECD
2013). SMEs continue to face numerous obstacles in borrowing funds
because they are small, less diversified, and have weaker financial struc-
tures. Moreover, ample evidence suggests that smaller companies face
greater perceived and actual constraints than larger firms. Collectively,
they have been considered unfavorable borrowers due to their difficulty
in providing high-quality collateral or their relative opaqueness with
respect to their creditworthiness (Boot et al. 1991; Ayadi and Gadi 2013).
In recent years, policymakers and researchers have increasingly begun
to explore the impact of the recent financial crisis on the rationing of
credit. The effect, in the case of SMEs, was on the reduction income
reflected in their balance sheet and overall collateral levels. Not only did
small businesses look less creditworthy, but they also faced greater per-
ceived and actual constraints than larger firms and that this would play a
critical role in the narrowing of available finance options (European
Central Bank 2015). Also, data on small business credit scores, such as
PAYDEX, indicate that lending to small business is lower than before the
financial crisis (Mills and McCarthy 2014). While bank loans remain of
vital importance for small businesses, changes in lending standards have
placed significant demands on banks focused in the SME, prompting a
significant decline in small business credit. The literature suggests that
regardless of the change in credit conditions in 2014, lending standards
remained comparatively tight and interest rates high for SMEs in coun-
tries hard hit by the financial crisis (OECD 2016).
There are a number of specific, efficient strategies that have been devel-
oped and demonstrated to alleviate credit rationing. In general, these
strategies involve three types of mechanisms. First it is clear that the pres-
ence of information asymmetries and principal/agent problems may
induce sellers of financial service to offer products that, due to monitor-
ing problems, leave potential borrowers without access to credit. Past
studies show that banks’ local network ties and relationships have reduced
the uncertainties and mitigated some of the risks opportunism associated
with bank lending to SMEs. Moreover, this literature has emphasized
how enabling environmental initiatives may have actually reduced infor-
mation asymmetries by establishing effective monitoring techniques.
Second, the use of collateral gives the SME with a serious credit problem
Fintech and the Financing of SMEs and Entrepreneurs... 105
an incentive to repay the loan. Research suggests that if collateral is not

available, a credit guarantee system offsets the reduced reliability of non-
audited financial statements and may improve access to credit as well as
improve loan terms (Beck et al. 2010). So, if collateral is not available, a
credit guarantee system for SMEs that offsets the reduced reliability of
non-audited financial statements may improve access to credit as well as
improve the loan terms. Thus, governments tend to invest in a loan guar-
antee program because they address the market imperfections that cause
credit restrictions to SMEs and spur innovation in the SME sector. The
presence of the guarantee can result in a lower rate paid for the loan.
However, as banks retreat from SME financing, strong online lending
has made it easier for low-income businesses and small young firms to
secure credit without government support (OECD 2015). This growth
of alternative online lending has supplied new competition to traditional
banks and venture capitalists, and is beginning to disrupt the tradition of
business of lending in a number of ways—not only by bringing competi-
tion to the corporate market, creating efficiencies and competition that
reduces online risk, but also making SMEs more profitable (Ahmed et al.
2017). Another important consequence of the new models of finance is
the reduction of systemic risk and more diversified lending options.
Established industry players confronting the reality of alternative online
platforms are improving the profitability of small business lending
(Deutsche Bank 2017).
More specifically, the booming demand for fintech—broadly defined
as the use of new technology and innovation to compete in the market-
place of financial institutions and intermediaries—is the result of fast
funding and online applications, which has lowered costs for their cli-
ents. This, in turn, has helped these lenders in the United States, for
example, to become an important provider of capital to low-income busi-
nesses and small young firms while helping to bridge the funding gap in
the SME credit market (GAC 2015).
Fintech has disrupted or is disrupting the financial service sector in at
least three ways. First, online platforms, which differ from traditional
funding channels, allowing financial service providers to offer a wide
range of new services that remove intermediaries and administrative lay-
ers to make transactions more effective and less prone to error. In this
way, financial services are decentralized and made flatter. Most obviously,
there is the growth of mobile banking that allows customers to perform a
wide range of transactions online. Second, networked access to financial
services facilitates quicker access to all manner of transactions from
checking financial status, making payments, and withdrawing and trans-
ferring funds. Third, behind-the-scenes activities of financial institutions
are similarly transformed. In part, this involves the use of Big Data to
deliver a more efficient service, but it also allows firms to use technology
to manage legal risk more effectively. Finally, in the absence of industry-
wide standardization (i.e., no capital requirements) it is clear that peer-
to-peer (‘P2P’) platforms will enjoy lower operating and capital expenses
compared to traditional banks.
To many observers, one of the most disturbing aspects of the 2008
financial crisis was the subsequent introduction of vast swaths of new
banking regulation. The rapid introduction of regtech—which involves
using new technologies to meet regulatory and compliance require-
ments—suggests that using big data analytics allows firms to accelerate
the cumbersome and costly process of implanting new regulation. There
are a number of areas of compliance and reporting where technology can
have significant benefits, such as risk data aggregation, modeling and
real-time transactions monitoring. Machine learning, artificial intelli-
gence, and biometrics have been particularly promising in tackling com-
pliance challenges.
Fintech has also facilitated the emergence of start-ups that offer an
alternative source of financial services. Fintech lenders, including equity
crowdfunding, invoice and supply chain financing, and marketplace
lending, are beginning to challenge traditional business models in a num-
ber of ways—not only by bringing competition to the corporate market,
creating efficiencies and competition that reduces online risk, but also
making SMEs more profitable (WEF 2015). In particular, app-based
companies are emerging everywhere. They challenge and disrupt incum-
bents, such as traditional banks, by supporting a wide range of financial
services, namely marketplace lending platforms; equity crowdfunding
platforms; insurance services; algorithm-driven robo-advisors offering
smarter, more personalized financial advice; and blockchain-based
crypto-currency and payment systems. This trend is borne out by the
Fig. 6.1 Global venture capital investments in fintech start-ups
investment data. Since around 2010, more and more investment is being
made into fintech. And even though deal activity has slowed over the last
year, there is little evidence that indicates that fintech is likely to perma-
nently stall or collapse (see Fig. 6.1).
Millennials—defined as the demographic cohort that reached matu-
rity around 2000—are thought to be one of the primary drivers of fin-
tech innovation. To begin, millennials are prompting changes in the need
of firms to focus on the consumer. Three aspects of the contemporary
consumer expectations that seem pertinent in this context include state-
of-the-art consumer experience, speed, and convenience (PWC 2016).
The delivery of innovative fintech solutions will require a degree of coop-
eration between multiple partners, including millennials, as stakeholders
and investors, in maintaining a focus on the core task of innovating.
In this chapter, we examine how fintech lenders target the SME seg-
ment, connecting companies and investors that want to lend or provide
some form of equity capital or debt to start-ups. To gain a better under-
standing of the online alternatives to bank financing, we provide an over-
view of the different platforms and external financing providers such as
crowdfunding, peer-to-peer and marketplace lenders. We also discuss the
factors responsible for the expansion of these well-developed credit sys-
tems to SMEs and the ecosystem that supported the creation of a

sector-
wide secondary market. The question that arises, however, is
whether fintech’s low-cost expansion of credit to SMEs and individuals,
based on a more efficient credit-assessment model, weaker underwriting
standards, and packaged loans to institutional investors, could persist in
the long run, and eventually become more profitable than traditional
banks. A significant body of literature has already sought to explain these
developments. On the one hand, new market mechanisms can facilitate
the introduction of explicit barriers to entry and new systems that become
oligopolies and other forms of intellectual property protection where the
governance and enforcement issues are quite difficult to enforce. On the
other hand, through such well-designed mechanisms, such as platform
ecosystem, the business benefit would be large leading to low-cost trading
systems that are open-access, transparent, and facilitate economic growth.
Recent studies show that that current of regulatory approach to fintech
and its financial practices are blocked by significant political economy
and coordination costs and are to promote much structural change
(Philippon 2016). In this chapter, we investigate the regulatory response
to fintech start-ups, distinguishing between two broad categories of
response—reactive and proactive.
The plan of this chapter proceeds as follows. Section 6.2 provides a
comprehensive overview of the crowdfunding platforms, analyzing the
advantages and disadvantages of the different portals and whether equity
crowdfunding platforms will provide a competitive new funding channel
for young companies and SMEs. Section 6.3 examines the features of the
peer-to-peer and marketplace lending process, including the lenders,
lending, and credit process. Section 6.4 will then discuss the results of our
empirical analysis of the regulatory determinants that have influenced the
formation of fintech start-ups in 12 countries. Section 6.5 concludes.
6.2 Crowdfunding
Crowdfunding is a method for raising finance in which start-ups can sell
directly or indirectly shares or equity in a company to a group of investors
through the Internet. Historically, crowdfunding has evolved from a way
to finance creative projects, such as books, films, and games, into a new
type of entrepreneurial finance which has the potential to dramatically
change the venture capital ecosystem. Crowdfunding makes it possible
for early-stage start-up companies to raise ‘venture capital’ from a large
group of individuals, sidestepping the traditional fundraising process that
includes lengthy due diligence periods and tough negotiations over the
pre-money valuation and contractual terms. The ‘crowd’ investors, who
invest relatively small amounts through Internet-based platforms (crowd-
funding websites) and/or through social networks—such as Facebook,
Twitter, and LinkedIn—need less contractual protection (the small
investment amounts do not justify close involvement in the growth pro-
cess of the start-up companies).
As noted above, accessibility and speed are the key drivers behind the
emergence and development of crowdfunding platforms. Another factor
likely to influence the rise of crowdfunding platforms is that they can
generate information about risks that can be interpreted as effective sig-
nals of project quality and thus effect the probability of funding success
(Ahlers et al. 2015). Thus, in addition to providing access to information
about credit scoring of potential borrowers, the platforms allow investors
through real-time notifications of lender bids on projects to diversify
their portfolio of investments (Morse 2015).
In their quest to answer these questions, many academics have exam-
ined crowdfunding from an economics perspective. Within economics,
there have been several approaches to the study of crowdfunding, includ-
ing the ‘wisdom of the crowds’ perspective. Management researchers have
also begun to look at why investors are likely to enter a crowdfunding
platform. Underlying this view, investors on equity crowdfunding plat-
forms tend to be a dispersed group who invest small denominations in a
start-up, and have little incentive to do due diligence research before the
investment and thereafter the investment will monitor managerial effort.
Platforms can attract investors by offering their own due diligence and
process a project before it is offered to the public or is likely to turn to
co-investment with a business angle or VC firm.
While these mechanisms have been influential and helpful, there exists
a wide array of mechanisms, each of which could be more or less signifi-
cant in shaping the dynamics of the business relationship. For example,
the Australian platform ASSOB requires every start-up to engage in a

business relationship with a professional business advisor, who guides the
company through the process and monitors the company after the offer-
ing. Note that the British platform, Crowdcube, discloses the largest
investment in a project. Underlying this approach is the view that if the
largest investment is highly proportional to the total amount, this signals
to the market that there is a higher chance of monitoring and due
diligence.
We can roughly distinguish among four categories of crowdfunding
platforms: (1) donation-based crowdfunding; (2) reward-based crowd-
funding; (3) lending-based crowdfunding; and (4) equity-based crowd-
funding. If investors follow the donation-based crowdfunding model,
they generally contribute to a charitable, creative, or social project
without the expectation of being compensated. The donation model
stands in contrast to the reward-based model where the ‘crowd’ that
decides to donate receives a reward, such as a finished product, perks,
or recognition in the credits of a movie, in return. The popularity of the
latter approach is confirmed by the results that it is the second largest
sector within European online alternative market (E&Y 2015, see
Fig. 6.2).
Given the apparent benefits, start-up companies and entrepreneurs
typically use lending-based crowdfunding and equity-based crowdfund-
ing to attract investments from the general public. Lending-based and
equity-based crowdfunding are jointly called ‘investment crowdfunding’.
If the companies grow and prosper, the investors usually receive a finan-
cial return. For example, in the lending-based model, they will receive
their investment back plus interest (the rate of which is dependent on the
risk level). Investors that contribute cash through equity-based crowd-
funding platforms indirectly or directly become beneficial owners or
shareholders of the start-up company.
Equity-based crowdfunding increasingly attracts attention from start-
up companies, investors, and the media. This is not surprising since
recent research on equity crowdfunding platforms suggests that they, in
the presence of information asymmetries, are likely to mitigate distance-
related costs, such as monitoring investments, in early-stage financing
(Agrawal et al. 2015). That said, it is only to be expected that the number
Lending
14%
Dona on, Philanthropy and Sponsorship

45%
Invesng (Equity, Profit and Revenue Sharing)

41%
Fig. 6.2 Crowdfunding platforms in Europe in 2015
of equity-based crowdfunding platforms will increase further in the near

future as we increasingly observe several regulatory initiatives that are
intended to give a boost to equity crowdfunding (by increasingly allow-
ing non-professional investors to participate in deals).
So far, we have been focusing on the growth of equity-based platforms.
An important source of participation is the within-group effects of
funders and fundraisers on crowdfunding platforms. Faced with cross-
group and within-group external effects, crowdfunding platforms need
strategies to effectively mitigate coordination failures while minimizing
the risks posed by asymmetric information as the number of potential
fundraisers on the platform increases (Belleflamme et al. 2016). Scholars
have sought to show that within the group of funders, it is likely that the
external effects will be positive. Applied to the design of crowdfunding
platforms, these studies show that the external effects are positive if a
project has to reach their funding goal, reducing the risk that undercapi-
talized projects may be realized. For example, the ‘All-Or-Nothing’
(AON) or fixed-funding model, which has been adopted by most plat-

forms, allows the fundraiser to collect any funds received if they reached
the specific goal by the end of the campaign period. In practice, a second
model has emerged. The ‘Keep-It-All’ (KIA) model permits fundraisers to
keep any of the money raised even if they raised only part of the threshold
level. In the latter context, fundraisers are charged higher fees on the
money that was raised in the unsuccessful campaign.
Current research on non-price strategies suggests that fundraisers may
prefer the flexibility of the KIA model. To check this claim empirically,
Cumming et al. (2015) recently compared the AON versus KIA models
based on the Indiegogo platform that offers firms the option to choose
between the two models. In comparing the two different models, they
analyze the company types that use a particular funding model as well as
their disclosures and success. They find evidence that is consistent with
the view that AON fundraising campaigns have larger fundraising targets
for their projects and tend also to be successful in realizing their capital
goals. Moreover, they show that the KIA model is likely to be used by
firms that can scale their business. Thus, the results in Cumming et al.’s
study indicate that flexible platforms are likely to be attractive to a num-
ber of firms, creating sustainable user growth, for example, of Indiegogo’s
fund.
Another factor likely to influence the dynamics of investor behavior is
whether investors have a public profile. In fact, an informational advan-
tage may occur when investors have chosen a public profile. This infor-
mation in turn may lead to more bids as well as interest from other
investors. Prior research points to numerous examples of investors with
expertise, particularly venture capitalists and business angels are likely to
disclose this information and their investment decisions, particularly in
first-come-first-served environments. Vismara (2016) found, using a
sample of 111 equity offerings posted in 2014 on Crowdcube, informa-
tion cascades among individual investors are crucial for the success of
crowdfunding campaigns. For example, successful campaigns have a
higher fraction of public investors, particularly in the first five days of the
launch. Looking at the numbers, most investors prefer not to make their
profile public. However, Vismara further showed, using a group of 200
public profile investors in Crowdcube, that the public profile investor
numbered more than 4.8 investments in the platform whereas the aver-
age made 2.7 investments. He then mapped the public profile investors
to their level of entrepreneurial and project-specific expertise and found
that 88% of the public profile investors had entrepreneurial and start-up
skills and 44% had experience in the funded project’s industry. In com-
bination with augmented data from Crunchbase, the results support the
view that public profile investors are more likely to be sophisticated than
other blind investors.
The importance of signaling to potential small investors in a start-up is
also likely to have implications for the success of proposed campaigns. In
the context of hidden information, start-up firms tend to employ a range
of signals to induce investors to devote resources to the project. Some
evidence from a recent study, Ahlers et al. (2015), reveals that the signals
that investors are more likely to rely on, as a proxy for project quality,
include the number of board members, and board experience, measured
in terms if a board member has an MBA. Yet external certification (pat-
ents and government grants) has no impact on the probability of attract-
ing investors.
Despite its popularity and growth, equity crowdfunding poses sev-
eral challenges. First, it requires some experience in making a pitch to
smaller investors (Lewis 2013). Moreover, there are usually no one-to-
one conversations with interested investors. All the relevant informa-
tion should be made available upfront, which in turn could easily lead
to confidentiality and transparency issues. Second, unlike business
angels and venture capitalists, crowdfunding investors typically do
not intensively monitor and support the business in the post-invest-
ment period. Current research suggests that, in order for the start-up
to succeed, risk investors must be willing to provide the entrepreneur
with ‘value-added’ services. These services include identifying and
evaluating business opportunities, including management, entry, or
growth strategies; negotiating further investments; tracking the port-
folio firm and coaching the firm participants; providing technical and
management assistance; and attracting additional capital. When
assessing the potential of crowdfunding, the absence of real value-
added services could become significant and may have the potential to
retard growth.
The third challenge is that crowdfunding may lack connectivity to

follow-on investors, key stakeholders, and other advisors. High-potential
growth companies, particularly in highly capital-intensive sectors (such
as biotechnology and medical), must be able to attract follow-on funding
from later-stage investors. The connectedness between early-stage inves-
tors and the venture capital community provides companies with
improved access to external financing. Clearly, crowdfunding investors
that typically follow a ‘spray and pray’ strategy (spreading small invest-
ments among as many firms as possible) when it comes to making invest-
ment decisions have fewer resources and/or incentives to assist portfolio
companies in securing the next stage of finance. A related problem is that
this strategy may be exacerbated by the fact the companies that pitch for
crowdfunding investors are more likely to end up with a multitude of
investors. As such, these circumstances not only enhance the free-rider
problem among investors but also add an additional ‘negotiation chal-
lenge’ to potential follow-on investor, as it is easier to negotiate the fund-
ing with only a few investors (Kolodny 2013).
If one adds to these challenges the legislative and regulatory issues that
surround crowdfunding, the jury is still out on whether this source of
capital will have a significant impact on the new venture capital industry
in the near future. The crowdfunding provisions of Title III of the JOBS
Act that took effect on May 16, 2016, are not promising. The fact that
these provisions require start-up companies to have public accounting
firms audit their financials will arguably have a deterrent effect on the use
of equity crowdfunding in the United States. High-profile venture capi-
talists have already announced that they will most likely pass on ‘crowd-
funded’ start-up companies (Mittal 2016).
We have seen that Regulation Crowdfunding (Reg CF) has provided
some early evidence on the type of issuers that are using the new securi-
ties exemption created by the JOBS Act of 2012 and the quantified utili-
zation during the period of May 2016 to December 2016.
Saha and Parsont (2017) documented how during the first 100 days
since implementation that a majority (72%) of companies were organized
within five years and are technology firms. Moreover, as of October 10,
2016, 14 out of 33 companies succeeded in reaching their funding goals
and the average capital raised was about USD 400,000 (and the median
was approximately USD 266,000). Finally, the relationship between the

level of prior capital raising and successful Reg CF issues seems to be sig-
nificant. An analysis shows that 42 (49%) companies s ucceeded in earlier
capital raising efforts, with a majority of the successful examples raised
funds from accredited investors. The results suggest that while 49% of the
firms have been successful in earlier funding rounds, Reg CF is perhaps
more suitable for the follow-on financing needs of firms.
Along similar lines, Abrams (2017) found that 141 companies had,
as of November 12, 2016, started securities issues across 19 portals with
5 companies already having completed an issue under Reg CF, and col-
lectively these companies have raised over USD 13.6 million in funds.
The typical successful equity issue has raised USD 90,000 from 120
investors with a minimum offering amount of USD 100,000 with
37 days to collect the rest. Start-up firms represent the majority of firms
pursuing issues, with the median issuer age of 10 months. From this
perspective, the median issuer has three employees, assets of USD
26,000, and seeks to raise USD 70,000. The evidence shows that 26 of
the 50 closed issues were successful in meeting the minimum offering
amount by their deadline. While investors appear to be sophisticated,
they commonly invest in issues that make more information available
to the SEC, have more assets, less long-term debt, and higher Stratifund
ratings. In addition, sophisticated investors tend to appear within one
month of the issue and are located on average 900 miles from the firms
seeking funds. In sum, the growing number of platforms and successful
issues in a range of industries in the United States suggests that the
market could play a key role in the fundraising activities of SMEs and
young firms.
6.3 P
eer-to-Peer or Marketplace Lending
Model
Despite the attention given to crowdfunding over the last decade, we
have seen the rapid development of peer-to-peer lending (‘P2P’). More a
hybrid of crowdfunding and marketplace lending, P2P is best under-
stood as a form of debt-based crowdfunding.
When it comes to debt, the P2P transactional marketplaces take three

forms. They may be organized as either: (1) balance sheet lenders that
fund loans off their own balance sheet; (2) marketplace lending which is
non-bank based Internet lending; and (3) peer-to-peer lending focused
on retail investors and borrowers. If lenders follow the balance sheet lend-
ing model, they are considered to be more diversified financial institu-
tions that, in contrast to the marketplace or P2P model, retain some
loans on their own balance sheet and are also less dependent financially
on directly selling loans. The marketplace lending model, which stands in
contrast to the fintech balance sheet lending model, serves to connect
borrowers to investors, which receives a higher rate of return than being
offered by traditional banks.
Furthermore, the P2P model, unlike a traditional bank, matches bor-
rowers who are seeking a loan with investors, who obtain revenue from a
portion of the interest that borrowers pay on the loan. Platforms operate
by assisting in the collection, scoring and distributing the credit qualifica-
tions of potential borrowers, reporting real-time bids on projects, and
supplying online servicing and monitoring of the loan (Morse 2015).
Using this information, lenders are able to review the applications.
Generally speaking, investors may choose to invest algorithmically,
directly, or through a group. Unlike traditional banks, the P2P loan pro-
cess involves the direct matching of lenders and borrowers via online
auctions in which bid/ask is matched until a loan is fully funded, or is
matched by fixed rate and category. For the most part, platforms have
adopted the AON rule, which requires projects to meet their funding
goal in order to be funded. Other bidding rules provide that lenders can-
not underbid each other, but loan applicants can raise the offered interest
rate during the bidding period.
There are a number of factors that explain the success of P2P lending
platforms and their potential to be disruptive. On the one hand,
platform-based data tools can be used to lower transaction costs in
matching financing requests and investment opportunities, leading to
smaller loan amounts and the splitting of large loans (Feng et al. 2015).
On the other hand, P2P enables modern investors to have direct access
to an asset class that was limited previously to large institutional inves-
tors, which may allow them to diversify their portfolios and create
enhanced risk-adjusted returns through the savings achieved by a lower-
cost operating model.
As a result, the P2P model has experienced significant growth rates in
the United States and United Kingdom. Evidence indicates that P2P
lending in the United States reached USD 12 billion at the end of 2014
(Morgan Stanley Research 2015), with similar loan levels for the United
Kingdom. Moreover, the P2P market is expected to be worth between
USD 150 and USD 490 billion globally between 2016 and 2020, from
USD 26.16 billion in 2015. In the United Kingdom, the volume of P2P
consumer lending rose to EUR 366 million in 2015 whereas business
lending rose to EUR 212 million for the same period (Cambridge/
KPMG 2016). Unsurprisingly, commercial banks have not been shy
about jumping into this sector once they witnessed the earlier success of
the fintech business model. In fact, large commercial banks pursuing this
strategy have purchased new fintech start-ups and created competitive
platforms designed not only to improve the efficiency of their traditional
financial products but to look for other market opportunities (Parker
et al. 2016).
Despite its popularity and growth the P2P lending poses several chal-
lenges. First, there are likely to be some agency costs involved with this
new channel of funding. We can expect, based on prior research, that
borrowing history has a significant impact on the success rate of loans
(Iyer et al. 2015). Second, if lenders believe that there are adverse selec-
tion problems, this is likely to lead to high interest rates and low rates of
success (Yum et al. 2012). Third, a major concern for lending platforms
is whether any loan is in arrears and could potentially default. A primary
concern is that investors maintain a close watch on developments in
marketplace lending, such as ensuring that the modeling of the assumed
default rate is accurate, or that there is clear identification of the servic-
ing cost (for the outsourced loans) for platforms. Finally, another factor
likely to influence the efficiency of the online P2P markets is the high
risk from borrowers that are unable to finance their projects to comple-
tion, leading to loans that are illiquid and cannot be withdrawn ahead of
maturity.
6.4 R
egulatory Determinants of Fintech
Start-Ups
This section considers the regulatory factors that are influencing fintech
start-ups. Several researchers have written about the influence of country-
level factors on fintech. A primary factor that prior researchers have
examined is the relationship between country-level legal and cultural
traits and their impact on platform formation (Dushnitsky et al. 2016).
Second, as highlighted by Cumming and Schwienbacher (2016), the
extent of venture capital deals in the fintech sector can be seen as a func-
tion of the differential enforcement level of financial rules among start-
ups and large financial institutions. In addition to legal and cultural
factors, researchers have also considered the primary economic and tech-
nical factors influencing the number of fintech start-ups, including the
presence of a well-developed capital market, ready availability of the latest
technology, and people more likely to possess telephone subscriptions
(Haddad and Hornuf 2016). The magnitude of the labor market is asso-
ciated with the increase of new fintech start-up formations. While the
degree of soundness of banks has a negative effect on the formation of
start-ups, the variable VC financing has a significant effect on the num-
ber of new fintech start-ups that provide payment services.
To be sure, prior work suggests that fintech innovations will take place
with or without changes in regulation. Thus, one possibility is that poli-
cymakers might wish to create incentives so that fintech will lower the
cost of services to end-users and encourage entry in highly concentrated
markets so that regulators could ensure a level playing field. As noted
above, another possibility is that the recent fintech innovations are stifled
due to the strength of industry groups and labor that might want to curb
incentives to fintech firms and support existing subsidies and barriers to
entry. We thus attempt to shed light on whether lawmakers respond to
the ongoing development of fintech firms or attempt to support the
extant financial system and their own style of regulation.
In this section, we provide some preliminary evidence of 12 country-
level regulators’ responses to fintech. In general, if we look around the
world today we can distinguish between two broad categories of
government response — reactive and proactive— each of which has a

number of sub-categories.
Reactive. The first group includes countries in which nothing is being
done. There is No Regulatory Talk or Action. The second group consists
of countries in which there is partial or Fragmented Regulation of fin-
tech. Certain institutions, such as the Consumer Financial Protection
Bureau (CFPB) in the United States, may offer certain safe harbor provi-
sions for certain type of fintech companies. Yet there appears little will-
ingness to genuinely embrace the technology and its regulatory
implications, nor is there any comprehensive plan as to how fintech can
or should be regulated.
Proactive. In such countries, there is a significant amount of regulatory
attention paid to fintech. Such attention can take the form of consulta-
tion papers, White Papers, or conferences. But action is limited and there
is a risk that prioritizing fintech can slide into an empty lip service aimed
at projecting an image of regulatory action when, in reality, action is
limited.
A second group of countries engage in what might be characterized as
regulatory guidance. Regulators provide advice to fintech start-ups and
incumbents in order to help navigate them through the regulatory sys-
tem. This does not necessarily entail changes in regulatory structure, but
it does promote a collaborative dialogue between regulators, traditional
service providers, and fintech companies.
A final group of countries have embraced the possibilities of fintech by
creating a so-called regulatory sandbox. We characterize this approach as
Regulatory Experimentation. Regulators create a regulatory sandbox in
which they facilitate and encourage a space to experiment. This allows the
testing of new technology-driven services, under the supervision of regu-
lators. This ensures that meaningful data can be gathered for the evalua-
tion of risk in a safe environment. Such data can then facilitate
evidence-based regulatory reform.
A key point about this last approach is that it is collaborative and dia-
logical, in the sense that regulators, incumbents, and new service provid-
ers are engaged in an ongoing dialogue about the most effective means to
gather relevant information and to identify the most appropriate regula-
tory model.
6.4.1 E
mpirical Study of Regulatory Effects
on Fintech Start-Ups
In order to better understand the effects, risks, and opportunities associ-

ated with these regulatory choices, we focus on the regulatory responses
to fintech in 17 jurisdictions (see Fig. 6.3). In particular, we looked at
first-time venture capital investments in fintech companies. The inten-
tion was to see whether there was a meaningful connection between levels
of investment and regulatory choice.
Five jurisdictions were cut due to a lack of reliable data. For instance,
we were unable to find a sufficient number of companies receiving invest-
ment; or there were doubts about the veracity of the data and it was dif-
ficult to independently verify; or there was conflicting information. The
12 remaining jurisdictions were examined. When we look at the results
of year-on-year percentage growth of first-time venture capital backed
companies, we get the following in Fig. 6.4.
In many cases, this data confirms anecdotal evidence of a slow-down
of interest in fintech in 2015. From 2015 to 2016, the total fintech
funding declined approximately 50 percent, down to USD 25 billion
from USD 47 billion in 2015 (KPMG 2017a). But interestingly, in 6 of
the 12 jurisdictions there was an increase in investment activity in 2016.
The question this data raises is whether there are any signals as to a cor-
relation between regulatory initiative and increased activity in the fin-
tech sector.
In contrast, in those countries with a more proactive response —
particularly involving Regulatory Guidance or Regulatory
Experimentation — there is evidence that this proactive approach makes
the jurisdiction more attractive as a potential location for starting fintech
operations (Fig. 6.5).
This suggests that the regulatory environment does affect the degree of
investment and — perhaps as importantly — affects the willingness of
companies to start operations in one jurisdiction, rather than another.
Regulation matters, but we have to realize that there are other compo-
nents that make up an attractive ecosystem for fintech. Consider Israel. A
market known for its venture capital industry, a strong R&D focus, and
large multinationals that are open to fintech. These ingredients play a
Fig. 6.3 Overview of countries in our study

% 200
122
150
100
Netherlands
M. Fenwick et al.
Ireland
United States
50 United Kingdom
Hong Kong
China
Germany
India
0 Singapore
2014 2015 2016 Russia
Israel
Switzerland
–50
–100
–150
Fig. 6.4 Year-on-year percent growth of first-time venture capital backed fintech companies (country)
% 200
150
Experimental
100
Guidance
50
Priority
0
2014 2015 2016
–50
Fragmented
–100
No Action
–150
Fintech and the Financing of SMEs and Entrepreneurs...
Fig. 6.5 Percentage growth of first-time venture capital backed fintech companies (regulatory approach)
123
crucial role in making Israel an attractive site for investing. But the evi-
dence does suggest that collaborative regulation that facilitates experi-
mentation is key. For now, policy experimentation seems to be the way to
go for regulators. It is, therefore, crucial that we track the effectiveness of
regulatory sandboxes in 2017. After all, they are relatively new and we
need to build a better understanding of their effectiveness in order to
improve their design. To be sure, such knowledge will show whether
other countries can follow this more proactive and experimental model
and whether it might work also in other industries that have a tradition
of being heavily regulated.
6.5 Conclusion
This chapter considered how alternative sources of business lending can
help to fill the financing gap for SMEs and young firms. By canvassing
the empirical literature on alternative finance, we evaluated the benefits
and costs of the respective alternative lending models.
We initially examined crowdfunding, which is a new funding source
that complements traditional forms of finance. In particular, we reviewed
the efficiency benefits of the respective non-price strategies and consid-
ered whether the differences are likely to attract more investors. AON
fundraising campaigns have larger fundraising targets for their projects
and tend also to be successful in realizing their capital goals. In contrast,
the KIA model is used by firms that can scale their business. In sum, flex-
ible platforms are attractive to a number of firms, creating sustainable user
growth. We also discussed whether an investor has a public profile and
whether it influences the dynamics of investor behavior. An informational
advantage is likely to occur when investors have chosen a public profile.
This will likely lead to more bids as well as interest from other investors.
We then considered the P2P model, which matches borrowers who are
seeking a loan with investors. In short, platforms operate by assisting in
the collection, scoring, and distribution of the credit qualifications of
potential borrowers, reporting the real-time bids on projects and provid-
ing the online servicing and monitoring of the loan. Using this
information, lenders are able to review the loan applications. Generally
speaking, investors may choose to invest algorithmically, directly, or

through a group. Unlike traditional banks, the P2P loan process involves
the direct matching of lenders and borrowers via online auctions in which
bid/ask is matched until a loan is fully funded, or is matched by fixed rate
and category. For the most part, platforms have adopted the AON rule,
which requires projects to meet their funding goal in order to be funded.
In terms of the factors which explain the success of P2P lending plat-
forms, platform-based data tools can be used to lower transaction costs in
matching financing requests.
At the same time, P2P offers investors access to an alternative asset
class that has been limited solely to large institutional investors, which
also enables SMEs to obtain short-term credit at attractive rates and
enables investors to achieve higher benchmarked returns.
Finally, this chapter focused on the regulatory responses to fintech in
17 jurisdictions. We examined the first-time venture capital investments
in fintech companies to determine whether there is a meaningful connec-
tion between levels of investment and regulatory choice. The findings
here have implications for how regulation is likely to play an important
role in the development of the fintech market.
References
Abrams, E. 2017. Securities Crowdfunding: More than Family, Friends and Fools?
Agrawal, Ajay, Christian Catalini, and Avi Goldfarb. 2015. Crowdfunding,
Georgraphy, Social Networks, and the Timing of Decision. Journal of
Economics and Management Strategy 24: 253–274.
2015. Signalling in Equity Crowdfunding. Entrepreneurship Theory and
Practice 39: 955–980.
Ayadi, R., and S. Gadi. 2013. Access by MSMEs to Finance in the Southern and
Eastern Mediterranean: What Role for Credit Guarantee Schemes? European
Commission, MEDPRO Technical Report No. 35/2013.
Beck, Thorsten, Leora F. Klapper, and Juan Carlos Mendoza. 2010. The Typology
of Partial Credit Guarantee Funds Around the World. Journal of Financial
Stability 6: 10–25.
Belleflamme, Paul, Nessrine Omrani, and Martin Peitz. 2016. Understanding

the Strategies of Crowdfunding Platforms. CESifo DICE Report 2: 6–10.
Boot, Arnoud W.A., Anjan V. Thakor, and Gregory F. Udell. 1991. Secured
Lending and Default Risk: Equilibrium Analysis, Policy Implications and
Empirical Results. The Economic Journal 101: 458–472.
Cambridge Centre for Alternative Finance/KPMG. 2016. Sustaining Momentum:
The 2nd European Alternative Finance Industry Report. September. https://
assets.kpmg.com/content/dam/kpmg/xx/pdf/2016/09/sustaining-momen-
tum.pdf. Accessed 20 Feb 2017.
Cumming, Douglas J., Gaël Lefoeuf, and Armin Schweinbacher. 2015.
Crowdfunding Models: Keep-it-All vs. All-Or-Nothing. Social Science Research
Network. https://papers.ssrn.com/abstract=2447567. Accessed 20 Feb 2017.
Cumming, Douglas J., and Armin Schwienbacher. 2016. Fintech Venture
Capital. Social Science Research Network. http://ssrn.com/abstract=2784797.
Deutsche Bank. 2017. Synthetic Securitisation: Making a Silent Comeback. EU
Monitor: Global Financial Markets, February 21. http://dbresearch.de
Dushnitsky, Gary, Massimiliano Guerini, Evila Piva, and Cristina Rossi-
Lamastra. 2016. Crowdfunding in Europe: Determinants of Platform
Creation Across Countries. California Management Review 58: 44–71.
———. 2015. Moving Mainstream—The European Alternative Financing
Benchmark Report. February. http://www.ey.com/Publication/vwLUAssets/
EY-and-university-of-cambridge/$FILE/EY-cambridge-alternative-finance-
report.pdf. Accessed 20 Apr 2017.
European Central Bank. 2015. Survey on the Access to Finance of Enterprises in the
Euro Area, October 2014 to March 2015. June. https://www.ecb.europa.eu/
pub/pdf/other/SAFE_website_report_2014H2.en.pdf. Accessed 20 Apr
2017.
Feng, Yan, Xinlu Fan, and Yeujun Yoon. 2015. Lenders and Borrowers’ Strategies
in Online Peer-to-Peer Lending Market: An Empirical Analysis of PPDai.
com. Journal of Empirical Research 16: 242–260.
Global Agenda Council. 2015. The Future of FinTech: A Paradigm Shift in Small
Business Finance. October. www3.weforum.org/
Haddad, Christian, and Lars Hornuf. 2016. The Emergence of the Global Fintech
Market: Economic and Technological Determinants. CESifo Working Paper No.
6131. https://papers.ssrn.com/abstract=2830124. Accessed 20 Feb 2017.
Science 62: 1554–1577.
Kolodny, Lora. 2013. AngelList and Beyond: What VCs Really Think of
Crowdfunding. Wall Street Journal. October 8. http://blogs.wsj.com/venture-
capital/2013/10/08/angellist-and-beyond-what-vcs-really-think-of-crowd-
funding/. Accessed 20 Apr 2017.
KPMG. 2017a. The Pulse of FinTech Q4 2016: Global Analysis of Investment in
FinTech. February 21. https://assets.kpmg.com/content/dam/kpmg/xx/
pdf/2017/02/pulse-of-fintech-q4-2016.pdf. Accessed 20 Apr 2017.
———. 2017b. US Fintech Funding Drops in 2016: KPMG Report. February
21. https://home.kpmg.com/us/en/home/insights/2017/02/us-fintech-
funding-and-deal-volume-drop-significantly-in-2016-kpmg-q4-16-pulse-of-
fintech-report.html. Accessed 20 Apr 2017.
Lewis, Neil. 2013. Business Angels vs Equity Crowdfunding: 7 Key Differences.
iBusinessAngel. http://www.ibusinessangel.com/2013/04/business-angels-
vs-equity-crowdfunding/. Accessed 20 Feb 2017.
Mills, Karen, and Brayden McCarthy. 2014. The State of Small Business Lending:
Credit Access during the Recover and How Technology May Change the Game.
Harvard Business School Working Paper 15-004. https://papers.ssrn.com/
sol3/abstract=2470523. Accessed 20 Feb 2017.
Mittal, Alex. 2016. Read the Fine Print Before You Turn to Equity Crowdfunding.
Mattermark. April 25. https://mattermark.com/read-fine-print-turn-equity-
crowdfunding/. Accessed 20 Feb 2017.
Morgan Stanley Research. 2015. Can P2P Lending Reinvent Banking? June 17.
https://www.morganstanley.com/ideas/p2p-marketplace-lending. Accessed
20 Feb 2017.
Morse, Adair. 2015. Peer to Peer Crowdfunding: Information and the Potential
for Disruption in Consumer Lending. National Bureau of Economic Research.
http://www.nber.org/papers/w20899. Accessed 20 Feb 2017.
OECD. 2013. SMEs and Entrepreneurs 2013: An OECD Scorecard. April 17.
http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=
CFE/SME(2012)12/FINAL&docLanguage=En. Accessed 20 Feb 2017.
———. 2015. New Approaches to SME and Entrepreneurship Financing. https://
www.oecd.org/cfe/smes/New-Approaches-SME-full-report.pdf. Accessed 20
Feb 2017.
———. 2016. Financing SMEs and Entrepreneurs 2016: Highlights. April.
h t t p : / / w w w. o e c d . o r g / c f e / s m e s / f i n a n c i n g - s m e s - a n d - e n t re p re -
neurs-23065265.htm. Accessed 20 Feb 2017.
Parker, Geoffrey G., Marshall W. van Alsyne, and Sangeet P. Choudary. 2016.
Platform Revolution: How Networked Markets Are Transforming the Economy—
And How to Make Them Work For You. New York: W.W. Norton and
Company.
Philippon, Thomas. 2016. The FinTech Opportunity. National Bureau of
Economic Research. http://www.nber.org/papers/w22476. Accessed 28 Apr
2017.
———. 2016. Blurred Lines: How Fintech is Shaping Financial Services. March.
https://www.pwc.se/sv/pdf-reports/blurred-lines-how-fintech-is-shaping-
financial-services.pdf. Accessed 20 Feb 2017.
Saha, A., and J. Parsont. 2017. Regulation Crowdfunding: A Viable Capital-Raising
Method for Tech Companies? http://clsbluesky.law.columbia.edu/2017/03/06/
regulation-crowdfunding-a-viable-capital-raising-method-for-tech-compa-
nies/
Vismara, Silvio. 2016. Information Cascades Among Investors in Equity
Crowdfunding. Enterpreneurship Theory and Practice. https://doi.org/
10.1111/etap.12261.
World Economic Forum. 2015. The Future of FinTech: A Paradigm Shift in Small
Business Finance. October. http://www3.weforum.org/docs/IP/2015/FS/
GAC15_The_Future_of_FinTech_Paradigm_Shift_Small_Business_
Finance_report_2015.pdf. Accessed 20 Feb 2017.
Yum, Haewon, Byungtae Lee, and Myungsin Chae. 2012. From Wisdom of the
Crowds to my Own Judgment in Microfinance Through Online Peer-to-Peer
Lending Platforms. Electronic Commerce Research and Applications 11:
469–483.
Mark Fenwick is Professor of Law at Kyushu University. His research areas are
white-collar and corporate crime, terrorism, emergencies and the law, bioethics
and criminal law and theoretical criminology and social theory. He received his
PhD from Cambridge University.
Joseph A. McCahery is Professor of International Economic Law at Tilburg

University Law School and TILEC. He has held visiting appointments at
Auckland University, Columbia University, Solvay Business School and
University of Pennsylvania. His research interest areas include: banking regula-
tion and supervision, corporate finance, financial market regulation, and corpo-
rate law and governance. He has published widely in the top finance and law
journals and is author and editor of more than ten books, including Law,
Economics and Organization of Alliances and Joint Ventures (Cambridge University

Press, forthcoming); Institutional Investor Activism: Hedge Funds and Private
Equity, Economics and Regulation (Oxford University Press, 2015); and Corporate
Governance of Non-listed Companies (Oxford University Press, 2008). He has
served as a consultant to publicly traded firms, governmental agencies, invest-
ment companies, and law firms.
Erik P.M. Vermeulen is Professor of Business and Financial Law at Tilburg

University and Tilburg Law and Economics Center (TILEC) in the Netherlands.
He is also Senior Counsel Corporate of Philips in the Netherlands. He serves as
a Vice President at the legal department where he advises on corporate gover-
nance, corporate venturing activities, international joint ventures, and mergers
and acquisitions. He teaches courses on corporate governance, venture capital,
entrepreneurship, joint ventures, and company law. He frequently lectures on
these and other topics at universities around the world. In addition, he has
served as an expert advisor to various organizations, such as the European
Commission, the Organisation for Economic Cooperation and Development
(OECD), the World Bank, the International Finance Corporation, the Dutch
Development Finance Institution, the United Nations Commission on
International Trade Law (UNCITRAL) and several national and local govern-
ments, concerning innovation, financial and venture capital markets, corporate
law, and corporate governance of listed and non-listed companies.
Part III
Backers and Investors
7
Crowdfunding as a Font
of Entrepreneurship: Outcomes
of Reward-Based Crowdfunding
Ethan Mollick
Despite the relatively low level of consequences for failure, I find that
crowdfunding project creators deliver their promised rewards the vast
majority of the time (over 90%), and seem to make great efforts to fulfill
their obligations. Additionally, a large number of projects, especially
those in product-oriented categories, turn into ongoing ventures. Overall,
the data suggests that crowdfunding is a viable method of producing new
enterprises.
7.1 Surveys and Methods

I conducted two surveys with the help of Kickstarter.1 The first survey
was of project creators. The creators of all 61,654 successful Kickstarter
projects that raised over USD 1000 before May 2015 were surveyed via
email. Of those projects, 10,078 completed part of the survey (16.3%)
E. Mollick (*)
The Wharton School, University of Pennsylvania, Pennsylvania, PA, USA

https://doi.org/10.1007/978-3-319-66119-3_7
134 E. Mollick
and 8448 (13.7%) completed most or all of the survey. These response
rates are comparable with other web-based surveys in non-traditional
industries within the management literature (Kriauciunas et al. 2011).
Additionally, it is likely that many of the email accounts were set up for
completed projects and were no longer actively used, artificially lowering
response rates, though the proportion of these emails is difficult to deter-
mine. Therefore, in order to provide a more accurate accounting of actual
responses, open rates on emails were tracked (Nickerson 2007), with an
open rate of 47.8%. Open rate tracking works well for web-based email
addresses (Gmail, Yahoo, Hotmail), but may not work in all cases, and
could result in an underestimate of read emails. Nonetheless, using open
rates suggests that overall response rates were between 16% and 34% of
delivered email. Response rates varied by amount raised, with larger proj-
ects responding at a higher rate. After controlling for this factor, there was
no significant difference between respondents and non-respondents in
the types of backers they attracted (those who had backed projects before
or those who had never backed projects), or the number of projects
backed or launched by the creator.
The second survey was of project backers. In total 456,751 backers
were surveyed, representing 65,326 projects. All projects from 2009
through May 2015 that raised over USD 1000 were included in the sam-
ple, as well as half the projects that raised less than USD 1000 but over
USD 250, and a quarter of projects raising less than USD 250. Backers
were selected randomly, without replacement, to maximize the number
of backers per project. A mean of 7.2 backers were surveyed per project,
with 7 backers surveyed in 89% of projects and 10 backers surveyed in
7.8% of projects.
A total of 47,188 backers (10.3%) responded. In total, there is at least
one response for 30,323 projects, (46.4% of all projects), with 1.56
backer responses per project on average. The mean backer in the sample
contributed USD 76.43 to the project they backed.
Response rates were not entirely representative of the project backer
population, as response rates were higher for projects that traditionally
produce consumer products, such as games (83% of all projects), tech-
nology (72% of all projects), design (70% of all projects), and comics
(72% of all projects). They were lower for categories focused more on
Crowdfunding as a Font of Entrepreneurship: Outcomes… 135
traditionally artistic pursuits, such as those in theater (35% of all proj-

ects), dance (31%), music (36%), and film (37%). Larger projects and
more recent projects also had higher response rates. Across all categories,
however, response rates were acceptable, and are unlikely to bias the
findings.
For analyses of economic impact, responses were adjusted by iterative
proportional fitting (“raking”) to create weighted observations based on
the total population of projects using the “ipfweight” command in
STATA (Bergmann 2011). The raking model was based on the amount
pledged, the degree to which projects raised more than their goal, and
project category. This standard approach reduces non-response bias and
increases representation.
Several questions in the surveys used ranges as potential answers. These
included questions about age, children, personal earnings, and total earn-
ings by projects. For the analyses, I converted these answers to a single
scale, taking the midpoint of each range.
7.2 Measuring Failure Rates

First, I will examine the degree to which projects fail to deliver their
promised rewards to project creators. Since creators raise money before
trying to fulfill their promises, it is likely that many unanticipated prob-
lems could emerge that could interfere with project completion. Since
budgets are fixed by the amount raised, these problems could be unsur-
mountable if they include cost overruns. Additionally, there are few clear
legal recourses available to backers of failed projects (though see Cumming
et al. 2016 for exceptions), making the consequences of failure somewhat
unclear. Thus, project failure represents a real possibility. However, we
have little evidence about how often failure occurs.
One challenge is determining what a “failed” project might be. Backers
might consider a project failed if it did not deliver on its promises, if it
delivered something different than expected, or for any one of a number
of reasons. For the purpose of this chapter, I focus specifically on the
rewards promised to project backers in return for backing projects
(rewards on Kickstarter include a mix of physical, digital, and intangible
136 E. Mollick
rewards). The delivery of rewards seems to be the major way in which

project backers evaluate the success of a project. At the same time, it is
important to note that rewards are but one potential outcome of a project
as there are many ways by which a project could “succeed” but still fail to
deliver rewards—for example, an art exhibit may have been successfully
staged, but not deliver a promised t-shirt or sticker to backers. Given this
caveat, the degree to which backers believe they receive the expected out-
come is a reasonable measure of one kind of success or failure.
There are many potential ways to classify projects as failed, based on
my data. Respondents were asked to select from one of five reward status
options, see Table 7.1.
For this chapter, I consider failures to be those projects where backers
answer that they “never expect to get the promised reward” (5.2% of all
responses) or that they “received the reward but it was not what was
promised” (2% of all responses). It is important to note, however, that
there may be a number of reasons that people may never expect to get the
promised reward, including reasons unrelated to failure.
This issue becomes more complicated when considering projects rather
than individual backer opinions, because there might be multiple backers
who answer the survey about a single project, and they might disagree
about whether promised rewards were delivered. Thus, at the level of
projects, rather than respondents, there is a need to decide how to classify
projects as failures. The broadest definition is to say if anyone reported
the project as a failure, then the project has failed. This would classify
9.95% of all projects as failures. However, given that individual com-
plaints are not uncommon, this is likely too harsh a definition. If instead,
we classify projects where at least half of backers considered the project as
Table 7.1 Respondents’ selection of reward status options

Category Response N %
Completed I received the reward 28,503 60.40
Completed I was not expecting a reward 6398 13.56
Waiting I am still expecting to get the promised reward 8879 18.82
Failed I never expect to get the promised reward 2456 5.20
Failed I received the reward, but it was not what I was 951 2.02
promised
a failure (which I will refer to as the “middle definition” of failure), the

rate drops to 8.6%, and if we take the strict definition that all backers
should consider the project a failure, the failure rate is 5.6%.
Failure rates are highest for smaller projects, lowest for mid-size proj-
ects, and somewhat elevated for the largest projects. Using the middle
50% failure standard, in terms of dollars, 8.2% of all dollars pledged to
successfully funded projects goes to those that ultimately fail to deliver
promised rewards.
We might also be concerned that a number of the projects that are cur-
rently waiting for delivery will ultimately fail. If we look at older projects
from 2012 or earlier, it may provide a better sense of long-term success rates.
For projects from 2012 or earlier, the failure rate is 13.9% for the broadest
definition, 12.3% by the middle definition, and 8.6% by the strictest defi-
nition. Part of the reason for this failure is mechanical, longer projects may
fail at a higher rate. While these historical failure rates are higher, it is also
likely that overall failure rates have decreased since 2012, as creators have
climbed the learning curve of how to create successful projects, and backers
have become more educated on which projects to support.
Combining all of these results, the overall failure rate for Kickstarter
projects at the project level is around 9%, and likely in a range between
5% and 14%. A total of 7.2% of all backers reported that the project they
were surveyed about failed. At the same time, it is important to note that
even these numbers might overestimate project failure, as a project may
have failed to deliver its reward, but still succeeded in accomplishing the
goals of the creator.
Innovation involves risk, and so some failure rate in innovative proj-
ects is to be expected. At the same time, it is important to know if there
are any observable factors that can serve as a warning for backers that a
particular funded project is more likely to fail than another. A logistic
regression (see Table 7.9) sheds some light on these questions.
As previously mentioned, the most-funded and least-funded projects
are more likely to fail, though the smallest projects are more at risk than
the largest ones. Controlling for the amount pledged and the year of the
project creation, however, there are also some category-based risks. Film,
technology, and food projects have greater chances of failure, while music
projects are much less likely to fail. Again, this may be because of
138 E. Mollick
ifferences in ambition level across categories—it may be that film or

d
technology products are aiming for more breakthrough products or are
offering more complicated rewards (a completed movie or gadget, rather
than a band t-shirt), and are thus at a higher risk of failure.
Other than category differences, there were few factors apparent to
backers during the campaign that predicted failure, though projects that
showed signs of creator effort, by having videos or by posting updates
before the fundraising deadline, were less likely to fail (Mollick 2014).
These had relatively small effects, however. This is consistent with prior
research that has determined that crowds do a good job assessing project
quality (Mollick and Nanda 2016).
Given that one effect of crowdfunding is to increase the diversity of
people who can get access to funds, there was also a notable non-finding
in the analysis of failures—the characteristics of the project creator were
not significantly related to failure. There was no significant difference in
failure rates between women and men (though women are more likely to
raise funds, see Greenberg and Mollick 2016), between highly educated
and less-educated creators, between teams and individual projects,
between single or partnered creators, or between creators with children
and those without. Systematic differences may exist, but those that do are
not clearly observable to project backers.
Overall, for backers considering funding a project, there are currently
few signs about which project will fail, assuming it has reached its goal.
In general, for funded projects, a failure to deliver seems relatively rare,
accounting for around 9% of all projects, with a possible range of 5% to
14%. The fact that failures seem to be distributed in non-predictable
ways should offer some comfort about the underlying ability of backers
to weed out projects that might offer obvious signs of trouble. Project
backers should expect a failure rate of around 1-in-10 projects, and to
receive a refund 13% of the time when a project does fail. Since failure
can happen to anyone, creators need to consider, and plan for, the ways
in which they will work with backers in the event a project fails, keeping
lines of communication open and explaining how the money was spent.
Ultimately, there does not seem to be a systematic problem associated
with failure (or fraud) on Kickstarter, and the vast majority of projects do
seem to deliver. At the same time, it is important to realize that these
results apply only to Kickstarter, and other crowdfunding methods (such

as equity crowdfunding) and platforms that have different policies or
approaches may have higher failure rates.
Though many projects on Kickstarter have gone on to be artistic or
financial successes for project creators, to date there has been no clear
evidence about how often projects actually deliver on their promises to
backers. What evidence we have suggests that creators are generally hon-
est, if overconfident—many projects take longer to deliver than creators
estimate2 and overall fraud rates are low.3 However, while Kickstarter
warns potential backers about the risk of non-delivery in supporting
projects, the actual share of projects that fail—that is, either do not
deliver a promised reward, or deliver a reward that is very far from expec-
tations—has been unknown, and a subject of considerable speculation.
This chapter provides a first attempt to systematically understand deliv-
ery rates on Kickstarter.
7.3 Measuring Economic Impact

Projects therefore tend to deliver on their goals, but this does not mean
that they lead to viable long-term impacts. I next examine this issue,
which is complicated by the fact that Kickstarter projects span artistic
and commercial ventures, and encompass a wide range of different goals,
ambition levels, and expected outcomes. The first step in understanding
the long-term impact of reward-based crowdfunding is to understand the
variation among projects on Kickstarter. A logical way to do this would
be to use the categories Kickstarter uses to define projects. However, these
often span a wide range of project types—for example, the Design cate-
gory includes both product design and architecture.
For this analysis, I have regrouped the categories somewhat to add clar-
ity and to ensure that no one category makes up less than 2.5% of the
total projects. The revised categories are based on the original categories
in Kickstarter, with changes to rationalize and consolidate them.
Unchanged from Kickstarter are the Games, Fashion, and Comics cate-
gories. Categories with minor variations include: Food (the same as the
original, minus cookbooks and some gadgets), Technology (the same as
140 E. Mollick
the original, without makerspaces), and Film (the same as the original,
without movie theaters). The Art category now includes projects in art,
photography, graphic design, crafts, architecture, civic design, and typog-
raphy. The Publishing category includes cookbooks and journalism, as
well as the original publishing category. Dance and Theater are com-
bined. Product Design only includes product design projects and unclas-
sified design projects. Finally, I created a small category, Spaces, for
projects supporting movie theaters, makerspaces, and practice spaces;
however, due to its small size I exclude it from most further analyses.
We can further cluster these categories into two general groups:
“product-oriented” and “art-oriented.” Examining all 11 of the newly
defined categories by whether the goal of the creator was to create or
sustain an organization, or else to launch a one-time project, the contrast
between types of projects becomes clear. The five “product-oriented” cat-
egories are dominated by attempts to build organizations: three quarters
or more of the projects in these categories are started by current or new
formal organizations (mean = 0.84). On the other hand, the six “art-
oriented” categories are generally created by one-time or informal groups,
with less than half the projects involving organizations. Qualitatively, the
artistic categories tend to also contain a higher proportion of purely cre-
ative projects, while the product categories are more likely to be commer-
cial in nature (see Fig. 7.1).
Using these rough divisions, we can now begin to examine the multi-
ple types of impacts these projects have had, both for the creators them-
selves and for society overall. In the charts below, I often separate projects
into art-oriented and product-oriented categories. When I do, I also
separately rake both categories to yield more accurate weighting.
7.3.1 Careers and Salaries
One potential impact of crowdfunding is on the careers of the individuals

seeking funding. As part of the survey, I asked creators whether their
Kickstarter projects helped advance their career, increase the money they
earned, switch careers, and whether it created new job opportunities. The
career impact appeared to be substantial—a third of creators reported
that the project advanced their careers (see Table 7.2).
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Product-oriented categories Art-oriented categories

Pre-existing organization
New organization established for project
One time project, no organization
Fig. 7.1 What kind of organization created the project?
Table 7.2 Percent agreeing that “my Kickstarter campaign helped me…”
Advance in Increase the Switch Find new job
my career (%) money I made (%) careers (%) opportunities (%)
Product- 26 28 14 16
oriented
Art-oriented 41 18 5 21
I was also able to use salary data from the survey to examine the claims
of those individuals who felt that their project helped increase the money
they earned. Looking at creators who raised money before 2014, the total
earnings of those who say that Kickstarter increased their earnings went
up by USD 16,339 (SE = USD 1602) compared with USD 10,504
(SE = USD 689) for creators who reported that Kickstarter did not have
an impact on their earnings.
Projects also became the jobs for many creators. Almost 19% of proj-
ect creators said the project was their full-time job, even after the project
was completed (see Table 7.3).
In addition to direct career benefits, crowdfunding seemed to lead to
personal accomplishment as 60.1% of successful creators said their proj-
ect “helped fulfill a dream.”
142 E. Mollick
Table 7.3 Creator job status on projects

Ongoing Completed
projects (%) projects (%)
Project is my current full-time job 23.6 18.7
Project was my full-time job, but isn’t now 13.0 14.9
I am working on the project on the side 57.5 49.0
I am no longer working on the project 6.0 27.3
7.3.2 Economic Impact
Moving from careers to the wider economy, there are a number of ways
to measure the potential economic impact of crowdfunding. One useful
measure is to look at the organizations and companies that were founded
as a result of crowdfunding (see Table 7.4). Many projects did not attempt
to create organizations, while others are projects from pre-existing com-
panies, and still others are new organizations created for Kickstarter.
Using the weighted sample and extrapolating to the population, I find
that, in total, through May 2015, around 4994 new formal organizations
(companies or partnerships) were created for Kickstarter projects (95%
confidence: 4642–5347). Of these, 3082 new for-profit companies and
1048 new not-for-profit companies are still in operation. Additionally,
11,314 (95% CI: 10,798–11,830) existing organizations raised money.
Another way of examining impact is to consider the earnings of proj-
ects outside of Kickstarter. The majority of projects created in Kickstarter
campaigns generated additional sales beyond the money they raised from
backers (see Table 7.5).
These results are lowered by the fact that many projects (30.8%) never
generate additional revenue. Of these, it is likely that most actually do
not seek additional outside revenue, as they could represent one-time
events or artistic efforts. Removing those we find the mean revenues are
higher (Table 7.6).
Extrapolating from the data, Kickstarter projects in total have gener-
ated non-crowdfunding revenues of around USD 3.4B (with a 95% con-
fidence interval of USD 2.8B to USD 4.0B). Overall, projects generate
an average of USD 2.46 of revenue from each dollar of pledges.
Figure 7.2 shows the ratio of dollars generated to dollars pledged for
projects by category, for those projects where creators stated that a project
Table 7.4 Organization types used by Kickstarter project creators

Product-oriented (%) Art-oriented (%)
No organization 48 73
Ongoing pre-existing 30 15
Ongoing new for-profit 15 2
Ongoing new non-profit 1 2
Organization now shut down 2 1
Table 7.5 Average yearly revenues (outside of Kickstarter campaign money)

Product Artistic
No organization USD 29,068 USD 1918
(5252) (356)
Ongoing pre-existing USD 89,642 USD 12,151
(13,211) (2705)
Ongoing new for-profit USD 106,910 USD 26,926
(21,329) (11,487)
Ongoing new non-profit USD 25,587 USD 49,454
(12,771) (29,272)
Standard errors in parentheses
Table 7.6 Average yearly revenues (outside of Kickstarter campaign money) for
projects that earned any income
Product Artistic
No organization USD 38,271 USD 3088
(6882) (572)
Ongoing pre-existing USD 104,020 USD 17,854
(15,246) (3959)
Ongoing new for-profit USD 121,739 USD 35,760
(24,144) (15,178)
Ongoing new non-profit USD 34,949 USD 71,069
(16,730) (41,928)
Standard errors in parentheses
is complete (that is, projects not still trying to deliver promised rewards
to backers). The lines represent 95% confidence intervals. All ratios are
positive and do not cross 0 except for the Film category.
In addition, the average project in the product-oriented category
added 0.6 permanent employees (SD = 0.1) (outside of founders), and
hired a maximum of 2.21 temporary employees (SD = 0.34) on average.
144 E. Mollick
$18
$16
$14
$12
$10
$8
$6
$4
$2
$0
* The lower bound for Film is -$.41, the upper bound for Food is $23.19
Fig. 7.2 Dollars in non-crowdfunding revenue per dollar in crowdfunding

pledges for completed projects
Art-oriented projects did not add permanent employees (in fact, the
number of permanent employees is slightly lower after the campaign,
−0.08, SD = 0.03), but hire a maximum of 2.69 temporary employees
(SD = 0.13). Thus, through May 2015, Kickstarter projects have created
5135 new ongoing jobs beside those that go to creators (though the 95%
confidence interval is large, ranging from 1188 to 9082), and led to the
hiring of 160,425 temporary workers (CI: 145,330 to 175,518).
Further, 11% of projects received additional funding after receiving
crowdfunding. A total of 6.6% (CI 6%–7%) received funding from angel
investors, VCs, or other companies. This suggests that crowdfunding can
be part of the fundraising mix available to entrepreneurs (Cosh et al.
2009). Indeed, recent research suggests that crowdfunding can lead to a
geographic expansion of venture capital (Sorenson et al. 2016).
While a hazard model examining the chances for failure, future fund-
ing, or exit would be ideal, it is difficult to do a longitudinal analysis with
the dataset. Nonetheless, failure rates do not seem particularly high, as
40%
35%
30%
25%
20%
15%
10%
5%
0%
Major Awards Patents
Fig. 7.3 Measures of innovation: percent of projects in category reporting win-

ning major awards or applying for patents
compared to other estimates of organizational failure rates for new

startups. Of the organizations that raised money on Kickstarter, 10.71%
report ceasing operations, and another 5.02% report ceasing operations
after acquisition.
7.3.3 Innovation and Creative Impact
Creators believe they are doing innovative work: 66% of them agreed or
strongly agreed that their project was innovative (see Fig. 7.3). There is
reason to believe that this self-assessment is largely accurate. In a separate
survey of backers, backers classified 50.1% of successful projects as inno-
vative. This innovativeness had a variety of measurable impacts. Around
4% of projects filed patents, meaning that, through May 2015, at least
2601 patents were filed by projects (CI = 2349–2854), though this could
be much higher since some projects likely filed multiple patents. In addi-
tion, 13.7% of projects reported winning major awards, which would
mean that 8446 projects (CI = 7975–8917) won these awards.
Additionally, all project creators were asked whether they agreed or
disagreed with the statements about the creative impact of the campaign
on their work in Table 7.7, with 1 being strongly disagree, 5 being
strongly agree, and 3 being neutral.
146 E. Mollick
Table 7.7 Responses to questions about artistic freedom (from 1, “strongly dis-
agree,” to 5, “strongly agree”)
Mean (1–5
scale) SE
This campaign afforded you the creative independence 4.00 0.011
you would not have been able to find through other
funding avenues
This campaign allowed you to bring the project to life 4.28 0.001
without compromising your vision
This campaign allowed you to pay collaborators you 3.61 0.014
would not have been able to pay otherwise
This campaign allowed you to pursue your vision full 2.79 0.015
time
This campaign helped you build a following or customer 3.53 0.013
base that patronized your work after your Kickstarter
campaign ended
7.3.4 Social Impact
Many projects reported a social impact to their work—either assisting a

community, building something for society, or engaging in charitable
work (see Table 7.8).
7.4 Conclusions
This data presents a consistent (and remarkably sunny) view of the value
of reward-based crowdfunding. Projects seem to deliver the vast majority
of the time, despite the frequent barriers they face and the low cost of
failure. Further, successful crowdfunding projects have implications that
go beyond the interactions of the backers and creators who participate in
projects. Crowdfunding campaigns lead to new organizations that
ultimately generate billions in non-crowdfunding revenue and have
hired thousands of employees. Individual project creators often use
crowdfunding campaigns to transition or advance their careers, or else to
start new ventures. There also appears to be substantial new innovations
and positive social good that comes from crowdfunding campaigns,
though this can be difficult to quantify. While it is not possible in this
Table 7.8 Social impact of projects

Percent responding
yes (%) SE
Did your project produce something aimed at 53 0.0
helping a community?
The project helped do something important for 27 0.0
society
Project helped create something important 67 0.0
Table 7.9 Factors predicting campaign’s failure to deliver (Middle failure case)
(1) (2)
Variables Logit coeff Odds ratio
Log(Pledged) −1.511*** 0.221***
(0.257) (0.057)
Log(Pledged)2 0.161*** 1.174***
(0.033) (0.039)
Category: Comics −0.272* 0.762*
(0.139) (0.106)
Category: Crafts 0.313* 1.368*
(0.178) (0.244)
Category: Dance −0.424* 0.655*
(0.224) (0.147)
Category: Design 0.065 1.067
(0.111) (0.118)
Category: Fashion 0.077 1.080
(0.136) (0.147)
Category: Film & Video 0.375*** 1.455***
(0.085) (0.124)
Category: Food 0.441*** 1.555***
(0.108) (0.168)
Category: Games 0.166 1.181
(0.108) (0.127)
Category: Journalism −0.068 0.934
(0.281) (0.262)
Category: Music −0.220** 0.802**
(0.088) (0.071)
Category: Photography 0.004 1.004
(0.150) (0.150)
Category: Publishing −0.179* 0.836*
(0.106) (0.088)
Category: Technology 0.466*** 1.594***
(0.117) (0.186)
(continued)
148 E. Mollick
(1) (2)
Variables Logit coeff Odds ratio
Category: Theater 0.028 1.028
(0.120) (0.123)
Provided updates during −0.015*** 0.985***
campaign
(0.005) (0.004)
Had video −0.191*** 0.827***
(0.063) (0.052)
Creator commented during 0.000 1.000
campaign
(0.001) (0.001)
Days project was live 0.003* 1.003*
(0.002) (0.002)
Constant 0.860 2.362
(0.573) (1.353)
Observations 30,323 30,323
df_m 26 26
χ2 665.7 665.7
Pseudo r2 0.037 0.037
Omitted category is Art. Year controls included. Standard errors in parentheses
***p < 0.01; **p < 0.05; *p < 0.1
study to compare the efficiency of crowdfunding to other methods of

encouraging entrepreneurship or subsidizing creative work, it is clear
that, overall, the money raised from campaigns leads to positive returns
across a variety of measures.
An important question is whether these results apply to other forms of
crowdfunding. In equity crowdfunding, early work suggests that many of
the same factors apply. In particular, equity crowdfunded companies in
Germany appear to have relatively low failure rates but also low exit rates
(Hornuf and Schmitt 2016). This appears consistent with startups on
Kickstarter, which also have low failure rates and relatively few companies
achieving large scale. Similarly, signal quality seems to matter in both
equity and reward crowdfunding (Ahlers et al. 2015). At the same time,
the equity crowdfunding market is rapidly evolving, and the lessons from
reward crowdfunding may attenuate as time goes on.
There is much to learn about crowdfunding, but these early results are
encouraging. In general, reward-based crowdfunding appears to be a via-
ble way for founders to launch sustainable organizations. Innovative proj-

ects appear common, as do projects that improve social good.
Notes
1. Kickstarter collaborated on data gathering, but these results are indepen-
dent and solely my own work. I was not paid by Kickstarter, and all analy-
ses were conducted independently of Kickstarter. Kickstarter was offered
the chance to comment on, but not change, this chapter before it was
made public. For the survey of project creators, the survey was conducted
by me alone, and responses were not shared with Kickstarter. For the
backer data, Kickstarter conducted the survey using questions jointly
developed with me, but shared all relevant non-private data. All errors and
omissions are mine. I would also like to acknowledge the help of Derya
and Matt Lane, who assisted me with the research. Funding for the proj-
ect was provided in part by the Kauffman Foundation.
2. Based on this survey, it appears that backers receive (or expect to receive)
their rewards on time in the majority of cases. Backers agreed or strongly
agreed with the statement that “the reward was delivered on time” for
65% of projects (i.e. the average answers from backers for a project ranged
from 4 to 5 on a 5-point scale); they disagreed or strongly disagreed with
the statement for 17% of projects (1–2 on the scale); and for the remain-
der neither agreed nor disagreed that delivery was on time (2.01–3.99 on
the scale). This only includes cases where backers were expecting a reward
of some kind.
3. See Mollick (2014), The Dynamics of Crowdfunding: An Exploratory
Study, Journal of Business Venturing, 29 (1).
References
Ahlers, Gerrit K.C., Douglas Cumming, Christina Günther, and Denis
Schweizer. 2015. Signaling in Equity Crowdfunding. Entrepreneurship Theory
and Practice 39: 955–980.
Bergmann, Michael. 2011. IPFWEIGHT: Stata Module to Create Adjustment
Weights for Surveys. Statistical Software Components. Boston College
Department of Economics.
150 E. Mollick
Cosh, Andy, Douglas Cumming, and Alan Hughes. 2009. Outside

Enterpreneurial Capital. The Economic Journal 119: 1494–1533.
2016. Disentangling Crowdfunding from Fraudfunding. Social Science
Feb 2017.
Greenberg, J., and E. Mollick. 2016. Activist Choice Homophily and the
Crowdfunding of Female Founders. Administrative Science Quarterly 62 (2):
341–374.
Crowdfunding. DICE Report 14: 16–22.
Kriauciunas, Aldas, Anne Parmigiani, and Miguel Rivera-Santos. 2011. Leaving
Our Comfort Zone: Integrating Established Practices with Unique
Adaptations to Conduct Survey-based Strategy Research in Nontraditional
Contexts. Strategic Management Journal 32: 994–1010.
Mollick, E. 2014. The Dynamics of Crowdfunding: Determinants of Success
and Failure. Journal of Business Venturing 29: 1–16. https://doi.org/10.2139/
ssrn.2088298.
Mollick, E., and R. Nanda. 2016. Wisdom or Madness? Comparing Crowds
with Expert Evaluation in Funding the Arts. Management Science 62:
1533–1553. https://doi.org/10.1287/mnsc.2015.2207.
Nickerson, David W. 2007. Does Email Boost Turnout. Quarterly Journal of
Political Science 2: 369–379.
Sorenson, Olav, Valentina Assenova, Guan-Cheng Li, Jason Boada, and Fleming
Lee. 2016. Expand Innovation Finance via Crowdfunding. Science 354:
1526–1528.
Ethan Mollick is the Edward B. and Shirley R. Shils Assistant Professor of
Management at the Wharton School. He studies innovation and entrepreneur-
ship and has published papers in top academic journals on topics ranging from
crowdfunding to entrepreneurial strategy. He is a Schultze Distinguished
Professor and Kauffman Foundation Junior Faculty Fellow.
8
Crowdfunding Creative Ideas:
The Dynamics of Project Backers
Venkat Kuppuswamy and Barry L. Bayus
8.1 Introduction
An important barrier to commercializing new ideas is the availability of
early stage funding (Cosh et al. 2009). Given the difficulties that new
ventures face in attracting financing from angel investors, banks, and ven-
ture capital funds, some entrepreneurs are tapping into large, online com-
munities of consumer-investors (Schwienbacher and Larralde 2012;
Agrawal et al. 2015). A relatively new form of informal venture financing
called “crowdfunding” allows entrepreneurs to directly appeal to the gen-
eral public for financial help in getting their innovative ideas off the
ground. Related to crowdsourcing (Bayus 2013), crowdfunding involves
an open call (through the Internet) for the provision of financial resources
either in the form of donation or in exchange for some form of reward in
order to support initiatives for specific purposes (Belleflamme et al. 2014).
V. Kuppuswamy • B.L. Bayus (*)

Kenan-Flagler Business School, University of North Carolina at Chapel Hill,
Chapel Hill, NC, USA

https://doi.org/10.1007/978-3-319-66119-3_8
152 V. Kuppuswamy and B.L. Bayus
Prominent examples include Sellaband (which offers consumer-investors

an interest in the venture in the form of some sort of profit-sharing agree-
ment; Agrawal, et al. 2015), Prosper (involving crowdlending in which it
is expected that the original principal is repaid along with some fixed inter-
est; Zhang and Liu 2012), JustGiving (in which funders voluntarily donate
their money with no expectations of any tangible reward; Smith et al.
2014), and Kickstarter (where project backers receive nonfinancial rewards
for their contributions; Mollick 2014). Kickstarter, which is the leading
crowdfunding platform in the United States, has raised USD 2.14 billion
in pledges to fund 108,000 creative ideas (Kickstarter 2016). By itself,
Kickstarter has provided more funding than the National Endowment for
the Arts (Boyle 2013; Mollick and Nanda 2016), and is one of the biggest
publishers of graphic novels in the United States (Flood 2012).
Despite the rapidly growing interest in this online form of venture
financing, research into this phenomenon is in its infancy (see the reviews
by Kuppuswamy and Bayus 2017; Moritz and Block 2016). To date, the
majority of empirical studies in this domain focus on identifying the
project and entrepreneur characteristics associated with successful fund-
ing outcomes. For example, research shows that funding success is posi-
tively related to project quality signals such as preparedness (Mollick
2014), narrative in the project description (Herzenstein et al. 2011b;
Allison et al. 2015), information disclosure (Hornuf and Schwienbacher
2017), and others’ contributions (Herzenstein et al. 2011; Zhang and
Liu 2012; Burtch et al. 2013; Smith et al. 2014), as well as individual
quality signals like gender, race, personal characteristics (Pope and Sydnor
2011; Gorbatai and Nelson 2015; Marom et al. 2015), creditworthiness
(Herzenstein et al. 2011; Zhang and Liu 2012), internal social capital
accumulated from supporting other projects (Colombo et al. 2015;
Zheng et al. 2014), social networks (Lin et al. 2014), and the geographic
distance between entrepreneurs and their supporters (Agrawal et al.
2015). With few exceptions, the level of analysis for the vast majority of
existing crowdfunding studies is the project (i.e., studies are cross-
sectional in nature; see Kuppuswamy and Bayus 2017). Researchers do
not generally use panel data to model the dynamics of project-funding
behavior over the project-funding cycle and, more importantly, to c ontrol
for unobserved project-level heterogeneity (e.g., with fixed project
Crowdfunding Creative Ideas: The Dynamics of Project Backers 153
effects). While many studies attempt to include appropriate controls with

measured variables, the reported conclusions from project-level (cross-
sectional) studies should be viewed with caution due to unobserved dif-
ferences in the inherent quality of projects that can potentially explain
observed project-funding outcomes.
Our interest in this chapter is to complement the existing cross-
sectional research by explicitly considering the dynamics of project sup-
port over time using panel data. Because most crowdfunding campaigns
last for only a few weeks, understanding funding behaviors over time is
important as we do not expect contributions to be uniform over the
project-funding cycle. For example, as suggested by related research in
online auction bidding (Ariely and Simonson 2003), the key drivers of
contribution decisions may vary over the beginning, middle, and later
stages of a crowdfunding campaign. Thus, the purpose of this chapter is
to add to our empirical understanding of crowdfunding by focusing on
the number of project backers added to a project each day over its fund-
ing cycle. We refrain from formally developing and testing specific
hypotheses because our empirical study is exploratory in nature. We
believe this approach is appropriate for a nascent and evolving topic like
online crowdfunding as very little prior work on backer dynamics exists
with which to guide our research. Instead, we expect that our empirical
findings will be useful for future theory-building.
8.2 Empirical Setting and Available Data

In this section, we briefly discuss the empirical setting of our study. Based
in the United States, Kickstarter is one of the world’s largest crowdfunding
platforms. According to their website, “Kickstarter is focused on creative
projects. We’re a great way for artists, filmmakers, musicians, designers,
writers, illustrators, explorers, curators, performers, and others to bring
their projects, events, and dreams to life.” Projects are grouped into broad
categories: Art, Comics, Dance, Design, Fashion, Film and Video, Food,
Games, Music, Photography, Publishing, Technology, and Theater. The
website defines a project as “something finite with a clear beginning and
end. Someone can be held accountable to the framework of a project—a
project was either completed or it wasn’t—and there are definable expecta-

tions that everyone can agree to.” Kickstarter does not accept projects cre-
ated to solicit donations to causes, charity projects, or general business
expenses.
In order to participate, individuals must join the Kickstarter commu-
nity (at no cost) by selecting an anonymous username. Like most online
communities, information on demographics and personal characteristics
are not collected (the Kickstarter community is a large, undefined
“crowd”). Community members can propose projects for funding, back
a project by financially contributing (with a credit card via Amazon),
and/or comment on projects. Kickstarter projects can only be proposed
by US residents (for tax purposes); project contributors have no geo-
graphic restrictions.
To use Kickstarter, an entrepreneur (called “creator” in Kickstarter)
creates a webpage for the project on the platform explaining the purpose
of the project and the specific deliverables that they aim to produce with
the contributed funds. Along with an end date for the project-funding
cycle, the creator also indicates the funding goal of the project, that is, the
amount of money they require to execute the project as specified. Creators
can communicate with their supporters by posting public updates that
everyone can see.
When a potential funder (called “backer” in Kickstarter) visits an
active project’s webpage, they are presented with all the project informa-
tion initially posted by the creator. Moreover, potential backers are shown
the current funding status of the project (i.e., the funds raised thus far),
the ultimate funding goal, and the number of days remaining until the
project-funding cycle expires. A potential funder can also see a listing of
the other backers who have contributed to the project, as well as the tim-
ing of these contributions.1 To help potential backers discover projects
they want to support, Kickstarter has a number of search options. In
particular, projects can be sorted based on the first week after their initial
launch (“Recently Launched”), the last week before the project funding
closes (“Ending Soon”), or popularity (based on the number of backers
recently added to a project).
There are two important features of Kickstarter that distinguish it from
many other smaller crowdfunding platforms, as well as more traditional
forms of entrepreneurial finance. The first is the “all-or-nothing” aspect

of fundraising on the platform. A project must be fully funded before its
funding cycle concludes or no money pledged by any backer is trans-
ferred to the project creator. An overambitious funding goal may thus
result in the fundraising effort falling short and, consequently, raising no
funds whatsoever. At the same time, once a project has reached its fund-
ing goal, it can continue to receive contributions until its deadline. As a
result, funded projects can exceed their original funding goal.
The second important feature of the Kickstarter model is the fact that
individuals contributing to a project do not receive equity in the project
in return for their funds. Specifically, backers do not receive any financial
incentives, returns, or repayment in exchange for their contributions.
Instead, project creators typically offer more modest “rewards” to con-
tributors which vary by the level of contribution. According to the
Kickstarter website, the four most common reward types are (a) copies of
the thing (e.g., the actual product, an assembled version of a DIY kit); (b)
creative collaborations of various kinds (e.g., a backer might appear as a
hero in the comic, or he or she may be painted into the mural); (c) cre-
ative experiences (e.g., a visit to the film set, a phone call from the author,
dinner with the cast, a concert in the backer’s backyard); and (d) creative
mementos (e.g., photos sent from filming location, or explicit thanks in
the closing credits of the movie).
Data for our study come from publicly available information on the
Kickstarter website. We extracted information on all backed projects
posted on the platform from its inception in May 2009 through February
2012. We focused on projects with at least one backer since we were
interested in the dynamics of backer behavior (projects with zero backers
would not contribute any information to our analyses). To allow a time
buffer for community activity around a project to stabilize, projects com-
pleted after 2011 were dropped from the analysis. In addition, projects
started in 2009 were not used in the analysis because the look and feel of
the website underwent several revisions in the first few months after
launch. We restricted our analyses to projects with a duration of at least
21 days to ensure an adequate length of time to examine backer behaviors
during the early, middle, and late stages of the funding cycle. After clean-
ing the data for inaccuracies and incomplete information, daily data of
two years on 14,704 projects that began on or after January 1, 2010, and
concluded by December 31, 2011, are available for analysis purposes.
Descriptive statistics for these projects are reported in Table 8.1. The
average project2 has a goal of just over USD 9,900 but only receives a
little more than USD 2,100 in pledged contributions.3 Projects tend to
last for around six weeks; a relatively large proportion of backers support
a project in the first or last weeks of its funding cycle. Almost 80 percent
of the projects include a video. The average project offers more than seven
reward categories as incentives for their donors and receives about USD
70 per backer. Creators generally post a couple of project updates. Over
90 percent of creators only propose a single Kickstarter project.
There is a considerable amount of variance in the funding outcomes
for Kickstarter projects. Figure 8.1 shows the distribution of project suc-
cess: projects that reach their funding goal do so by a small margin (almost
half of all the successful projects are within 10 percent of their original
funding goal), while projects that miss their targets do so by a large mar-
gin (almost half of all the unsuccessful projects achieved less than 10
percent of their goal).
Table 8.1 also reports descriptive statistics by funding level achieved.
While unsuccessful projects have a funding goal more than four times as
large as successful projects (USD 14,686 compared to USD 3,486), these
projects receive less than half of the amount contributed to successful
projects (USD 1,214 compared to USD 3,496). Successful projects tend
to be shorter in duration. All projects receive a relatively large proportion
of their backers in the first week, and successful projects also get a lot of
support in the last week of their funding cycle. Not surprisingly, success-
fully funded projects have significantly more backers than unsuccessful
projects, and add more backers each day. Successful projects tend to com-
municate more to the community and their backers by posting updates.
8.3 Empirical Analyses

In this section, we attempt to shed some empirical light on the dynamics
of backer behaviors in reward-based crowdfunding. To do this, we exploit
the panel structure of the Kickstarter data to explore the relationship
Table 8.1 Summary statistics for Kickstarter projects 2010–2011 (N = 14,704)

Funding level achieved
(1) (2) (3) (4)
Total sample <100% of 100% of >100% of
mean goal goal goal
Variable (N = 14,704) (N = 8681) (N = 897) (N = 5126)
Goal (USD) 9,907.24 14,686.4 3,485.68 2,937.36
Total amount pledged 2,160.22 1,214.07 3,496.46 3,528.72
(USD)
Percent of goal funded 62.39 15.44 100.23 135.27
Percent of goal achieved 21.32 6.09 30.33 45.53
in first week
Percent of goal remaining 51.8 87.01 26.81 −3.45
in last week
Duration (days) 43.47 46.72 40.1 38.53
Number of backers 28.63 17.27 30.34 47.55
Number of backers in first 9.31 6.57 7.93 14.19
week
Number of backers in last 6.21 2.39 9.1 12.19
week
Number of backers added 0.64 0.36 0.74 1.2
per day
Average contribution per 70.57 59.52 129.35 78.99
backer (USD)
Number of reward 7.59 7.62 7.04 7.64
categories
Maximum reward claimed 339.94 255.68 471.53 456.26
(USD)
Percent of rewards 79.63 79.44 74.39 80.87
claimed
Has video (1 = yes) 0.78 0.78 0.77 0.8
Number of days on top 50 0.32 0.12 0.19 0.67
most popular list
Number of updates 1.95 1.56 1.91 2.63
Number of updates in 0.49 0.49 0.38 0.56
first week
Number of updates in 1.15 0.93 1.08 1.54
middle period
Number of updates in last 0.42 0.24 0.63 0.7
week
Number of active projects 1.86 1.86 1.82 1.87
(×1000)
(continued)
Funding level achieved

(1) (2) (3) (4)
Total sample <100% of 100% of >100% of
mean goal goal goal
Variable (N = 14,704) (N = 8681) (N = 897) (N = 5126)
Maximum number of 0.28 0.28 0.27 0.28
backers on competing
projects
Proposed by a serial 0.07 0.06 0.1 0.08
creator (1 = yes)
Creator previously backed 0.21 0.18 0.22 0.27
a project (1 = yes)
5000
4500
4000
3500
3000
Frequency
2500
2000
1500
1000
500
Percent of Funding Goal Achieved
Fig. 8.1 Distribution of project-funding outcomes
between the daily support a project receives and various explanatory and
control variables. The key dependent variable in our analyses is
BackersAdded, a count variable which is the number of backers project i
receives on day t. Because the dependent measure is a non-negative inte-
ger, our empirical strategy is to estimate appropriate panel count models
(using a Poisson Quasi-Maximum Likelihood estimator). To account for
any unobserved project heterogeneity (e.g., projects may differ in unob-

served “quality”), we estimate fixed-effects models. Essentially, fixed-
effects models incorporate project-specific intercept terms. Based on a
Hausman-type test (see Allison 2005), fixed-effects models are preferred
over random-effects models for the Kickstarter data. Importantly, a fixed-
effects model removes any unobserved time-invariant heterogeneity
across projects and allows these unobserved differences to be correlated
with the independent variables (and thus is less likely to be biased).
Although time-invariant characteristics are controlled, estimation of the
fixed-effects models is accomplished using a conditional maximum likeli-
hood estimator where all time-invariant project effects are conditioned
out of the model using an individual’s total count (Cameron and Trivedi
2009). Cluster-robust standard errors for the estimated coefficients are
used for statistical tests due to dependence among the errors over time
within a project.
8.3.1 The Dynamics of Project Support
We begin by empirically exploring the dynamics of project support over

its funding cycle. The average number of backers added to a project over
its relative funding cycle is depicted in Fig. 8.2. Consistent with the
descriptive statistics in Table 8.1, projects tend to get a lot of backer sup-
port in the first and last weeks of their funding cycle. A high level of ini-
tial project support in the first few days is followed by generally decreasing
support over most of the first week. A pronounced lull in project activity
occurs during the middle period of the funding cycle. As the project
approaches its conclusion, there is an increase in contributions. To better
understand the dynamics of project-funding behaviors, we next turn to
an econometric analysis of these data.
We define binary variables to capture the first seven days (Day T, where
T = 1, …, 7) and last seven days (L LastDay, where L = 1, …, 7) in the
project-funding cycle. Here the reference category is the middle period.
In addition, several time-varying variables that account for possible effects
due to other project or situational factors are included in our analyses. As
suggested by Fig. 8.2, several projects in our sample exceed their original
1.8
1.6
Average Number of Backers 1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
0–10 10–20 20–30 30–40 40–50 50–60 60–70 70–80 80–90 90–100
Percent of Funding Cycle Elasped
Fig. 8.2 Average number of backers added to a project on any day
funding goal. To account for any differences in backer behaviors for these
projects, we include PostFunded, defined to be one for each day a project
has already been funded and zero otherwise. We control for competition
among projects for backer support by including ActiveProjects (the num-
ber of Kickstarter projects across all categories4 that are accepting pledges
on day t in thousands) in our estimations. We also include
MaxCompetingBackers (the maximum number of cumulative backers
across all competing projects accepting pledges on day t) to control for
any possible negative effects due to other projects that are receiving a lot
of backer support. Finally, we control for the possibility that pledges con-
centrate on certain days by including separate dummy variables for day of
week and account for any other unobserved time-varying effects by
including month-year dummy variables. This framework with the dummy
variables for time in the project-funding cycle, along with control vari-
ables, is the basic econometric model used in most of our analyses.
The results of estimating a conditional fixed-effects Poisson model that
corrects for overdispersion and allows for cluster-robust standard errors
(Wooldridge 1999; Cameron and Trivedi 2009) are given in Table 8.2.
While we do not report the estimation details for day of week and month-
year to conserve space, we can make a few observations. First, projects are
more likely to receive contributions on weekdays compared to weekends,
with activity increasing from Sunday to a peak on Wednesday; thereafter,
Table 8.2 Panel estimation results for the dynamics of backer support (cluster-robust standard errors; t-statistics in
parentheses)
Model 1 Model 2 Model 3 Model 4 Model 5
(Goal ≤ USD (Goal > USD
Variable (All) (Funded) (Unfunded) 3,500) 3,500)
Day in the project-funding cycle
Day 1 1.30 (0.02)*** 1.13 (0.02)*** 1.58 (0.02)*** 1.27 (0.02)*** 1.32 (0.02)***
Day 2 1.11 (0.02)*** 1.00 (0.02)*** 1.31 (0.02)*** 1.06 (0.02)*** 1.14 (0.02)***
Day 3 0.81 (0.01)*** 0.68 (0.02)*** 1.03 (0.02)*** 0.75 (0.02)*** 0.85 (0.02)***
Day 4 0.61 (0.02)*** 0.49 (0.02)*** 0.83 (0.02)*** 0.56 (0.02)*** 0.64 (0.02)***
Day 5 0.47 (0.02)*** 0.36 (0.02)*** 0.66 (0.03)*** 0.43 (0.02)*** 0.50 (0.02)***
Day 6 0.37 (0.02)*** 0.28 (0.02)*** 0.56 (0.03)*** 0.32 (0.02)*** 0.42 (0.02)***
Day 7 0.28 (0.02)*** 0.19 (0.02)*** 0.44 (0.02)*** 0.24 (0.02)*** 0.31 (0.03)***
7th LastDay 0.34 (0.02)*** 0.45 (0.02)*** 0.04 (0.04) 0.38 (0.03)*** 0.31 (0.03)***
6th LastDay 0.42 (0.02)*** 0.55 (0.02)*** 0.11 (0.03)** 0.47 (0.02)*** 0.39 (0.03)***
5th LastDay 0.53 (0.02)*** 0.69 (0.02)*** 0.15 (0.04)*** 0.59 (0.03)** 0.48 (0.03)***
4th LastDay 0.69 (0.02)*** 0.87 (0.02)*** 0.31 (0.04)*** 0.76 (0.03)*** 0.63 (0.03)***
3rd LastDay 0.94 (0.02)*** 1.16 (0.02)*** 0.51 (0.04)*** 1.02 (0.02)*** 0.88 (0.03)***
2nd LastDay 1.23 (0.02)*** 1.53 (0.02)*** 0.73 (0.03)*** 1.31 (0.02)*** 1.16 (0.03)***
LastDay 1.02 (0.03)*** 1.45 (0.03)*** 0.46 (0.04)*** 1.22 (0.03)*** 0.87 (0.04)***
Explanatory variables
PostFunded −0.94 (0.02)*** −1.41 (0.03)*** NA −1.20 (0.03)*** −0.63 (0.04)***
Control variables
Active projects −0.20 (0.07)** 0.36 (0.08)*** −0.56 (0.10)*** 0.18 (0.09)* −0.40 (0.09)***
MaxCompetingBackers −0.05 (0.04) −0.04 (0.05) −0.06 (0.07) −0.10 (0.05) −0.03 (0.06)
Crowdfunding Creative Ideas: The Dynamics of Project Backers
Fixed-effects
Day of week Yes Yes Yes Yes Yes
Month-year Yes Yes Yes Yes Yes
(continued)
161
162
Model 1 Model 2 Model 3 Model 4 Model 5

(Goal ≤ USD (Goal > USD
Variable (All) (Funded) (Unfunded) 3,500) 3,500)
Project Yes Yes Yes Yes Yes
V. Kuppuswamy and B.L. Bayus
N (observations) 653,820 239,520 414,300 311,150 342,670

N (projects) 14,704 6,023 8,681 7,499 7,205
Chi-square 22,021.77*** 12,647.52*** 12,595.90*** 12,856.73*** 10,590.52***
*Significant at 0.05 level; **significant at 0.01 level; ***significant at 0.001 level
activity decreases to its lowest point on Saturday. Month-year fixed effects

indicate that projects are less likely to add backers as we move from the
beginning of the sample period (January 2010) to the end (December 2011).
The coefficient estimates for MaxCompetingBackers are insignificant in
Table 8.2. These results do not strongly support the idea of a “Blockbuster
Effect” in which a project with a large number of backers steals potential
backers from other projects (Kickstarter 2013). Across all the models in
Table 8.2, the coefficient estimate for PostFunded is negative and signifi-
cant. This indicates that backer support drops off considerably once a
project surpasses its goal. From Model 1, we find the effect of ActiveProjects
on backer support is negative and significant. This is consistent with the
idea of “Kickstarter Fatigue” as proposed by some industry followers in
which potential backers are becoming weary due to an increasing number
of projects asking for their financial contributions (Goninon 2013;
Maxwell 2013; Nelson 2013). This particularly seems to be the case for
projects with high goals (Model 4). Further, the results in Models 2 and
3 indicate that a large number of competing projects is associated with
more backer support for projects that are eventually funded and less for
unsuccessful projects. Together, these results suggest that there are limits
to the financial support of backers.
Strongly confirming a U-shaped pattern of backer support, the coeffi-
cient estimates for the Day and LastDay binary variables are jointly sig-
nificant and positive in all the models. Moreover, these variables
significantly decrease in magnitude over the first week and significantly
increase in magnitude over the last week.5 The positive coefficient
estimates indicate that backers are more likely to pledge in the first and
last week as compared to the middle period in the project’s funding cycle.
Deadline effects in which a lot of action occurs as the end of an experi-
ence is approached has been widely observed in many contexts (Webb
and Weick 1979; Ariely and Simonson 2003). Consistent with the idea
of a deadline effect, almost two-thirds of the projects in our sample
achieved their target goal in the last week of their funding cycle. More
persuasively, the significant and increasing coefficient estimates for the
LastDay variables strongly suggest a deadline effect.
Models 2 and 3 demonstrate that both successfully and unsuccessfully
funded projects also exhibit a U-shaped pattern of backer support, as do
projects with different goal targets (Models 4 and 5). It is interesting that
successfully funded projects exhibit the same dip in activity during the
middle period of the funding cycle as projects that do not meet their goal.
Thus, even successful projects find it very difficult to maintain their ini-
tial momentum in continuing to get pledges over the entire funding
cycle. In our extended working paper (Kuppuswamy and Bayus 2015),
we confirm that this U-shaped pattern of project support is pervasive
across different project types (Art, Product Design, Film and Video,
Games, Music, Technology). These results extend common thinking that
only successfully funded projects exhibit a U-shaped pattern in project
support over its funding cycle (de Witt 2012; Steinberg 2012)—in fact,
this U-shaped pattern is systematic and persistent across Kickstarter
projects.6
8.3.2 Inside the Dynamics of Project Support
In this section, we consider several factors that have been related to

project-funding success by other researchers. We extend these prior stud-
ies by empirically exploring the dynamics associated with these factors.
Specifically, we consider four questions: (1) Is the U-shaped pattern of
project support due to collective attention effects, that is, do backers sim-
ply support projects that are easily found and most visible from using the
available platform project-sorting options (Qui 2013)? (2) What is the
role of family and friends over the project-funding cycle (Agrawal et al.
2015)? (3) What are the dynamic effects of social influence in supporting
a project (Herzenstein et al. 2011; Zhang and Liu 2012; Agrawal et al.
2015; Hornuf and Schwienbacher 2017; Vismara 2015)? (4) What is the
role of project updates over the project-funding cycle (Mollick 2014;
Block et al. 2017)?
8.3.2.1 Collective Attention Effects
One interesting perspective that might account for the U-shaped pattern
of backer support comes from research on the effects of consumers’ lim-
ited attention in the digital economy where information is abundant
(Falkinger 2008; Wu and Huberman 2007; Hodas and Lerman 2013).

The problem of collective attention is at the center of online communi-
ties and the spread of ideas—“a wealth of information creates a poverty
of attention” (Simon 1971: 40). This collective attention framework is
extended by Hodas and Lerman (2013), who find little evidence that the
novelty of news stories decays over time (i.e., older stories are just as
appealing as newer stories). Instead, they argue that people pay more
attention to recent stories because they are easy to find and more visible.
This idea is consistent with Nelson (2013), who suggests that the major-
ity of pledges to a crowdfunding campaign come at the beginning and
end of a project because projects are most visible then. In an online envi-
ronment, there are often several website features and sorting options that
lower search costs, making projects more visible (Bakos 1997).
In the case of Kickstarter, projects can be sorted based on whether
they were “Recently Launched” (the first week after a project’s initial
launch) or will be “Ending Soon” (the last week before a project’s fund-
ing closes). Thus, the collective attention argument is that the significant
coefficient estimates for the first and last weeks’ daily variables in
Table 8.2 are due to the use of these sorting options in Kickstarter—
potential backers simply support projects that are most visible from
using these sorting options. If this were true, however, we would also
expect that the positive effects of the first and last weeks will be accentu-
ated when there are more p otential backers who can use these options to
view the projects. To examine this idea, we incorporate information on
daily traffic to Kickstarter over time in our basic econometric model
(from Quantcast.com, KickstarterTraffic is the number of unique visitors
to the Kickstarter website on day t in hundred thousands). If visibility is
a plausible explanation for the U-shaped pattern of project support, the
marginal effects of time in the funding cycle should be increasing as traf-
fic to the website increases. Based on the analyses reported in our
extended working paper (Kuppuswamy and Bayus 2015), we find an
insignificant trend in project support as Kickstarter traffic increases.
Thus, the greater project support observed in the first and last weeks does
not seem to be due to higher project visibility associated with the
“Recently Launched” and “Ending Soon” sorting options available with
Kickstarter.
8.3.2.2 The Role of Family, Friends, and Followers
Even though there are relatively few empirical studies, it is generally

acknowledged that financial support from family and friends is an impor-
tant source of early stage funding for new ventures (Cumming and Johan
2009; Agrawal et al. 2015). Agrawal et al. (2015) empirically show the
importance of friends and family investors in the SellaBand crowdfund-
ing community. This is consistent with the general belief among crowd-
funding pundits who argue that successful projects create a critical mass
of early funding from the people in their close social circles (de Witt
2012; Steinberg 2012).
To explore this idea, we examine the timing of Kickstarter pledges
from direct family relatives. Given the anonymous nature of members
in the Kickstarter community, we rely on a manual coding of user-
names to construct an indicator variable for whether a project was sup-
ported by a backer who has the same last name as the project creator.
Based on an analysis reported in our extended working paper
(Kuppuswamy and Bayus 2015), we find that family members are most
likely to support a Kickstarter project in the first week after launch, as
well as just before it ends. Further, we find evidence that Kickstarter
project creators attract most of their funding by mobilizing their own
social network of friends (who are directly known by the project cre-
ator) and followers (who indirectly know the project creator from social
media connections).
8.3.2.3 The Effects of Social Influence
As noted by several researchers in lending and donation-based settings

(Herzenstein et al. 2011; Zhang and Liu 2012; Burtch et al. 2013;
Agrawal et al. 2015), an important factor that can influence the behavior
of backers in crowdfunding communities is information on others’ prior
funding decisions. In particular, the level of financial support for each
project as well as its timing is publicly visible on most platforms.
Figure 8.1 highlights an interesting phenomenon in Kickstarter that
involves social influence within the community. Commonly known as
the “Kickstarter Effect,” as a project nears its goal there can be a flurry of
activity that pushes it over its target (Galinsky 2010; Nelson 2013). Matt
Haughey, a backer of more than 150 Kickstarter projects, sums it up this
way (Steinberg 2012: 149):
[O]nce you pass 50 percent of your funding, at any point, you have a 95 percent
chance of reaching your goal. … Only a handful of projects have finished
unsuccessfully having reached 85 percent or more of their funding. The people
who are at like 60, 70 percent with a week to go, it’s gonna be OK!
Clearly, there is solid empirical support for this notion from the strong
U-shaped pattern of project support over the project-funding cycle.
While much of the research studying the reasons for goal pursuit has
emphasized individuals and their personal goals, this work can be used to
understand the motivations for individuals to contribute to the shared
goals of a group (Fishbach et al. 2011). When group identification is rela-
tively weak (as in crowdfunding communities with anonymous mem-
bers), research finds that individuals decide to pursue a shared group goal
if they believe the goal is worthwhile (Fishbach et al. 2011). Here, others’
prior contributions can positively influence the assessment of goal value.
In the case of crowdfunding, whether or not a project is deemed worthy
of support depends on how much of the goal has already been pledged.
Backers want the project to succeed, and projects closer to their target
goal are more likely to reach their funding objective.
Given that a project is considered to be worthwhile, the Kickstarter
Effect further suggests an acceleration in funding activity as a project
nears its goal. Such an increase in motivation and effort to reach a goal as
it is approached has been found in humans and other animals (Liberman
and Forster 2008; Toure-Tillery and Fishbach 2011). Rats run faster
through a maze as they get closer to food (Hull 1932), people increase
their purchases as they approach rewards from loyalty cards (Kivetz et al.
2006), and groups of donors contribute more to charitable campaigns
close to reaching their goals (Fishbach et al. 2011; Cryder et al. 2013).
More formally, the “goal-gradient” hypothesis is that motivation to reach
a goal increases monotonically with proximity to the desired end state
(Hull 1932). One key reason for goal-gradient behavior is that the
erceived impact of later-stage decisions tends to increase over the course

p
of goal pursuit (Toure-Tillery and Fishbach 2011). For example, the mar-
ginal impact of a USD 100 contribution to a project that is halfway
toward its goal of USD 1,000 is much less than the marginal impact of
the same contribution if this project has already achieved 90 percent of
its goal. As discussed by Cryder et al. (2013), perceived impact is an
important rationale for prosocial acts like crowdfunding. Even in situa-
tions when there are no financial rewards, backers still perceive that later-
stage funding decisions close to the goal have more impact and thus they
are even more likely to make a donation when the target is in sight.
Based on analyses reported in Kuppuswamy and Bayus (2017), we find
strong evidence for the goal-gradient pattern of increasing project sup-
port as the target goal is approached. Thus, there does seem to be empiri-
cal evidence for positive effects of social influence linked to how much
has already been pledged to the project goal.
8.3.2.4 The Role of Project Updates
To reach their crowdfunding goals, industry pundits insist that project

creators need to develop and execute an effective campaign that commu-
nicates with the media, bloggers, and potential contributors (Steinberg
2012; Dushnitsky and Marom 2013). While comprehensive and detailed
information on any marketing efforts external to the Kickstarter com-
munity is not available, project creators can communicate with potential
backers via project updates. In fact, many experts highly recommend
updates as a way to generate visibility and excitement around crowdfund-
ing projects (Budman 2012). Based on an analysis of updates reported in
our extended working paper (Kuppuswamy and Bayus 2015), we find
that higher levels of project support are positively related to updates.
We also find that updates tend to occur during the early and late stages
of a project and that it is difficult to maintain the initial excitement that
comes right after project launch. This especially seems to be the case for
successfully funded projects—as reported in Table 8.1, successful projects
have significantly more updates than unsuccessful projects, and add sig-
nificantly more backers each day (and during the first and last weeks). In
addition, creators tend to use updates more aggressively as their project

nears its goal.
8.4 Discussion and Implications

Given the difficulties that new ventures face in attracting financing from
traditional sources, many entrepreneurs are directly appealing to the gen-
eral public for help through large, online communities of consumer-
investors. These crowdfunding campaigns typically involve relatively
small contributions of many individuals over a fixed time limit (generally
a few weeks). The aim of this chapter is relatively modest; we seek to add
to our empirical understanding of backer dynamics over the project-
funding cycle. The empirical setting for our study is Kickstarter, one of
the oldest and largest reward-based crowdfunding communities on the
Web. Publicly available information of two years on successfully and
unsuccessfully funded projects is used to obtain the following empirical
findings.
• Backer support over the project-funding cycle is not uniform. Potential

backers are more likely to pledge in the first and last weeks as com-
pared to the middle period of the funding cycle.
• A U-shaped pattern of project support is persistent across crowdfund-
ing projects—including both successfully and unsuccessfully funded
projects, those with large and small goals, and projects in different
categories like Art, Design, Film and Video, Games, Music, Technology.
• There is a strong deadline effect in which project support tends to
increase in the last week of the project-funding cycle.
• Potential backers are less likely to contribute once a project reaches its
goal.
• For the full sample of projects, there is evidence supporting the idea of
Kickstarter Fatigue in which the number of other active projects on
the platform is negatively related to backer support.
• For the full sample of projects, there is no evidence for a Blockbuster
Effect in which a project with a lot of backers draws potential con-
tributors away from other projects.
• Most backer contributions do not come in during the first and last
weeks because projects are more visible then due to sorting options
available on the platform.
• Support from family members tends to occur in the first week and just
before the project ends.
• Most of the contributors at any point in the funding cycle are one-
time backers that likely come from the creator’s own social circle.
• As the end goal is approached, project support monotonically increases.
Thus, there is strong and consistent evidence for the Kickstarter Effect
in which projects nearing their goal often see a flurry of activity that
pushes it over its target.
• Potential backers are influenced by how much of the goal has already
been pledged.
• Project support is positively related to updates, and updates are more
likely to be posted during the first week and last three days as com-
pared to the middle period of the funding cycle.
• Project creators tend to post updates as their project nears its goal.
These empirical findings significantly extend our understanding of

backer dynamics over the project-funding cycle. While all of our find-
ings only apply to the Kickstarter reward-based crowdfunding commu-
nity, we can make some comparisons with other crowdfunding settings.
Our analyses confirm the general results of Agrawal et al. (2015) in a
crowdinvesting community regarding the importance of friends and
family investors, particularly in the early stages of the funding cam-
paign. At the same time, the vast majority of Kickstarter contributors
are one-time backers who only pledge to a single project (most of these
backers join the community and pledge on the same day). In contrast,
serial backers with prior experience are the primary investors in other
forms of crowdfunding (Agrawal et al. 2015). This distribution of
backer experience suggests that the project creator’s own social network
of family, friends, and followers is even more important in reward-
based crowdfunding than in crowdinvesting, crowdlending, or dona-
tion-based crowdfunding. Further research with appropriate data is
needed to map out the details of project backers and their social con-
nections with the project creators.
The effects of social influence from others’ prior funding decisions are
of great interest in crowdfunding, particularly since the level of financial
support and its timing is publicly visible on most platforms. The effects
of social influence are found to be positive in crowdinvesting and
crowdlending communities (Herzenstein et al. 2011; Zhang and Liu
2012; Agrawal et al. 2015) and negative in a donation-based setting
(Burtch et al. 2013). In this chapter, we find strong evidence for positive
effects of social influence in reward-based crowdfunding. Because
consumer-investors in crowdinvesting and crowdlending expect a finan-
cial return on their contributions, the literature on rational herding and
information cascades argues that positive herding based on the number
of prior contributors signals that a project is of high quality (Devenow
and Welch 1996). In this case, herding behavior is a “rational” way for
individuals to reduce their own risk in the face of uncertainty about a
proposed new idea. For reward-based crowdfunding, we find positive
herding based on how much of the project goal has already been pledged
by others. We believe that the positive effects of social influence in reward-
based crowdfunding involve rational herding that comes from payoff
externalities in which a project closer to its goal is more likely to succeed
and, thus, a backer expects that their contribution will have more impact
if they also support this same project (Devenow and Welch 1996). Cryder
et al. (2013) present some empirical results from field and lab experiments
that are consistent with this idea. Further research is needed to confirm
the individual-level details of perceived impact of contributions near the
end of goal completion and whether payoff externalities do indeed explain
the observed goal-gradient behavior.
While there are some hints for other crowdfunding platforms that
project contributions follow a U-shaped pattern (Ceyhan et al. 2011)
and additional contributions are less likely once a project reaches its goal
(Herzenstein et al. 2011), further research is needed to firmly establish
whether these backer behaviors generalize across settings and projects.
For example, Hornuf and Schwienbacher (2017) find that the contribu-
tion pattern in crowdinvesting is L-shaped and very little is known about
the dynamics associated with different reward-based crowdfunding
models (does the entrepreneur keep all of the funds contributed no mat-
ter whether the target goal was reached versus the entrepreneur not
receiving any of the contributed funds if their target goal is missed;

Cumming et al. 2015).7 Outside of our results not supporting collective
attention effects in Kickstarter, little is known about the search costs of
potential investors and project visibility due to the sorting options avail-
able on other crowdfunding platforms. And, other than our findings
regarding the importance of project updates in Kickstarter, not much is
known about the possible effects of communications between project
creators and their potential contributors in other crowdfunding settings
(for an exception, see Block et al. 2017). Additional research can help
establish whether any further empirical regularities exist across the vari-
ous types of crowdfunding communities.
8.4.1 Implications for Entrepreneurs
With very few notable exceptions, the vast majority of creative ideas on
Kickstarter involve relatively modest amounts of money (from Table 8.1,
the average project has a goal of USD 9900 and successful projects on
average receive around USD 3,500). Typically, crowdfunding involves
small contributions from many people (from Table 8.1, the average
contribution is USD 70 and more than 25 backers support the average
project). As emphasized in the “how to crowdfund” books (e.g., de Witt
2012; Steinberg 2012), setting appropriate funding goals is paramount to
having a successful project. Many project failures set unreasonable fund-
ing targets given the scope of their creative idea (from Table 8.1, the aver-
age goal for unsuccessful projects is almost five times the goal for successful
projects). In general, projects with large goals are less likely to be funded
(Mollick 2014). Our results emphasize the importance of setting appro-
priate project goals—potential backers make their pledging decision
based on how much of the project goal has already been funded by oth-
ers. In light of these results, entrepreneurs may be tempted to artificially
set low goals so as to ensure that their project will achieve its target, at the
same time hoping that their project will exceed its low goal. Such a strat-
egy, however, may backfire as potential backers are also much less likely
to contribute to a project once it reaches its goal. If the project creator
actually requires more funding than their goal to make their creative idea
a reality, they may end up with insufficient funds. While the importance
of setting goals is usually noted in the various types of crowdfunding
communities, further research is needed to test whether goal-gradient
behavior generalizes across platforms.
Very few Kickstarter projects achieve at least 50 percent of their goal
and are not eventually funded (Fig. 8.1). This suggests that the Kickstarter
community is generally sympathetic to an entrepreneur’s plea for help:
Kickstarter reports an overall success rate of almost 45 percent. At the
same time, our econometric results highlight the difficult challenge fac-
ing project creators. Inherent to the Kickstarter crowdfunding model is a
strong U-shaped pattern of project support over its funding cycle—the
initial excitement around a new project is quickly followed by a sharp
drop in support and a prominent lull in activity until the last week of the
funding cycle. As a result, some entrepreneurs want to allow as much
time as possible to raise funds by setting their funding cycle as long as
possible. Due to goal-gradient behavior and deadline effects, however, it
is difficult if not impossible to overcome this period of low activity
between the first and last weeks of the funding cycle. In fact, research
finds that project duration is negatively related to funding success
(Mollick 2014). Kickstarter also lowered the maximum project duration
from 90 to 60 days because they observed that most pledges come in the
first and last weeks of the funding cycle, with the length of the middle
period not really mattering to eventual project success (Strickler 2011).
Even though contributions during the middle period of the funding cycle
are generally lower than in the first and last weeks, these pledges are still
important for a project to experience the Kickstarter Effect (e.g., see
Table 8.1). Further research on the “optimal” project duration might
explore these trade-offs.
Because most project supporters in Kickstarter are one-time backers,
entrepreneurs must rely on their own social circle of family, friends, and
followers. Indeed, project creators need to be proactive by communicat-
ing with their social network. We find that project support is positively
related to updates at any point in the funding cycle, even though project
creators currently tend to only post updates in the first and last weeks of
the funding cycle. Clearly, our analysis of project updates is very basic.
Data limitations prevent us from considering the potential role of other
social and online media in generating buzz around a crowdfunding proj-

ect. Several guidebooks stress the importance of crafting an online mar-
keting campaign and its importance in generating excitement and project
support throughout the funding cycle (de Witt 2012; Steinberg 2012).
At this point, however, only anecdotal case studies of success stories and
their marketing efforts exist, indicating that further research would be
helpful in carefully sorting out the various possible effects and whether
the lull in activity between the first and last weeks can be overcome.
8.4.2 Implications for Policy Makers
With the passing of the JOBS Act by the US Congress in 2012, policy
makers are persuaded by the potential of crowdfunding to help fund
small businesses and entrepreneurs with creative ideas (Stemler 2013). At
the same time, however, many pundits have sounded alarms at the poten-
tial for fraud associated with unregulated investing behavior, especially by
consumer-investors (the “crowd”). Of particular concern is that project
creators with unreasonable ideas will still find funding from naive inves-
tors due to “irrational” herding behavior (i.e., consumers will simply
mimic each other without any regard to project quality). In contrast to
this perspective, we find no evidence for irrational herding in the
Kickstarter community. Instead, we argue that goal-gradient behavior is
an example of rational herding that comes from payoff externalities, that
is, others’ previous funding decisions signal that a project is likely to suc-
ceed and thus a contribution to the same project will have greater impact.
Further research is needed to determine if our findings generalize to other
financial-based crowdfunding communities.
Another possible fear is that project creators propose projects, receive
the funding from consumer-investors, and then never complete the proj-
ect or deliver the promised rewards. Interestingly, Mollick (2014) con-
cludes that most Kickstarter project creators make serious efforts to fulfill
their obligations, but the majority deliver the promised rewards later than
expected. Although explicitly disclaimed by Kickstarter, many consumer-
investors believe that the website is essentially an online retail storefront
in which project creators presell products.
To explore the idea of new product pre-orders and the possible effects
of product rewards on backer behavior, we consider a separate model for
only Design, Games, and Technology projects—categories that typically
offer tangible new products as rewards for contributions (Steinberg 2012;
Mollick 2014). Based on analyses reported in our extended working
paper (Kuppuswamy and Bayus 2015), we do find that backer behavior
in this subsample differs once a project reaches its funding goal—here,
the coefficient estimate for PostFunded is positive and significant. Thus,
there is strong evidence that successfully funded projects in the Design,
Games, and Technology categories receive even more contributors before
their funding cycle ends. Once a project offering product pre-orders is
successfully funded, the risk for other “consumers” is reduced since the
project creator will receive all the pledged funds. Although our data do
not allow us to determine whether this represents rational or irrational
herding behavior, it is interesting to speculate that this herding behavior
for successfully funded projects may be responsible for the product
rewards delivery delays reported by Mollick (2014). Successfully funded
projects offering product pre-orders may actually be suffering from their
own success! This will especially be the case for projects that dramatically
exceed their original goal. For example, Eric Migicovsky’s Pebble E-Paper
Watch, one of the largest funded Kickstarter projects, received almost
69,000 backers—well over the 1000 backers expected with their original
goal of USD 100,000. While the promised watches were shipped more
than three months after the promised delivery date, all of their backers
(including the authors) did not receive their watches for several more
months.
Additional studies are needed to more completely understand the
possible herding behavior of consumer-investors in crowdfunding com-
munities. For example, an obvious recommendation might be to estab-
lish a restriction on the number of additional new backers that can
support a project once it reaches its goal. Here, the thinking would be
that small start-up businesses with limited resources and connections
should not be stressed beyond their real capabilities. Such a restriction,
however, could also change the dynamics of backer behavior—poten-
tial backers may be even more interested in contributing to projects
with a lot of past project support because the project (and its product
rewards) may not be available once it meets its target. Thus, herding
and goal-gradient behaviors may be extreme if project backers are lim-
ited. Further research should tackle these topics more deeply by consid-
ering backer motivations and behavior in supporting projects that have
already reached their goal.
Acknowledgments Comments from participants in research workshops at the

University of North Carolina at Chapel Hill, Duke, University of Illinois,
University of Utah, DRUID 2013, Emory, HEC Paris, and University of
California at Berkeley helped to improve this chapter. We also thank Atul
Nerkar, Page Ouimet, Avi Goldfarb, Tarun Kushwaha, Sri Venkataraman, Rich
Bettis, Jennifer Conrad, Amin Sayedi, the book co-editors, for helpful com-
ments on an earlier draft.
Notes
1. Shortly after our data collection in March 2012, Kickstarter removed this
information from their updated website design.
2. One project had a goal of over USD 21 million (Kickstarter’s limit) to
help reduce the national debt (http://www.kickstarter.com/projects/
2116548608/help-erase-the-national-debt-of-the-usa?ref=search). This
project only had eight backers who pledged USD 180.
3. The largest funded project in our sample received a little over USD
95,000. Since our data collection, several projects have received over USD
1 million in funding.
4. An alternate measure involving the number of competing projects in the
same category as project i gives the same results across all our estimated
models as those reported for ActiveProjects.
5. The consistent drop in the coefficient estimate for the very last day comes
from the fact that projects end at various times during the last day, that is,
many projects do not have a complete 24 hours of funding time on the
last day.
6. Yan Budman, Director of Marketing at Indiegogo, reports a similar pat-
tern of backer behavior for Indiegogo projects (Budman 2012).
7. Some of our preliminary analyses involving the Kickstarter (all-or-noth-
ing) and Indiegogo (keep-it-all) communities suggest that the goal-gradi-
ent effect is robust across platforms.
References
Agrawal, Ajay, Christian Catalini, and Avi Goldfarb. 2015. Crowdfunding:
Geography, Social Networks, and the Timing of Investment Decisions.
Journal of Economics and Management Strategy 24: 253–274.
Allison, Paul D. 2005. Fixed Effects Regression Methods for Longitudinal Data
Using SAS. Cary, NC: SAS Institute.
Allison, Thomas H., Blakley C. Davis, Jeremy C. Short, and Justin W. Webb.
2015. Crowdfunding in a Prosocial Microlending Environment: Examining
the Role of Intrinsic Versus Extrinsic Cues. Entrepreneurship Theory and
Practice 39: 53–73.
Ariely, Dan, and Itamar Simonson. 2003. Buying, Bidding, Playing, or
Competing? Value Assessment and Decision Dynamics in Online Auctions.
Journal of Consumer Psychology 13: 113–123.
Bakos, J. Yannis. 1997. Reducing Buyer Search Costs: Implications for Electronic
Marketplaces. Management Science 43: 1676–1692.
Bayus, Barry L. 2013. Crowdsourcing New Product Ideas Over Time: An
Analysis of the Dell IdeaStorm Community. Management Science 59:
226–244.
585–609.
Boyle, Katherine. 2013. Yes, Kickstarter Raises More Money for Artists than the
NEA. Washington Post, July 27. http://www.washingtonpost.com/news/
wonkblog/wp/2013/07/07/yes-kickstarter-raises-more-money-for-artists-
than-the-nea-heres-why-thats-not-really-surprising/. Accessed 12 Sep 2014.
Budman, Yan. 2012. In a Crowdfunding Campaign, What is the Donation
Pattern. Quora Answer to Question. http://www.quora.com/Crowdfunding/
In-a-crowdfunding-campaign-what-is-the-donation-pattern-Peaks-and-
valleys-vs-time-into-the-campaign. Accessed 7 Nov 2013.
Burtch, Gordon, Anindya Ghose, and Sunil Wattal. 2013. An Empirical
Examination of the Antecedents and Consequences of Investment Patterns in
Crowd-Funded Markets. Information Systems Research 24: 499–519.
Cameron, A. Colin, and Pravin K. Trivedi. 2009. Microeconometrics: Methods
and Applications. New York: Cambridge University Press.
Ceyhan, Simla, Xiaolin Shi, and Jure Leskovec. 2011. Dynamics of Bidding in
a P2P Lending Service: Effects of Herding and Predicting Loan Success. In
Proceedings of the 20th International Conference on World Wide Web: 547–556.
http://dl.acm.org/citation.cfm?id=1963483. Accessed 27 Nov 2013.
Crowdfunding Projects. Entrepreneurship Theory and Practice 39: 75–100.
Cosh, Andy, Douglas Cumming, and Alan Hughes. 2009. Outside
Entrepreneurial Capital. The Economic Journal 119: 1494–1533.
Cryder, Cynthia E., George Loewenstein, and Howard Seltman. 2013. Goal
Gradient in Helping Behavior. Journal of Experimental Social Psychology 49:
1078–1083.
Cumming, Douglas, and Sofia A. Johan. 2009. Venture Capital and Private
Equity Contracting: An International Perspective. New York: Academic Press.
Crowdfunding Models: Keep-It-All Versus All-Or-Nothing. Social Science
Feb 2017.
Devenow, Andrea, and Ivo Welch. 1996. Rational Herding in Financial
Economics. European Economic Review 40: 603–615.
Dushnitsky, Gary, and Dan Marom. 2013. Crowd Monogamy. Business Strategy
Review 24: 24–26.
Falkinger, Josef. 2008. Limited Attention as a Scarce Resource in Information-
Rich Economies. The Economic Journal 118: 1596–1620.
Fishbach, Ayelet, Marlone D. Henderson, and Minjung Koo. 2011. Pursuing
Goals with Others: Group Identification and Motivation Resulting From
Things Done Versus Things Left Undone. Journal of Experimental Psychology:
General 140: 520–534.
Flood, Alsion. 2012. Kickstarter Becomes the Fourth Biggest Publishers of
Graphic Novels. The Guardian. http://www.theguardian.com/books/2012/
jul/11/kickstarter-fourth-biggest-publisher-graphic-novels. Accessed 12 Sep
2014.
Galinsky, Michael. 2010. The Kickstarter Effect: Fundraising as Game Theory.
International Documentary Association. http://www.documentary.org/con-
tent/kickstarter-effect-fundraising-game-theory. Accessed 7 Oct 2013.
Goninon, Mark. 2013. Is Kickstarter Fatgiue Starting to Kick In? Choicest
Games, July 24. http://www.choicestgames.com/2013/07/is-kickstarter-
fatigue-starting-to-kick.html. Accessed 8 Oct 2013.
Gorbatai, Andrea Daniela, and Laura Nelson. 2015. Gender and the Language
of Crowdfunding. Academy of Management Proceedings 1: 15785.
Herzenstein, Michal, Uptal M. Dholakia, and Rick L. Andrews. 2011a. Strategic
Herding Behaviors in Peer-to-Peer Loan Auctions. Journal of Interactive
Marketing 25: 27–36.
Herzenstein, Michal, Scott Sonenshein, and Uptal M. Dholakia. 2011b. Tell Me
a Good Story and I May Lend You Money: The Role of Narratives in Peer-to-
Peer Lending Decisions. Journal of Marketing Research 48: 138–149.
Hodas, Nathan O., and Kristina Lerman. 2013. Attention and Visibility in an
Information-Rich World. Second International (ICME) Workshop on Social
Multimedia Research arXiv: 1307.4798 [cs.SI].
Hornuf, Lars, and Armin Schwienbacher. 2017. Market Mechanisms and
Funding Dynamics in Equity Crowdfunding. Journal of Corporate Finance.
http://www.sciencedirect.com/science/article/pii/S0929119916302450.
Hull, Clark. 1932. The Goal-Gradient Hypothesis and Maze Learning.
Psychological Review 39: 25–43.
Kickstarter. 2013. Blockbuster Effects. Accessed October 15, 2013. http://www.
kickstarter.com/blog/blockbuster-effects
———. 2016. Kickstarter Stats. https://www.kickstarter.com/help/stats.
Accessed 28 Oct 2016.
Kivetz, Ran, Oleg Urminsky, and Yuhuang Zheng. 2006. The Goal-Gradient
Hypothesis Resurrected: Purchase Acceleration, Illusionary Goal Progress,
and Customer Retention. Journal of Marketing Research 43: 39–58.
Kuppuswamy, Venkat, and Barry L. Bayus. 2015. Crowdfunding Creative Ideas:
The Dynamics of Project Backers in Kickstarter, Social Science Research
Network. http://ssrn.com/abstract=2234765. Accessed 20 Feb 2017.
———. 2017. A Review of Crowdfunding Research and Findings. In Handbook
of New Product Development Research, ed. P. Golder, and D. Mitra.
Northhampton, MA: Edward Elgar.
———. 2017. Does My Contribution to Your Crowdfunding Project Matter?
Liberman, Nira, and Jens Forster. 2008. Expectancy, Value and Psychological
Distance: A New Look at Goal Gradients. Social Cognition 26: 515–533.
Lin, Yan, Wai F. Boh, and Kim H. Goh. 2014. How Different are Crowdfunders?
Examining Archetypes of Crowdfunders and Their Choice of Projects.
Academy of Management Proceedings. http://proceedings.aom.org/con-
tent/2014/1/13309.short. Accessed 4 Jan 2016.
Marom, Dan, Alicia Robb, and Orly Sade. 2015. Gender Dynamics in
Crowdfunding (Kickstarter): Evidence on Entrepreneurs, Investors, Deals
and Taste Based Discrimination. Social Science Research Network. http://ssrn.
com/abstract=2442954. Accessed 20 Feb 2017.
Maxwell, Brian. 2013. Kickstarter Fatigue a Myth, Says Richard Garriott. http://
www.edge-online.com/news/kickstarter-fatigue-a-myth-says-richard-garri-
ott/. Accessed 10 Oct 2013.
Mollick, Ethan, and Ramanda Nanda. 2016. Wisdom or Madness? Comparing
1533–1553.
Moritz, Alexandra, and Jörn Block. 2016. Crowdfunding: A Literature Review
and Research Directions. In Crowdfunding in Europe: State of the Art in Theory
and Practice, ed. D. Bruntje and O. Gajda, 25–53. Cham: Springer
International Publishing.
Nelson, S.. 2013. The Kickstarter Effect (Or How I Learned to Stop Worrying
and Love Crowdfunding). Kickstarteradventure. http://www.kickstartadven-
ture.com/home/the-kickstarter-effect-or-how-i-learned-to-stop-worrying-
and-love-crowdfunding/. Accessed 7 Oct 2013.
Pope, Devin G., and Justin R. Sydnor. 2011. What’s in a Picture? Evidence of
Discrimination from Prosper.com. Journal of Human Resources 46: 53–92.
Qiu, Calvin. 2013. Issues in Crowdfunding: Theoretical and Empirical
Investigation on Kickstarter. Social Science Research Network. http://ssrn.
com/abstract=2345872. Accessed 20 Feb 2017.
Schwienbacher, Armin, and Benjamin Larralde. “Crowdfunding of
Entrepreneurial Ventures.” In The Oxford Handbook of Entrepreneurial
Finance, by D. Cumming (ed.), 369-391. Oxford: Oxford University Press,
2012.
Simon, Herbert. 1971. Designing Organizations for an Information-Rich
World. In Computers, Communications, and the Public Interest, ed.
M. Greenberger, 38–52. John Hopkin: Baltimore.
Smith, Sarah, Frank Windmeijer, and Edmund Wright. 2014. Peer Effects in
Charitable Giving: Evidence from the (Running) Field. The Economic Journal
125: 1053–1071.
Steinberg, Don. 2012. The Kickstarter Handbook. Philadelphia, PA: Quirk
Books.
Stemler, Abbey R. 2013. The JOBS Act and Crowdfunding: Harnessing the
Power—and Money—of the Masses. Business Horizons 56: 271–275.
Strickler, Yancey. 2011. Shortening the Maximum Project Length. Kickstarter,
June 17. http://www.kickstarter.com/blog/shortening-the-maximum-proj-
ect-length. Accessed 17 Oct 2013.
Toure-Tillery, Maferima, and Ayelet Fishbach. 2011. The Course of Motivation.
Journal of Consumer Psychology 21: 414–423.
Vismara, Silvio. 2015. Information Cascades Among Investors in Equity
Crowdfunding. Social Science Research Network. https://ssrn.com/
Webb, Eugene, and Karl E. Weick. 1979. Unobtrusive Measures in Organizational
Theory: A Reminder. Administrative Science Quarterly 24: 650–659.
de Witt, Nelson. 2012. A Kickstarter’s Guide to Kickstarter. Kickstarterguide.
http://kickstarterguide.com/files/2012/07/A-Kickstarters-Guide.pdf.
Accessed 15 Nov 2012.
Wooldridge, Jeffrey M. 1999. Distribution-Free Estimation of Some Nonlinear
Panel Data Models. Journal of Econometrics 90: 77–97.
Wu, Fang, and Bernardo A. Huberman. 2007. Novelty and Collective Attention.
Proceedings of the National Academy of Sciences 104: 17599–17601.
Zhang, Juanjuan, and Peng Liu. 2012. Rational Herding in Microloan Markets.
Management Science 58: 892–912.
Zheng, Haichao, Dahui Li, Jing Wu, and Xu. Yun. 2014. The Role of
Multidimensional Social Capital in Crowdfunding: A Comparative Study in
China and US. Information and Management 51: 488–496.
Venkat Kuppuswamy is Assistant Professor of Strategy & Entrepreneurship at

the University of North Carolina at Chapel Hill and a board member of
NCGrowth at the Kenan Institute of Private Enterprise. His research has
appeared in prestigious scholarly journals in addition to popular press outlets,
such as The Atlantic, Forbes, Washington Post, Huffington Post, and National
Public Radio (NPR). His research focuses on understanding when and why the
crowd contributes to crowdfunding campaigns, as well as the benefits of crowd-
funding campaigns for entrepreneurs. More recently, he has explored whether
crowdfunding truly represents a discrimination-free platform for minority
entrepreneurs to raise capital.
Barry L. Bayus is the Roy O. Rodwell Distinguished Professor of Marketing at

the Kenan-Flagler Business School, University of North Carolina. His current
research focuses on crowdsourcing and crowdfunding innovative ideas, as well as
design thinking. He is part of a National Institutes of Health (NIH)-sponsored
research team studying the effectiveness of crowdsourced health messages. Bayus
has written over 50 research papers in academic and business journals. The
Journal of Product Innovation Management cited him as one of the world’s top
five scholars in innovation management (2007 and 2012) and Management
Science named him as one of the top researchers in the field of innovation (2004).
Part IV
Recent Regulatory Efforts
9
The Regulation of Crowdfunding
in the United States
C. Steven Bradford
9.1 Introduction
The regulation of crowdinvesting involves a trade-off between small busi-
ness capital formation and investor protection. Offerings of securities in
the United States, including both equity and debt securities, must ordi-
narily be registered with the Securities and Exchange Commission (SEC).
This registration process involves extensive mandatory disclosure and
complicated limits on the offer and sale of the securities. These require-
ments, designed to protect investors, are too expensive for the small capi-
tal offerings typically attracted to crowdinvesting.
The registration requirements do not apply to donation- and reward-
based crowdfunding, and these types of crowdfunding have been very
popular in the United States. But sales of equity through crowdinvest-
ing and sales of debt securities through crowdlending are subject to the
SEC registration requirements; because of the high cost of registration,
C. Steven Bradford (*)
University of Nebraska-Lincoln College of Law, Lincoln, NE, USA

https://doi.org/10.1007/978-3-319-66119-3_9
186 C. Steven Bradford
these types of offerings can succeed in the United States only if they are
exempted from these requirements.
Four different exemptions are available for crowdinvesting in the
United States. Two of these exemptions—federal Rules 506(b) and
506(c)—limit sales to sophisticated or wealthy investors, and therefore
are probably not accurately described as crowdinvesting exemptions.
They do not allow sales to the “crowd” of public investors. However,
Regulation Crowdfunding, finalized by the SEC in 2015 to implement
an exemption in section 4(a)(6) of the Securities Act, is specifically aimed
at retail crowdinvesting by the general public. In addition, many US
states have adopted state crowdfunding exemptions that allow debt and
equity offerings limited to the residents of a particular state. These state
exemptions are coordinated with a federal intrastate offering exemption,
so, like the other exemptions discussed, they provide a coordinated
exemption from both federal and state securities law.
There are three different groups involved in crowdinvesting, and thus
three different possible loci for any crowdinvesting regulation: the issuers
who sell securities to raise capital; the intermediaries who operate the
platforms through which these securities are sold; and the investors buy-
ing the securities. The Rules 506(b) and 506(c) exemptions focus their
regulation almost exclusively on investors, limiting who may invest. The
policy idea is to limit investment to those who can protect themselves
and therefore do not need mandatory disclosure or other regulation. The
absence of other significant restrictions reduces the regulatory cost, but it
is not clear that the basic premise of these rules is sound. Many of the
investors who qualify for these offerings are not sophisticated investors.
Regulation Crowdfunding and the state exemptions broadly regulate
all three groups, imposing substantial regulatory requirements on issuers,
intermediaries, and investors. The investor protection motive underlying
these extensive regulatory requirements may be admirable, but the cost
may be too high for many small business offerings. It is not clear that any
of the US exemptions has found the appropriate balance between capital
formation and investor protection.
This chapter discusses the various exemptions available for crowdfund-
ing and the policy underlying them. Section 9.2 briefly describes the US
registration requirement, its scope, and the problem it poses for crowd-
The Regulation of Crowdfunding in the United States 187
funding. Section 9.3 discusses the Rule 506(b) and 506(c) exemptions.
Section 9.4 discusses the crowdfunding exemption in section 4(a)(6) of
the Securities Act, and Regulation Crowdfunding adopted to implement
it. Section 9.5 discusses the intrastate crowdfunding exemptions. Section
9.6 provides a brief comment on the scope of these exemptions.
9.2 A
pplicable Regulation in the Absence
of a Crowdfunding-Specific Exemption
9.2.1 The Registration and Prospectus Requirements
In the United States, companies selling securities must register their offer-
ings with the SEC unless an exemption is available.1 The offering com-
pany must file an extensive disclosure document known as a registration
statement with the SEC and must provide most of that disclosure to
investors in a document known as the prospectus. There are also compli-
cated limits on communications with potential investors, including post-
ing on websites, before and during the offering.
The registration process for first-time registrants often takes months
(SEC 1996, 88,439; Cohn and Yadley 2007, 7), and the direct cost to
prepare and file the registration statement—including legal fees, account-
ing fees, registration fees, and printing costs—can be hundreds of thou-
sands of dollars (U.S. Government Accountability Office 2000, 23; Prifti
2010, § 1A-17; Sjostrom 2001, 575–576). This cost is simply too high
for the smaller amounts entrepreneurial capital start-ups and other small
businesses want to raise through crowdinvesting and crowdlending.
Because of economies of scale, registration expenses that might be man-
ageable for large offerings are not feasible for smaller offerings (Bradford
2001, 25–27). And the United States, unlike some countries, has no gen-
eral exemption for smaller offerings.
Registration, however, is not impossible. Two US crowdlending sites,
Prosper and Lending Club, register the notes they offer, but they had to
completely restructure their business models to make it work (Bradford
2012a, 43–44). The model they use would not work for crowdinvesting.
9.2.2 What Is a Security?
The US registration requirement applies only when a company is selling

“securities.” The definition of “security” in section 2(a)(1) of the Securities
Act2 is a little vague, but it is reasonably clear that certain kinds of crowd-
funding do not involve securities for purposes of federal law.
Donation- and reward-based crowdfunding, including pre-purchases,
do not involve the sale of securities (Bradford 2012a, 31–32). Therefore,
federal securities law, including the registration requirement, does not
apply to them. Donation- and reward-based crowdfunding are essentially
unregulated, except for the prohibitions on fraud and false advertising
that would apply to any commercial transaction. Neither the federal
government nor the states have imposed any special regulation on non-
securities crowdfunding.
Crowdlending probably involves a security, and therefore is subject to
US securities regulation, unless, as on the Kiva website, lenders do not
receive interest. If lenders are entitled only to a return of their principal,
with no interest, a security is probably not involved (Bradford 2012a,
34–42). Crowdinvesting, where investors receive equity in the company
or any participation in the company’s profits, almost certainly involves
the sale of a security (Bradford 2012a, 33–34).
9.3 Accredited Investor Crowdfunding

Two US exemptions allow unregistered Internet offerings limited to
“accredited investors,” or, in the case of one of the exemptions, also
sophisticated investors who are not accredited investors. One of these
exemptions, Securities Act Rule 506(b),3 has been in place for many
years. The other, Rule 506(c),4 was added by the SEC in 2013 in response
to Congressional direction in the ambitiously titled Jumpstart Our
Business Startups (JOBS) Act.5
The term “accredited investor” is defined to include, among others,
institutional investors such as banks, brokers, insurance companies, pro-
fessionally directed employee benefit plans, and, more generally, any
business entity with more than USD 5 million in assets.6 But it also
includes individual investors with either (1) a net worth of at least USD
1 million (excluding the value of their home and related mortgage indebt-
edness up to the value of the home)7 or (2) an annual income of more
than USD 200,000 (or joint income with a spouse of at least USD
300,000).8
The argument for exempting offers to sophisticated investors such as
brokers and insurance companies is apparent: these investors can fend for
themselves and do not need the regulatory protection that registration
provides.9 The extension of this argument to wealthy, unsophisticated
investors is more controversial. Wealth is a very imperfect proxy for inves-
tor sophistication; the person who wins USD 5 million in a lottery, for
example, may know absolutely nothing about investing. One might
argue that wealthy people can afford to lose the money they are investing,
and do not need as much protection for that reason. But the wealth and
income levels necessary to qualify as an accredited investor are relatively
low; many of these people do not have money to burn. In addition, there
are no limits on how much of their wealth accredited investors may
invest. An investor who has a net worth of USD 1 million and invests the
entire USD 1 million in a single offering certainly cannot afford to lose
that money. There has been some discussion at the SEC about restructur-
ing the definition of accredited investor or limiting how much accredited
investors may invest (SEC 2015c), but the SEC has not yet taken any
action on these proposals.
Because of the limits on who may purchase, securities cannot be sold
to the general public in Rule 506(b) and 506(c) offerings. Since the issuer
is not selling to the “crowd,” it is probably inappropriate to call these
offerings crowdinvesting or crowdfunding. But these terms have been
applied to Rule 506 offerings, and therefore these offerings are discussed
here.
Rule 506(b) and Rule 506(c) share some common requirements. First,
they contain so-called bad actor disqualifications barring issuers from
using the exemption if they or certain related persons have been found to
have engaged in various types of wrongdoing in the past.10 The theory is
that companies and individuals who have been involved in past wrong-
doing are more likely to engage in similar behavior now; barring them
helps to protect investors in the current offering. There are no other lim-
its on the companies that may use the Rule 506(b) and 506(c) exemp-
tions; any company not barred by the “bad actor” disqualifications is
eligible.
The two exemptions also share resale restrictions. Securities acquired in
a Rule 506(b) or (c) offering may not be resold without registration or an
exemption for the resale.11 The most commonly applicable resale exemp-
tion in the United States would allow resale after a 6- or 12-month hold-
ing period.12
9.3.1 The Rule 506(b) Exemption
To qualify for the Rule 506(b) exemption, sales must be made only to
accredited investors or up to 35 non-accredited investors who satisfy a
sophistication requirement.13 Each non-accredited investor must “either
alone or with his purchaser representative(s) … [have] … such knowl-
edge and experience in financial and business matters that he is capable
of evaluating the merits and risks of the prospective investment.”14
Accredited investors are not required to meet this standard. Even if a
particular purchaser does not fall within one of these two categories, the
issuer’s exemption is still protected as long as the issuer reasonably believed
the purchaser qualified.15
Otherwise, Rule 506(b) offerings are lightly regulated. Rule 506(b)
does not limit either the size of the offering or the amount each investor
may invest. The issuer is not required to use an intermediary and, if it
does sell through an intermediary, Rule 506(b) imposes almost no
requirements on that intermediary. However, if an intermediary is
involved, depending on how the intermediary operates, there is a risk
that it could be a securities broker or investment adviser, and in viola-
tion of federal securities law if it is not registered as such (Bradford
2012a, 51–80).
No mandatory disclosure is required if the issuer sells only to accredited
investors. If, however, the issuer also sells to non-accredited, sophisticated
investors, it must furnish those investors with detailed information about

the issuer, including financial statements.16 The balance sheet must gener-
ally be audited and, in larger offerings, the issuer’s other financial state-
ments must also be audited.17 Because of that and because of the
uncertainty of the sophistication standard, Rule 506(b) offerings are typi-
cally limited to accredited investors only (Ivanov and Bauguess 2012, 6).
The biggest problem with using Rule 506(b) for crowdinvesting is that
the rule prohibits “any form of general solicitation or general advertis-
ing,” including “[a]ny advertisement, article, notice or other communica-
tion, published in any newspaper, magazine, or similar media or broadcast
over television or radio.”18 The SEC staff has read this broadly to prohibit
any offers to investors with whom the issuer or its sales agents do not have
a preexisting relationship (Sjostrom 2004, 13).
This interpretation has two important implications for crowdinvest-
ing. First, although Rule 506(b) does not require the use of an intermedi-
ary, an issuer using an intermediary can take advantage of the intermediary’s
customer base—the intermediary already has a preexisting relationship
with those investors. Second, the staff interpretation effectively prohibits
putting information about an offering on a website accessible to the
general public because the posting would reach investors with whom the
issuer and its intermediary have no preexisting relationship (SEC 2000,
25,851–25,852). The issuer could sell through a website, but the offering
materials would have to be placed behind a gateway through which only
investors with a preexisting relationship could pass.
However, SEC staff interpretations make the general solicitation
restriction slightly less draconian and slightly more amenable to crowdin-
vesting. The SEC staff has allowed intermediary brokers to solicit potential
investors publicly, qualify them as eligible for Rule 506(b) offerings, and
then allow them access to Rule 506(b) offerings—but only to offerings
that postdate their initial solicitation.19 This interpretation allows Rule
506(b) to be used for what some people call “crowdfunding,” but it is
crowdfunding in a very limited sense. Public websites advertise for inves-
tors without mentioning any specific offering, and offering materials
appear behind a firewall that only accredited or sophisticated investors
are allowed through.
9.3.2 The Rule 506(c) Exemption
Rule 506(c) is much more amenable to crowdinvesting than Rule

506(b). General solicitation and advertising are allowed, so the offering
may be posted on a publicly accessible website. However, actual sales
are limited to accredited investors, and Rule 506(c) enforces this
requirement a little more stringently than Rule 506(b). The issuer must
“take reasonable steps to verify that purchasers … are accredited inves-
tors.”20 If it does not do so, the exemption is lost, even if it turns out
that all of the investors actually were accredited. Rule 506(c) does not
mandate any particular steps to verify accredited investor status, but it
does provide some non-exclusive alternatives, such as looking at tax
forms to verify income.21
These are the only significant limitations in Rule 506(c). There are no
mandatory disclosure requirements, limits on the size of the offering or
the amount each investor may invest, or restrictions on the web portal
hosting the offering. As with Rule 506(b), the issuer is not even required
to use an intermediary. It could post the offering on its own website.
9.4 S
ection 4(a)(6) and Regulation
Crowdfunding
The Section 4(a)(6) crowdfunding exemption was added to the Securities
Act by the JOBS Act in 2012.22 However, the SEC did not adopt the
required implementing regulations, known as Regulation Crowdfunding,
until November 2015; these regulations became effective on May 16,
2016 (SEC 2015b). The statutory requirements of the crowdfunding
exemption lie primarily in sections 4(a)(6) and 4A of the Securities Act.23
Regulation Crowdfunding incorporates these requirements and adds
additional ones.24 For convenience, I will refer to the exemption as the
section 4(a)(6) exemption, even though one must look to the regulation
to see the full set of requirements.
The section 4(a)(6) exemption, unlike the Rule 506(b) and 506(c)
exemptions, is designed for and limited to crowdfunded securities offer-
ings. Section 4(a)(6) is also much more regulatory than those other
exemptions, imposing significant restrictions on all three groups involved
in crowdinvesting: the issuers selling securities; the intermediaries through
whom the securities are sold; and the investors purchasing the securities.
Section 4(a)(6) also imposes structural requirements on the offerings
themselves.
Section 4(a)(6) offerings are open to the general public, and many of
these requirements are designed to protect unsophisticated investors. But
the cost to comply with these regulatory requirements, although less than
the cost of registration, is significant. Crowdfunding regulation requires
a careful balancing of cost and investor protection, and the section 4(a)
(6) exemption may have tilted too far to the investor protection side.
Hence, many small business issuers may find section 4(a)(6) too expen-
sive, and it is unlikely to be the capital formation panacea many of its
supporters hoped for.
9.4.1 Restrictions on Investors
Section 4(a)(6) offerings are open to the general public. Anyone—from

the most sophisticated institutional investor to the financially illiterate—
may invest in a section 4(a)(6) offering. But section 4(a)(6) restricts
investors in other ways. The amount they may invest in crowdfunded
offerings is limited; they must be provided with “investor education”; and
there are restrictions on the resale of the securities they purchase.
9.4.1.1 Investment Limits
Section 4(a)(6) limits how much each investor may invest; the limit
depends on each investor’s net worth and annual income, and there are
special rules for calculating these.25 Net worth may be calculated jointly
with the investor’s spouse, as long as the aggregate investment of the two
does not exceed the limits that would apply to the two of them individu-
ally.26 Generally, the investor’s principal residence, and related mortgage
indebtedness up to the value of that residence, is excluded from the net
worth calculation.27
If the investor’s annual income and net worth each exceed USD
100,000, the investor’s investment limit is 10 percent of annual income
or net worth, whichever is less. If not, then the limit is 5 percent of
annual income or net worth, whichever is less. However, there is a USD
2000 minimum and a USD 100,000 maximum. Every investor may
invest USD 2000, no matter how small their annual income and net
worth. And no one may invest more than USD 100,000, no matter how
great their annual income and net worth.
These are annual investment limits; an investor may not exceed his or
her limit in any 12-month period. But there are no limits on the total
investment in his or her portfolio. For example, an investor whose limit
is USD 7000 could invest USD 7000 now and an additional USD 7000
12 months later, even if he or she still owns the prior investment.
However, the limits are applied collectively to all section 4(a)(6) invest-
ments, not just on a per-offering basis. The total amount an investor
invests annually in all section 4(a)(6) offerings cannot exceed the inves-
tor’s limit. Assume again that the investor’s limit is USD 7000. If the
investor, in a single 12-month period, invests in section 4(a)(6) offerings
by issuers A, B, and C, the total of the investments in A, B, and C may
not exceed USD 7000.
The intermediary must disclose these limits to the investor when the
investor opens an account.28 The intermediary is also required to enforce
these limits at the time of any investment. Before accepting any invest-
ment commitment, the intermediary must “have a reasonable basis for
believing that the investor satisfies … [these] … limitations.”29 The inter-
mediary usually will not know what amounts the investor has invested
through other intermediaries, of course. But the intermediary is allowed
to rely on the investor’s representations as to annual income, net worth,
and the amount of the investor’s other section 4(a)(6) investments unless
the intermediary has some reason to question those representations.30
Therefore, the intermediary’s burden is nominal.
The policy argument for these investment limits is straightforward. They
limit each investor’s risk so that, even if the investor loses the entire amount
invested, the loss will be less than catastrophic. Of course, even a USD 2000
loss will be catastrophic to many poorer investors, and it is not clear whether
more sophisticated investors need this paternalistic protection. Moreover,
investors can easily circumvent these limits by lying about their net worth
or annual income. Hence, the limits might not be very effective.
9.4.1.2 Investor “Education” Requirements
The crowdfunding regulation also includes a series of “education” require-

ments, but these are really only glorified risk disclosure. To invest in an
offering pursuant to the crowdfunding exemption, investors must open
an account with the intermediary. When an investor opens such an
account, the intermediary must provide materials that explain various
aspects of crowdinvesting to the investor “in plain language.”31 These
educational materials must disclose the following:
• how the section 4(a)(6) process works and the risks associated with
section 4(a)(6) crowdfunding;
• the types of securities offered on the intermediary’s platform and the
risks associated with each type of security, including the risk of dilu-
tion in voting power;
• the restrictions on the resale of securities purchased in section 4(a)(6)
offerings;
• the types of information the issuer is required to provide, including
annual reports, and the possibility that these disclosure obligations
might terminate in the future, leaving the investor without current
financial information about the issuer;
• the limits on how much investors may invest;
• the rules regarding cancellation of an investment commitment, either
by the investor or by the issuer;
• the need for the investor to consider whether the investment is appro-
priate for the investor; and
• the fact that the relationship between the issuer and the intermediary
might terminate after the offering.
The intermediary must keep this disclosure posted on its platform at

all times, and, if it materially revises this disclosure, it must make the revi-
sions available to all investors before accepting any additional investment
commitments.32
In addition, each time before an investor invests in an offering, the

intermediary must obtain a representation from the investor that the
investor has reviewed this educational material, understands that his or
her entire investment may be lost, and can bear the loss.33 The intermediary
must also, again each time before an investor invests, require the investor
to complete a questionnaire that shows the investor understands that
• the investor’s ability to cancel an investment commitment and get his

or her money back is limited;
• it may be difficult for the investor to resell the securities;
• the investment is risky and the investor should not invest unless he or
she can afford to lose the entire amount invested.34
It is unlikely that these requirements will result in any serious educa-

tion of investors. The regulation does not mandate the format or wording
of the required questionnaire, so intermediaries may just ask leading
questions directing investors to the required response. The rest of the
“education” requirement is essentially just a risk disclosure document.
None of this will make unsophisticated investors sophisticated, but it will
at least expose them to warnings about the risks of investing in these
offerings. Whether they will benefit from such an exposure is a separate
question.
9.4.1.3 Restrictions on Resale
Investors who purchase securities in a section 4(a)(6) offering generally

may not resell or otherwise transfer these securities for one year.35
However, there are a number of exceptions. The securities may be trans-
ferred within the one-year holding period (1) to the issuer; (2) to any
accredited investor; (3) to anyone, in a registered offering; (4) to a family
member, broadly defined; (5) to a trust controlled by the transferor or
created for the benefit of a family member; or (6) in connection with the
transferor’s death, divorce, or similar circumstances.36
Resale restrictions such as these are commonly applied to exempted
offerings in the United States (Campbell 1995, 1331–1384). But, in this
case, they seem counterproductive, hurting investors rather than protecting

them in any way. The resale restrictions make these small business invest-
ments even less liquid than they already are, with one additional risk—the
risk of illiquidity—added to what is already a very risky investment.
9.4.2 Restrictions on Issuers
Section 4(a)(6) limits the companies that may use the exemption and the
amount of money these companies may raise. It also imposes significant
disclosure requirements on these issuers. Issuers must provide extensive
disclosure, including in some cases audited or certified financial state-
ments, to potential investors and to the SEC at the time of the offering.
In addition, issuers who successfully complete a section 4(a)(6) offering
must subsequently file annual reports that include audited or certified
financial statements. These disclosure requirements may prove too costly
for many of these small offerings, reducing the usefulness of the section
4(a)(6) exemption.
9.4.2.1 Who May Use the Exemption
There are a number of limits on the issuers that may use the crowdfund-
ing exemption. The issuer must be incorporated or organized under US
law.37 It cannot be a public company already subject to the reporting
requirements of the Securities Exchange Act of 1934,38 and certain other
types of companies are also excluded.39
Finally, the crowdfunding rules contain an extensive list of what are
known as “bad actor” disqualifications. The exemption is not available if
the issuer, or specified parties related to the issuer, have been found to
have engaged in any of a long list of violations in the past.40 These dis-
qualifications apply to the issuer; any predecessor or affiliated issuer; any
director, officer, general partner, or managing member of the issuer; any-
one who beneficially owns at least 20 percent of the issuer’s voting securi-
ties; any promoter connected with the issuer; any person who will be
compensated for soliciting purchasers in the offering; or any general part-
ner, director, officer, or managing member of any such solicitor.41 The
policy basis for these “bad actor” disqualifications is obvious: one of the
best ways to protect investors is to exclude past violators.
9.4.2.2 Offering Amount
The total amount of securities sold by the issuer pursuant to the crowd-
funding exemption cannot exceed USD 1 million in any 12-month
period.42 There is no cumulative limit; nothing would keep the issuer
from using the crowdfunding exemption to sell securities again and again,
as long as the amount raised in any 12-month period never exceeds USD
1 million.
9.4.2.3 Disclosure Requirements
The crowdfunding exemption imposes disclosure obligations on issuers at

two points: (1) when the issuer makes the offering; and (2) on an annual
basis after the offering is successfully completed. There is no general obli-
gation to promptly disclose material information at other times. US secu-
rities law does not ordinarily impose such a duty and the crowdfunding
exemption does not create any special duty of this sort just for crowd-
funding issuers.
Some of the crowdfunding exemption’s disclosure requirements are
complicated; a lawyer will probably be necessary to avoid violations.
Preparing and verifying this information will significantly add to the cost
of using the exemption.
Offering-Related Disclosure
The issuer must provide detailed disclosure about the company, the secu-
rities being offered, and the offering process. If, during the course of the
offering, the issuer makes any material changes to its disclosure or the
terms of its offering, it must notify all investors who have already com-
mitted to invest.43 All investment commitments are automatically can-
celed unless the investor reconfirms the commitment within five business
days after the notice.44 If a material change occurs within five business
days of the end of the offering, the offering deadline must be extended to
allow investors the full five business days.45
Information About the Issuer
The issuer must provide detailed disclosure about itself and its principals,
including:
• Its name, legal status (including its form of organization, jurisdiction

in which it is organized, and date of organization), physical address,
and web site46
• How many employees it has47
• A description of its business and its anticipated business plan48
• The names of its directors and officers, all the positions those people
hold with the company, and when they have served in those
positions49
• The business experience of its directors and officers in the last three
years, including details on their employment by other companies50
• The name of each person who is a beneficial owner of equity securities
holding 20 percent or more of the voting power, and the ownership
level of each such person51
• A description of recent transactions or proposed transactions with
various related parties (including officers, directors, and 20 percent
equity owners) that exceed 5 percent of the amount raised under the
crowdfunding exemption52
• A description of the issuer’s ownership and capital structure,
including
–– the terms of the securities being offering and every other class of
securities, including how the rights of the securities being offered
might be limited or diluted by the rights of other classes53
–– how the securities being offered are being valued and how they
might be valued by the issuer in the future54
–– the risks to purchasers of minority ownership and the risks asso-
ciated with corporate actions the issuer might take in the future55
–– the restrictions on transfer of the securities56 and

–– a description of how the exercise of rights held by the principal
shareholders could affect the purchasers of the securities being
offered57
• A discussion of the material factors that make an investment in the
issuer speculative or risky58
• The material terms of any indebtedness of the issuer, including the
amount of the indebtedness, interest rates, and maturity dates59
• A description of any exempt securities offerings the issuer has con-
ducted within the past three years60
• Any matters that would have disqualified the issuer from using the
exemption, but which occurred before the effective date of the
exemption61
• Where on the issuer’s website investors will be able to find the annual
report required by the exemption (discussed later) and when that
report will be available62
• Whether the issuer or its predecessors previously failed to comply with
the annual reporting requirement of the exemption63
Financial Information
The issuer is required to discuss its financial condition, including, to the

extent material, its liquidity, capital resources, and historical results of
operations.64 Some of this discussion is clearly intended to be forward-
looking. If the issuer has no operating history, its discussion must focus
on “financial milestones and operational, liquidity and other challenges.”65
If it has an operating history, it should focus on “whether historical results
and cash flows are representative of what investors should expect in the
future.”66 The discussion must include how the proceeds from the offer-
ing will affect liquidity and other available sources of capital.67
The amount of additional financial disclosure required depends on the
target amount of the offering.68
• USD 100,000 or less. If the target amount is USD 100,000 or less, the
issuer must disclose the total income, taxable income, and total tax
reported on its most recent federal income tax returns. The chief exec-
utive officer (CEO) must certify the accuracy of these figures. However,
if certified or audited financial statements are available, the issuer must
provide those instead.
• USD 100,000–USD 500,000. If the target amount is more than USD
100,000 but not more than USD 500,000, the issuer must furnish
financial statements reviewed by an independent public accountant.
However, if audited financial statements are available, the issuer must
provide those instead.
• More than USD 500,000. If the target amount of the offering is more
than USD 500,000, the issuer must furnish audited financial state-
ments, unless this is its first section 4(a)(6) offering. In that case, finan-
cial statements reviewed by an independent public accountant are
sufficient (unless it already has audited financial statements available).
Information About the Offering
The issuer must also include detailed disclosure about the offering and
the offering process:
• The purpose and intended use of the offering proceeds69

• The offering price, or the method of determining the price70
• The name and identification of the intermediary through which the
offering is being conducted71
• A description of the intermediary’s financial interest in the offering,
including the compensation the intermediary is to receive, and any
financial interest the intermediary has, or is expected to acquire, in the
issuer72
• The target amount of the offering and the deadline to reach that target73
• Whether the issuer will accept investments in excess of the target amount
and, if so, how much and how any oversubscriptions will be allocated74
• A description of the offering process, including how and when inves-
tors can cancel investment commitments75
• A statement that, if an investor does not reconfirm his or her commit-
ment after a material change to the offering, the commitment will be
canceled76
The issuer must also post updates on its progress in meeting the target
offering amount.77 At a minimum, it must disclose when it reaches 50
percent of its target offering amount and when it reaches 100 percent of
its target offering amount.78 If it sells more than its target amount, it
must within five business days of the offering deadline disclose the total
amount of securities it sold.79
Catch-All Disclosure Provision
The disclosure requirements also include a catch-all provision requiring

disclosure of any additional material information necessary to keep the
statements made in the issuer’s disclosure from being misleading.80
Annual Reports
Issuers which have successfully sold securities using the section 4(a)(6)
exemption are required to provide subsequent annual reports. These
annual reports must be filed with the SEC no later than 120 days after
the end of the issuer’s fiscal year, and must be posted on the issuer’s web-
site, but they are not required to be provided directly to investors.81
If the issuer has available financial statements that have been reviewed
or audited by an independent public accountant, these financial state-
ments must be included in the annual report. If not, the issuer must
provide financial statements that its CEO certifies are true and complete
in all material respects.82 These annual reports must also include much of
the disclosure that was required at the time of the offering, except for the
disclosures related to the offering and the offering process.83
The issuer’s annual reporting obligation generally continues until it
becomes a reporting company required to file reports under the Securities
Exchange Act; it (or someone else) repurchases all of the securities it sold
pursuant to the crowdfunding exemption; or it liquidates or dissolves its
business.84 There are also two size-based exceptions to the annual report-
ing requirement. The issuer no longer has to provide annual reports if (1)
after it has filed at least one annual report, it has fewer than 300 record
shareholders85; or (2) if it has filed annual reports for the past three years
and has total assets of less than USD 10 million.86
9.4.3 R
estrictions on Intermediaries and the Manner
of the Offering
One way that section 4(a)(6) attempts to protect investors is to require

that offerings be conducted through a neutral intermediary, which has an
enforcement role. Section 4(a)(6) also imposes requirements on the con-
duct of the offerings on the intermediary’s platform.
9.4.3.1 The Intermediary Requirement
The offering must be conducted through a web platform operated by a

registered securities broker or a registered funding portal.87 Funding por-
tals are a new type of regulated entity limited to operating section 4(a)(6)
crowdfunding platforms; they may not engage in many of the other
activities that ordinary securities brokers engage in.88
Neither the intermediary nor its directors, officers, or partners may
have any financial interest in the issuer.89 This requirement is designed to
protect investors from conflicts of interests that might arise if the inter-
mediary had a financial stake in the outcome of the offering (SEC 2013,
66,461). The intermediary may, however, receive some of the same secu-
rities being sold on the platform as compensation for its services.90 The
intermediary must disclose to investors establishing accounts on its plat-
form how it is being compensated.91
9.4.3.2 Off-Platform Activities
The issuer must sell the crowdfunded securities through the crowdfund-
ing platform. The issuer and its representatives may not even advertise the
offering off-platform.92 Nor may the issuer compensate anyone else for
promoting an offering off the intermediary’s platform.93 The issuer may,
however, publish a brief notice that directs investors to the intermediary’s
platform and contains limited information about the issuer and the
offering, including the type and amount of securities being offered, the
price, and the closing date.94
9.4.3.3 Communications Channels
The crowdfunding regulation requires the intermediary to establish com-

munications channels on its platform that allow potential investors to
communicate with the issuer, and with each other, about the offering.95
These communications channels must be publicly accessible, but only
investors who have opened an account with the intermediary may post
comments.96 The issuer and persons acting on its behalf may post com-
ments, but only if they disclose their affiliation in each such communica-
tion.97 The issuer may compensate people to promote its offering on the
intermediary’s communications channels, but only if it takes reasonable
steps to ensure that the compensation is disclosed in each communica-
tion the promoter posts.98
These communications channels are an attempt to take advantage of the
“wisdom of the crowd,” the idea that the collective decision-making of a
group of people is better than individual decision-making and, sometimes,
even better than expert decision-making (Surowiecki 2004). Surowiecki
(2004) argues that crowds can be collectively wiser than individual deci-
sion-makers, but only when their decisions are independently made.
Communications channels eliminate this independence and could lead to
irrational herding behavior. Nevertheless, these communications channels
do allow investors to share information they might have about the issuer
and its business, reducing the risk of fraud (Bradford 2012b, 219).
9.4.3.4 The Intermediary’s Enforcement Role
The crowdfunding intermediary has an enforcement role under the

exemption. As indicated earlier, the issuer is subject to mandatory dis-
closure requirements. The intermediary is required to make the issuer’s
disclosure available to the general public on its platform; that disclo-
sure must remain publicly available until the offering is completed or
canceled.99 The intermediary must also have a reasonable basis for

believing that various requirements of the exemption are satisfied:
• Investment Limits. The intermediary must have a reasonable basis for

believing that each investor satisfies the investment limits of the
exemption. However, the intermediary may rely on the investor’s rep-
resentations concerning compliance unless the intermediary has rea-
son to question the reliability of those representations.100
• Issuer’s Compliance. The intermediary must have a reasonable basis for
believing that the issuer is in compliance with the requirements of the
exemption. However, the intermediary may rely on the issuer’s repre-
sentations to that effect unless the intermediary has reason to question
the reliability of the issuer’s representations.101
• Issuer’s Record-Keeping. The intermediary must have a reasonable basis
for believing that the issuer has established means to keep accurate
records of the holders of the securities it is offering through the inter-
mediary’s platform. However, the intermediary may rely on the issuer’s
representations to that effect unless the intermediary has reason to
question the reliability of those representations.102
In satisfying these requirements, the intermediary can usually rely on

others’ statements; no independent investigation is required. However, at
least one enforcement requirement requires an independent check by the
intermediary. The intermediary must deny an issuer access to its platform
if it has a reasonable basis for believing that the “bad actor” disqualifica-
tions, discussed earlier, apply.103 To satisfy this requirement, the interme-
diary must, “at a minimum,” conduct a background and securities
enforcement regulatory check on the issuer and on each officer, director,
and 20 percent beneficial owner of the issuer’s voting securities.104
The issuer must also deny access to its platform if it believes the issuer
or the offering “presents the potential for fraud or otherwise raises con-
cerns about investor protection.”105 This requirement raises more ques-
tions than it answers. When exactly is a “potential” for fraud present?
And when does a non-fraudulent offering otherwise raise concerns
about investor protection? Most importantly, does this provision require
an intermediary to investigate each offering or is it enough that the
intermediary is unaware of any facts that might raise suspicion? The

answer to all of these questions is unclear (Bradford 2015, 376–377),
and their resolution will have an important impact on the investor pro-
tection/capital formation trade-off made by the exemption. The stron-
ger the intermediary’s due diligence role, the more protection the
intermediary’s presence provides to investors. But stronger due diligence
requirements also increase the intermediary’s compliance costs, and thus
the cost of using the exemption.
9.4.3.5 Conduct of the Offering
Section 4(a)(6) contains specific requirements as to how offerings are to

be conducted. The issuer, in its disclosure, must specify a target amount
it wants to raise in the offering and a deadline for raising that amount.106
The offering must be open for at least 21 days.107 Investors may cancel
their investment commitments until 48 hours prior to the specified
deadline.108
The issuer cannot access any investor funds until the target amount is
reached. If the offering does not reach the target amount by the deadline,
or the offering is not completed for some other reason, the intermediary
must, within five business days, direct the return of investors’ funds.109 If
the issuer reaches the target amount prior to the deadline, it may close the
offering early, as long as the offering has been open for at least 21 days.110
However, the issuer must notify investors of the new closing deadline and
the new deadline must be at least five business days after the notice.111
9.5 Intrastate Crowdfunding

Securities offerings in the United States are regulated by both the federal
government and the individual states in which the offerings occur.
However, the Securities Act of 1933 exempts purely intrastate offerings
from the federal registration requirement, essentially relegating these
offerings to regulation by the particular state in which they occur.112 The
exact outlines of that statutory exemption are uncertain, but the SEC has
adopted a safe harbor rule, Securities Act Rule 147,113 that provides more
certainty. To qualify for that intrastate offering safe harbor, all of the offer-
ees (not just the ultimate purchasers) must be residents of the same state
as the issuer. The issuer must be organized or incorporated under that
state’s laws and have its principal office in the state.114
Until recently, the issuer also had to meet several other requirements:
(1) at least 80 percent of its gross revenues had to be from operations in
that state; (2) at least 80 percent of its assets had to be located in the state;
and (3) at least 80 percent of the offering proceeds had to be used in
connection with operations in that state.115 All of these requirements had
to be met. However, the SEC amended Rule 147 in 2016 (effective in
2017) to phrase these requirements in the alternative. Now, only one of
these requirements or a new fourth requirement—that a majority of the
issuer’s employees be based in the state—must be met (SEC 2016, 197).
The SEC (2016, 202–207) also adopted a new intrastate exemption,
Rule 147A, that does not require the issuer to be incorporated in the state
and allows offers to non-residents, as long as the securities are sold only to
residents.
The intrastate offering exemption, as I indicated, is only from federal
registration requirements; it does not free issuers from the registration
requirements imposed by the law of the state in which the offering occurs.
However, many states have adopted crowdfunding exemptions under
state law that free intrastate crowdfunded offerings of securities from state
registration requirements as well. The exact requirements of these state
crowdfunding exemptions vary from state to state, but they generally
mimic many of the requirements of the federal crowdfunding exemption
(Pei 2014, 869–876). They limit the amount of the offering; limit the
amounts investors may invest; require risk disclosures; require disclosure
by the issuer; require that the offering be conducted through a state-
regulated portal; and restrict how these portals operate.116 However, there
is considerable variation among the states. Some state exemptions remove
investment limits for certain categories of investors; some of them allow
advertising; and some of them do not even require the use of an interme-
diary (Pei 2014, 869–876).
It is not clear how successful these intrastate provisions will be. The
requisite connections to a single state may be too restrictive, particularly
in smaller states, although the recent amendments to Rule 147 ease these
restrictions a bit. The SEC staff has also provided some relief, indicating
that an offer is not made to out-of-state offerees merely because it appears
on a web platform accessible from out of state. According to the SEC
(2015a), the offering would be intrastate as long as the portal makes it
clear that the offering is limited to residents of a particular state; the
offeree confirms his or her residence before accessing the offering materi-
als; and sales are made only to residents of the state. New Rule 147A
makes it even easier, completely eliminating the requirement that all
offerees be residents, but many of the state exemptions will have to be
amended to take advantage of that new rule.
9.6 The Extent of the Exemptions

The exemptions discussed in this chapter free crowdinvesting and
crowdlending from both state and federal securities registration require-
ments. They do not, however, completely exempt these offerings from
securities regulation. Federal and state antifraud provisions would still
apply.
9.6.1 State and Federal Registration Requirements
All of the exemptions discussed in this chapter exempt offerings from the
registration and prospectus requirements of both federal and state law.
Securities offered and sold pursuant to the Rule 506(b) or 506(c)
exemptions are “covered securities” as defined in section 18 of the
Securities Act of 1933.117 Securities sold pursuant to the crowdfunding
exemption in § 4(a)(6) of the Securities Act are also covered securities.118
Section 18(a) of the Securities Act expressly excludes offerings involving
covered securities from state registration, offering, and prospectus
requirements.119
The state crowdfunding exemptions are, by definition, exemptions
from state registration and prospectus requirements. But since these state
exemptions require that the offering also be in compliance with the
federal intrastate offering exemption, these offerings would also be

exempted from the federal registration requirement.120
9.6.2 Antifraud Rules
Issuers selling securities pursuant to one of the exemptions discussed in

this chapter would still be subject to federal and state securities law rules
prohibiting fraud. The crowdfunding exemptions only exempt offerings
from the registration and prospectus delivery requirements, not the anti-
fraud rules.
US securities law includes a number of general antifraud provisions
that could apply to crowdinvesting and crowdlending121 and one new
antifraud rule, section 4A(c) of the Securities Act, that applies specifically
to section 4(a)(6) crowdfunding.122 Rule 10b-5, for example, makes it
unlawful, in connection with the sale of any securities, “[t]o make any
untrue statement of a material fact or to omit to state a material fact nec-
essary in order to make the statements made … not misleading.”123 State
securities laws contain similar prohibitions on securities fraud (Long
2015, ch. 9).
Issuers making materially false statements in selling securities to crowd-
investors could be liable under these antifraud provisions. Crowdfunding
intermediaries might also be liable for false statements made by issuers,
although their liability risk is less clear (Bradford 2015, 371–410).
The existence of an antifraud remedy does not mean that it will be
used, however. Crowdinvesting typically involves relatively small invest-
ments by each investor; the section 4(a)(6) exemption even limits how
much each investor may invest. Hence, the cost of bringing a private
antifraud action would often exceed the potential recovery (Palmiter
2012, 416). Given the relatively small amount raised, even class actions
brought on behalf of all the investors in an offering might not be feasible
(416–417). Thus, private enforcement actions are unlikely in many cases.
The SEC and state securities regulators can bring actions against issu-
ers engaged in fraudulent crowdinvesting and crowdlending offerings,
but these regulators are unlikely to focus their limited resources on such
relatively low-profile offerings. Therefore, even public enforcement of the
antifraud provisions could be limited (Palmiter 2012, 375).
9.7 Conclusion
The regulation of crowdinvesting and crowdlending involves a trade-off
between capital formation and investor protection. Disclosure require-
ments, structural limitations on crowdfunded offerings, investment lim-
its, and other regulatory requirements designed to protect investors
increase the cost of crowdinvesting and crowdlending. As the regulatory
cost increases, crowdfunding become a less viable option for small busi-
ness capital formation. But, absent adequate investor protection, losses
due to fraud and manipulation may drive investors away from crowd-
funded securities offerings.
The two federal exemptions limited to accredited or sophisticated
investors—Rule 506(b) and Rule 506(c)—impose the least regulatory
cost. Issuers can avoid mandatory disclosure requirements, limits on the
structure of their offerings, and offering and investment amount limits.
But these two exemptions essentially take the “crowd” out of crowdin-
vesting. Issuers may sell only to sophisticated or wealthy investors and, in
the case of Rule 506(b), may not even advertise the offering on a publicly
accessible Internet site.
These exemptions also raise investor protection concerns. Their basic
premise—that investors who meet the wealth and income requirements
to qualify as accredited investors do not need regulatory protection—is
questionable, particularly since the amounts these investors may invest is
unlimited.
The Section 4(a)(6) crowdfunding exemption and the many intrastate
crowdfunding exemptions widen the scope of permissible investors. The
intrastate exemptions still limit the investors to the residents of a p
articular
state, a troublesome, perhaps archaic restriction in the global Internet
age. But all of the crowdinvesting-specific exemptions, state and federal,
allow the general public to invest, without any restrictions based on
wealth or sophistication.
That breadth comes at a regulatory price. The federal and state regula-
tors have imposed significant regulatory costs on these offerings—invest-
ment limits, sales through neutral intermediaries, limits on the structure
of offerings, and, probably the costliest part of these rules, substantial
mandatory disclosure requirements. The regulatory price paid to access

non-accredited investors is significant.
It is too early to say whether any of these four possibilities has struck
the right balance. The Rule 506 exemptions may prove too limited. The
Section 4(a)(6) exemption may prove too costly. The intrastate offering
exemptions may be both too limited and too costly. On the other hand,
one of these exemptions may allow crowdinvesting to explode, substan-
tially expanding small business capital formation opportunities and pro-
viding investors with significant new opportunities to invest in small
entrepreneurial enterprises.
Notes
1. Section 5(c) of the Securities Act of 1933 provides that no one may
offer securities until a registration statement has been filed with the
SEC. 15 U.S.C. § 77e(c). Section 5(a)(1) of the Act prohibits sales of
those securities until the registration statement has become effective. 15
U.S.C. § 77e(a)(1).
2. 15 U.S.C. § 77b(a)(1). Hazen (2016, §§ 1:49–1:79) provides a good
general discussion of the interpretation of that definition.
3. 17 C.F.R. § 230.506(b). Before 2013, when the Rule 506(c) exemption
was added, this exemption was known simply as the Rule 506
exemption.
4. 17 C.F.R. § 230.506(c).
5. Pub. L. 112–106, 126 Stat. 306 (2012).
6. See Securities Act Rule 501(a), 17 C.F.R. § 230.501(a).
7. Securities Act Rule 501(a)(5), 17 C.F.R. § 230.501(a)(5). A spouse’s
net worth may also be included to reach the USD 1 million limit. Id.
8. Securities Act Rule 501(a)(6), 17 C.F.R. § 230.501(a)(6).
9. See, for example, SEC v. Ralston Purina Co., 346 U.S. 119 (1953). In
Ralston Purina, the court held that the US private offering exemption
(now in section 4(a)(2) of the Securities Act) applies to offerings to
those who are “able to fend for themselves” and therefore do not need
the protection of registration. Id., at 125.
10. Securities Act Rule 506(d), 17 C.F.R. § 230.506(d).
11. Securities Act Rule 502(d), 17 C.F.R. § 230.502(d).
12. See Securities Act Rule 144, 17 C.F.R. § 230.144.

13. Securities Act Rule 506(b)(2)(ii), 17 C.F.R. § 230.506(b)(2)(ii).
14. Id.
15. Securities Act Rules 501(a), 506(b)(2)(ii), 17 C.F.R. §§ 230.501(a),
230.506(b)(2)(ii).
16. Securities Act Rule 502(b), 17 C.F.R. 230.502(b).
17. See Securities Act Rule 502(b)(2), 17 C.F.R. § 230.502(b)(2).
18. Securities Act Rule 502(c), 17 C.F.R. § 230.502(c).
19. See, for example, IPOnet, SEC No-Action Letter (July 26, 1996).
20. Securities Act Rule 506(c)(2)(ii), 17 C.F.R. § 230.506(c)(2)(ii).
21. Securities Act Rule 506(c)(2)(ii)(A)–(B), 17 C.F.R. § 230.506(c)(2)(ii)
(A)–(B).
22. See 15 U.S.C. § 77d(a)(6).
23. 15 U.S.C. §§ 77d(a)(6), 77d-1.
24. See 17 C.F.R. § 227.10 et seq.
25. 17 C.F.R. § 227.100(a)(2)(i),(ii).
26. 17 C.F.R. § 227.100, Instruction 2 to paragraph (a)(2).
27. 17 C.F.R. § 227.100, Instruction 1 to paragraph (a)(2); 17 C.F.R. §
230.501(a)(5)(i).
28. 17 C.F.R. § 227.302(b)(1)(v).
29. 17 C.F.R. § 227.303(b)(1).
30. Id.
31. 17 C.F.R. § 227.302(b)(1).
32. 17 C.F.R. § 227.302(b)(2).
33. 17 C.F.R. § 227.303(b)(2)(i).
34. 17 C.F.R. § 227.303(b)(2)(ii).
35. 17 C.F.R. § 227.501.
36. Id.
37. 17 C.F.R. § 227.100(b)(1).
38. 17 C.F.R. § 227.100(b)(2).
39. Investment companies and companies that would be investment com-
panies except for certain statutory exemptions are excluded. 17 C.F.R.
§ 227.100(b)(3). Also excluded are companies that have no specific
business plan or whose business plan is to engage in a merger or acqui-
sition with an unspecified company. 17 C.F.R. § 227.100(b)(6).
Companies that have used the crowdfunding exemption in the past and
have not filed the required annual reports in the past two years are also
excluded. 17 C.F.R. § 227.100(b)(5).
40. See 17 C.F.R. §§ 227.100(b)(4); 227.503.
41. 17 C.F.R. § 503(a).

42. 17 C.F.R § 227.100(a)(1).
43. 17 C.F.R. § 304(c).
44. Id.
45. Id.
46. 17 C.F.R. § 227.201(a).
47. 17 C.F.R. § 227.201(e).
48. 17 C.F.R. § 227.201(d).
49. 17 C.F.R. § 227.201(b).
50. 17 C.F.R. § 227.201(b).
51. 17 C.F.R. §§ 227.201(c); 227.201(m)(3).
52. 17 C.F.R. § 227.201(r).
53. 17 C.F.R. § 227.201(m)(1).
54. 17 C.F.R. § 227.201(m)(4).
55. 17 C.F.R. § 227.201(m)(5).
56. 17 C.F.R. § 227.201(m)(6).
57. 17 C.F.R. § 227.201(m)(2).
58. 17 C.F.R. § 227.201(f ).
59. 17 C.F.R. § 227.201(p).
60. 17 C.F.R. § 227.201(q).
61. 17 C.F.R. § 227.201(u).
62. 17 C.F.R. § 227.201(w).
63. 17 C.F.R. § 227.201(x).
64. 17 C.F.R. § 227.201(s).
65. 17 C.F.R. § 227.201(s), Instruction 2.
66. Id.
67. Id.
68. See 17 C.F.R. § 227.201(t).
69. 17 C.F.R. § 227.201(i).
70. 17 C.F.R. § 227.201(l).
71. 17 C.F.R. § 227.201(n).
72. 17 C.F.R. § 227.201(o).
73. 17 C.F.R. § 227.201(g).
74. 17 C.F.R. § 227.201(h).
75. 17 C.F.R. § 227.201(j).
76. 17 C.F.R. § 227.201(k).
77. 17 C.F.R. § 227.201(v)
78. 17 C.F.R. § 227.203(a)(3)(i).
79. 17 C.F.R. § 227.203(a)(3)(ii).
80. 17 C.F.R. § 227.201(y).

81. 17 C.F.R. § 227.202(a).
82. 17 C.F.R. § 227.202(a).
83. See 17 C.F.R. § 227.202(a).
84. 17 C.F.R. § 227.202(b)(1),(4),(5).
85. 17 C.F.R. § 227.202(b)(2).
86. 17 C.F.R. § 227.202(b)(3).
87. 17 C.F.R. § 227.300(a).
88. See Securities Exchange Act of 1934 § 3(a)(80), 15 U.S.C. § 78c(a)
(80); 17 C.F.R. §§ 227.401–227.402.
89. 17 C.F.R. § 227.300(b).
90. 17 C.F.R. § 227.300(b)(1),(2).
91. 17 C.F.R. § 227.302(d).
92. 17 C.F.R. § 227.204(a).
93. 17 C.F.R. § 227.205(b).
94. 17 C.F.R. § 227.204(b).
95. 17 C.F.R. § 227.303(c).
96. 17 C.F.R. § 227.303(c)(2),(3).
97. 17 C.F.R. §§ 227.204(c), 227.303(c)(4).
98. 17 C.F.R. § 227.205(a).
99. 17 C.F.R. § 227.303(a)(1),(3).
100. 17 C.F.R. § 227.303(b)(1).
101. 17 C.F.R. § 227.301(a).
102. 17 C.F.R. § 227.301(b).
103. 17 C.F.R. § 227.301(c)(1).
104. Id.
105. 17 C.F.R. § 227.301(c)(2).
106. 17 C.F.R. § 227.201(g).
107. 17 C.F.R. § 227. 303(a)(2).
108. 17 C.F.R. § 227.304(a).
109. 17 C.F.R. § 227.304(d).
110. 17 C.F.R. § 227.304(b).
111. 17 C.F.R. § 227.304(b)(2),(3).
112. Section 3(a)(11) of the Securities Act exempts “[a]ny security which is
a part of an issue offered and sold only to persons resident within a
single State or Territory, where the issuer of such security is a person
resident and doing business within, or, if a corporation, incorporated
by and doing business within, such State or Territory” 15 U.S.C. §
77c(a)(11).
113. 17 C.F.R. § 230.147.

114. 17 C.F.R. § 230.147(c)(1).
115. 17 C.F.R. § 230.147(c)(2).
116. For a fairly typical example of such a state exemption, see
NEB. REV. STAT. § 8-1111(24).
117. Securities Act of 1933 § 18(b)(4)(E), 15 U.S.C. § 77r(b)(4)(E).
118. Securities Act of 1933 § 18(b)(4)(C), 15 U.S.C. § 77r(b)(4)(C).
119. Securities Act of 1933 § 18(a), 15 U.S.C. § 77r(a).
120. See Securities Act of 1933 § 3(a)(11), 15 U.S.C. § 77c(a)(11); Securities
Act Rule 147, 17 C.F.R. § 230.147.
121. See Securities Act of 1933 § 12(a)(2), 15 U.S.C. § 77l(a)(2); Securities
Act of 1933 § 17(a), 15 U.S.C. § 77q(a); Exchange Act Rule 10b-5, 17
C.F.R. § 240.10b-5.
122. Securities Act of 1933 § 4A(c), 15 U.S.C. § 77d-1(c).
123. Exchange Act Rule 10b-5, 17 C.F.R. § 240.10b-5.
References
Bradford, C. Steven. 2001. Securities Regulation and Small Business: Rule 504
and the Case for an Unconditional Exemption. The Journal of Small and
Emerging Business Law 5: 1–47.
———. 2012a. Crowdfunding and the Federal Securities Laws. Columbia
Business Law Review, 1–150.
———. 2012b. The New Federal Crowdfunding Exemption: Promise
Unfulfilled. Securities Regulation Law Journal 40: 195–250.
———. 2015. Shooting the Messenger: The Liability of Crowdfunding
Intermediaries for the Fraud of Others. University of Cincinnati Law Review
83: 371–410.
Campbell, Rutheford B., Jr. 1995. Resales of Securities under the Securities Act
of 1933. Washington & Lee Law Review 52: 1331–1384.
Cohn, Stuart R., and Gregory C. Yadley. 2007. Capital Offense: The SEC’s
Continuing Failure to Address Small Business Financing Concerns.
N.Y.U. Journal of Law and Business 4: 1–87.
Hazen, Thomas Lee. 2016. Treatise on the Law of Securities Regulation. 7th ed.
St. Paul, Minn: Thomson Reuters.
Ivanov, Vlad, and Scott Bauguess. 2012. Capital Raising in the U.S.: The
Significance of Unregistered Offerings Using the Regulation D Exemption.
Securities and Exchange Commission (SEC). https://www.sec.gov/info/small-

bus/acsec/acsec103111_analysis-reg-d-offering.pdf. Last modified Feb 2012.
Long, Joseph C. 2015. Blue Sky Law. St. Paul, Minn.: Thomson/West Group.
Palmiter, Alan R. 2012. Pricing Disclosure: Crowdfunding’s Curious
Conundrum. Ohio State Entrepreneurial Business Law Journal 7: 373–427.
Pei, Matthew A. 2014. Intrastate Crowdfunding. Columbia Business Law Review:
854–898.
Prifti, William M. 2010. Securities: Public and Private Offerings. 2nd ed. Eagan,
Minn.: Thomson/West Group.
Securities and Exchange Commission (SEC). 1996. Report of the Advisory
Committee on the Capital Formation and Regulatory Processes. http://www.
sec.gov/news/studies/capform.htm. Last modified 24 July 1996.
———. 2000. Use of Electronic Media. Securities Act Release No. 7856, Federal
Register 65: 25843–25855.
———. 2013. Crowdfunding. Securities Act Release No. 9470, Federal Register
78: 66428–66602.
———. 2015a. Compliance and Disclosure Interpretations: Securities Act
Rules. www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.
htm. Last modified 8 Dec 2016.
———. 2015b. Crowdfunding. Securities Act Release No. 9974, Federal Register
80: 71388–71615.
———. 2015c. Report on the Review of the Definition of ‘Accredited Investor’.
https://www.sec.gov/corpfin/reportspubs/special-studies/review-definition-
of-accredited-investor-12-18-2015.pdf. Last modified 18 Dec 2015.
———. 2016. Exemptions to Facilitate Intrastate and Regional Securities
Offerings. Securities Act Release No. 10238. https://www.sec.gov/rules/
final/2016/33-10238.pdf. Last modified 26 Oct.
Sjostrom, William K., Jr. 2001. Going Public through an Internet Direct Public
Offering: A Sensible Alternative for Small Companies? Florida Law Review
53: 529–594.
———. 2004. Relaxing the Ban: It’s Time to Allow General Solicitation and
Advertising in Exempt Offerings. Florida State University Law Review 32:
1–50.
Surowiecki, James. 2004. The Wisdom of Crowds: Why the Many Are Smarter than
the Few and How Collective Wisdom Shapes Business, Economics, Societies, and
Nations. New York: Anchor Books.
U.S. Government Accountability Office. 2000. Small Business Efforts to Facilitate
Equity Capital. Washington, D.C.: U.S. Government Printing Office.
C. Steven Bradford is the Henry M. Grether, Jr. Professor of Law at the
University of Nebraska-Lincoln College of Law. He has written numerous arti-
cles on US securities law, including several articles on crowdfunding and the
regulation of small business securities offerings. He has testified on crowdfund-
ing issues before the US Congress and the Nebraska State Legislature. He has
made crowdfunding presentations to numerous groups, including the SEC
Government-Business Forum on Small Business Capital Formation, the
New York State Bar Association, and the Practising Law Institute.
10
The Regulation of Crowdfunding
in Europe
Lars Klöhn
10.1 T
he Capital Markets Union
and the European Institutions’ Work
on Crowdfunding
On September 30, 2015, the European Commission published its Capital
Markets Union (CMU) Action Plan.1 The plan aims to tackle investment
shortage by increasing and diversifying the funding sources for European
businesses—especially small and medium-sized enterprises (SMEs)—and
long-term projects and to provide more options and better returns for
savers and investors. Crowdfunding is a cornerstone of the CMU Action
Plan. The Commission conducted a public consultation on crowdfund-
ing, set up a website on which it informs market participants on its ongo-
ing work,2 and established a European Crowdfunding Stakeholder Forum
(ECSF), which at the time of writing, has held four meetings since its
creation.3
L. Klöhn (*)
Faculty of Law, Humboldt University of Berlin, Berlin, Germany

https://doi.org/10.1007/978-3-319-66119-3_10
220 L. Klöhn
The Commission’s work on crowdfunding had begun earlier. Building

on its Green Paper on Long Term Financing of the European Economy,4
the European Commission held a public consultation on crowdfunding
between October and December 2013 and subsequently published a pro-
grammatic communication paper to the other European institutions on
March 27, 2014, titled “Unleashing the potential of Crowdfunding in
the European Union.”5
In May 2016 the European Commission published a Commission
Staff Working Document, reporting on the Commission’s work on
crowdfunding since its publication of 2014.6 The report states that
“crowdfunding remains relatively small in the EU but is developing rap-
idly. It has the potential to be a key source of financing for SMEs over the
long term.”7 The Commission asserts that “[g]iven the predominantly
local nature of crowdfunding, there is no strong case for EU level policy
intervention at this juncture. Crowdfunding is still relatively small and
needs space to innovate and develop.”8 However, “[g]iven the dynamism
of crowdfunding and the potential for future cross border expansion, it
will be important to monitor the development of the sector and the effec-
tiveness, and degree of convergence of, national regulatory frameworks.”9
The Commission therefore intends to “maintain regular dialogue (…)
with the European Supervisory Authorities, Member States, and the
crowdfunding sector to promote convergence, sharing of best practice
and keep developments under review.” The aim is to be able to act in a
timely manner if further steps become necessary to support convergence
of regulatory approaches in the member states, “both to promote the
development of the sector and to ensure appropriate investor
protection.”10
The European Parliament stated in 2015 that “the CMU should create
an appropriate regulatory environment that enhances cross-border access
to information on the companies looking for credit, quasi-equity and
equity structures, in order to promote growth of non-bank financing
models, including crowdfunding and peer-to-peer lending.”11 The
European Parliament resolution of January 19, 2016, underlines the
potential of innovative market-based funding and stresses the need to
streamline regulatory regimes. At the same time, it—quite notably—asks
The Regulation of Crowdfunding in Europe 221
the Commission to give “breathing space for the emergence of these new
models and to explore and promote them, giving priority to their cross-
border dimension and ensuring the reduction of market entry
barriers.”12
10.2 Aim and Scope of This Chapter

The aim of this chapter is to give an overview of the regulation of
crowdfunding in Europe on the level of the member states as well as on
the supranational EU level and to assess whether there is need for more
supranational regulation.13 As such regulation should take into account
whether platforms have an incentive to provide investors with optimal
financing contracts and develop other market-based solutions for the
various risks faced by investors (regarding these risks compare Armour
and Enriques, Chap. 12 sub 12.2.; Dehner and Kong 2014, 441;
Gabison 2015, 369 et seq.; Wilson and Testoni 2014, 7), this chapter
also tries to shed light on the contractual terms, under which crowdin-
vesting is taking place in Europe, and investor protection mechanisms
crowdinvesting platforms have developed in the absence of regulatory
requirements.
The focus of this chapter is on crowdinvesting rather than crowdlend-
ing or reward-based or donation-based crowdfunding.14 While there is
a vibrant crowdlending market in Europe, it does not seem to be fre-
quented by start-ups, perhaps due to the fact that debt financing is
unsuitable for firms without hard assets (Armour and Enriques 2017,
11). The European market for reward-based or donation-based crowd-
funding appears rather insignificant, especially when compared to the
US. A regulatory reason seems to be the Directive on Consumer
Rights,15 which grants consumers purchasing under a distance sales
contract a right of withdrawal without justification within 14 days of
receipt of the goods (Armour and Enriques 2017, 30 et seq.). Finally,
this chapter will be limited to “hard” law, which means it will not cover
the various soft law regimes that have been established, for example, by
the European Crowdfunding Network.16
222 L. Klöhn
10.3 EU Law

10.3.1 Overview
Currently there is no specific crowdfunding regulation at the EU level.

There are, however, several legal acts which set the general regulatory
framework for crowdinvesting, such as the prospectus requirement and
conduct of business regulation for financial intermediaries. Note, how-
ever, that these acts apply only if the crowdinvesting model falls within
the scope of application of these acts. As a general rule, this requires the
distribution of transferable securities such as stocks or mini bonds. As the
German market shows, crowdfunding can take place on the basis of
investment contracts not covered by current European regulation (see
below Sect. 10.4.3.1).
10.3.2 Prospectus Requirement
The standard tool of Securities Regulation to mitigate information asym-

metries between investors and issuers prior to the investment decision is
the issuer’s duty to disclose all relevant information in a document known
as the prospectus (on information asymmetries in crowdinvesting see
Hornuf and Schwienbacher 2016, sub 4.5; Ibrahim 2015, 573 et seq.,
591 et seq.). Usually this obligation is enforced publicly (i.e. by the state)
by requiring issuers to submit the prospectus or an equivalent document
with the competent authority before offering or marketing the securities
(“gun jumping laws”). Moreover, securities laws around the world have
chosen to supplement this regime by means of private law because no
regulator has—and probably should not have—the manpower and the
resources to verify all information contained in a prospectus before
approving the offering within a reasonable period of time. The corner-
stones of this supplementary private law enforcement regime are the rules
on prospectus liability, that is liability for material omissions or misstate-
ments contained in a prospectus or for the complete failure to submit a
prospectus with the competent authority prior to the offer.
The EU Prospectus Directive17 and the accompanying Prospectus

Regulation18 regulate the public law side of the above-mentioned
regime and set out some rudimentary rules for the private law side. The
Prospectus Directive is a legal act which is not directly applicable. It
must be implemented by the member states, which means it obliges the
member states to pass domestic law implementing the rules contained
in the Directive. The Prospect Regulation is directly applicable in all
member states and thus does not need to be implemented by the mem-
ber states.
Under Art. 3(1) Prospectus Directive member states shall not allow
any offer of securities to be made to the public within their territories
without prior publication of a prospectus. Art. 13(1) Prospectus
Directive states that no prospectus shall be published until it has been
approved by the competent authority of the home member state. The
prospectus shall contain all information which, according to the par-
ticular nature of the issuer and of the securities offered, is necessary to
enable investors to make an informed assessment of the assets and lia-
bilities, financial position, profit and losses, and prospects of the issuer
and of any guarantor, and of the rights attaching to such securities, Art.
5(1) Prospectus Directive. The Prospectus Regulation sets minimum
requirements with regard to what information must be included in a
prospectus, the format of the prospectus, the modalities of disclosure,
and the methods of publication and dissemination of the prospectus.
Once a prospectus has been approved by the competent authority of
the home member state, it shall be valid for public offer in any number
of host member states, Art. 17(1) Prospectus Directive. This scheme of
mutual recognition in the EU is commonly referred to as the “European
Passport”.
The Prospectus Directive contains several exemption clauses. Under
Art. 3(2)(a), (b) Prospectus Directive, the prospectus requirement does
not apply to offers addressed solely to qualified investors and to offers
addressed to fewer than 100 natural or legal persons per member state,
other than qualified investors. Also, there is no prospectus requirement
for offers of securities with a total consideration of less than EUR
100.000 which limit shall be calculated over a period of 12 months, Art.
224 L. Klöhn
3(2)(e) Prospectus Directive. Finally, the Prospectus Directive allows

member states to refrain from imposing a prospectus requirement as
long as the total consideration of the offer is less than EUR 5 million,
Art. 1(2)(h) Prospectus Directive.19 Thus, member states must exempt
offers from the prospectus requirement if the total consideration is less
than EUR 100.000 and they must require a prospectus if the total con-
sideration is EUR 5 million or more. Within that range between EUR
100.000 and EUR 4.99 million member states can choose: They may
impose a prospectus requirement, and they may choose to allow such
offers without a prospectus.
Finally, the Prospectus Directive applies only to offerings of transfer-
able securities as defined by Art. 4(1)(44) MiFID. The paradigm of such
securities are stocks (common or preferred) and bonds, Art. 2(1) lit. a
Prospectus Directive. The concept of security under EU law is much nar-
rower than for example in the US.20 Thus, there are several investment
contracts not covered by the Prospectus Directive, especially subordi-
nated profit participating loans (partiarische Nachrangdarlehen) which are
issued on the German crowdinvesting market. Such offers must be
accompanied by a prospectus only if member states’ domestic securities
laws require a prospectus to be published.
In conclusion, there is no single unified prospectus regime in Europe
but a hotchpotch of different domestic regimes, partly harmonized by the
EU Prospectus Directive. The main divide runs along the investment
contracts that are being offered:
• If start-ups offer transferable securities as defined by MiFID, the har-

monized EU prospectus regime applies, unless the total consideration
is less than EUR 5 million and the member state, in which the offer is
being made, has chosen to exempt the offer from the prospectus
requirement. If the consideration is less than EUR 100.000, such
exemption is mandatory.
• If start-ups offer investment contracts which do not qualify as transfer-
able securities, the EU prospectus regime does not apply. Whether the
start-up has to publish a prospectus is a question of (non-harmonized)
domestic law.
10.3.3 Platform Regulation
10.3.3.1 A
uthorization, Organizational Requirements,
and Conduct of Business Regulation
Overview
The major regulation of financial intermediaries is contained in the

Markets in Financial Instruments Directive (MiFID)—a tight regulatory
regime which has just been remolded in 2014 (therefore often referred to
as MiFID II).21 As a directive, MiFID is not directly applicable; its rules
must be implemented by the member states. So, just like the Prospectus
Directive, MiFID obliges the European member states to pass domestic
law implementing the rules contained in the Directive.
Authorization and European Passport
MiFID establishes, among others, requirements in relation to the autho-

rization and operating conditions of investment firms. Under Art. 5(1)
MiFID each member state shall require that the provision of investment
services be subject to prior authorization by the competent authority. If
investment firms obtain authorization they may freely provide invest-
ment services within the territories of all EU member states, Art. 34(1)
MIFID. Thus, authorization obtained under MiFID grants investment
firms a “European Passport”.
Organizational Requirements
Art. 16 MiFID establishes organizational requirements, for example with

regard to the compliance structure of the investment firms or measures to
be taken to prevent conflicts of interest. While Art. 16 MiFID contains
the general organizational objectives and principles, the specific rules are
contained in delegated or implementing regulations passed by the
European Commission (so-called Level-2-acts).22 Art. 24 to 30 MiFID
226 L. Klöhn
contain the rules under which investment firms must conduct their busi-
ness with regard to investor protection. As a general rule, Art. 24(1)
MiFID obliges member states to make sure that, when providing invest-
ment services, an investment firm act honestly, fairly, and professionally
in accordance with the best interests of its clients and comply with all
principles set out in MiFID and the respective Level-2-acts. Specific
aspects of this general duty to always act in good faith are the investment
firm’s information duties and know-your-customer-requirements.
Information Duties
Under Art. 24(4) MiFID appropriate information shall be provided in

good time to clients or potential clients with regard to the investment
firm and its services, the financial instruments and proposed investment
strategies, execution venues, and all costs and related charges. The infor-
mation must be provided in a comprehensible form in such a manner
that clients or potential clients are reasonably able to understand the
nature and risks of the investment service and of the specific type of
financial instrument that is being offered and, consequently, to take
investment decisions on an informed basis, Art. 24(5) MiFID. All infor-
mation, including marketing communications, addressed by the invest-
ment firm to clients or potential clients shall be fair, clear, and not
misleading. Market communications shall be clearly identifiable as such,
Art. 24(3) MiFID.23
Know-Your-Customer-Rules
The requirements of the know-your-customer-rules depend on the nature

of the investment service:
• If an investment firm provides investment advice, it must obtain the

necessary information regarding the client’s or potential client’s knowl-
edge and experience, that person’s financial situation including the
investor’s ability to bear losses, and his or her investment objectives
so as to enable the investment firm to recommend to the client or
otential client the investment services and financial instruments that

p
are suitable for him or her (suitability test), Art. 25(2) MiFID.
• If an investment firm provides other investment services such as the
reception and transmission of orders in relation to financial instru-
ments, the investment firm must ask the client or potential client to
provide information regarding that person’s knowledge and experience
relevant to the specific type of product or service offered or demanded
so as to enable the investment firm to assess whether the investment
service or product envisaged is appropriate for the client (appropriate-
ness test), Art. 25(3) MiFID.
• An investment firm is exempted from the appropriateness require-
ment, if it merely receives and transmits client orders with respect to
non-complex financial instruments such as shares and bonds admitted
to trading on a regulated market or on an equivalent third-country
market or on a multilateral trading facility (MTF), Art. 25(4)
MiFID. This exception, however, is not relevant for the European
crowdinvesting market, because even if there is a secondary market,
financial instruments offered by start-ups to the crowd are neither
listed on a regulated or equivalent market nor on an MTF.
MiFID’s Scope of Application
All of these rules apply only to investment firms within the meaning of
Art. 4(1) MiFID, that is to firms providing financial services as defined by
Section A of Annex I MiFID, relating to financial instruments as defined
by Section C of Annex I MiFID. Therefore, the regulatory regime for
crowdfunding platforms in Europe is just as divided as the prospectus
regime:
• If crowdinvesting platforms broker investments in firms offering

stocks, bonds, units in collective investment undertakings or other
financial instruments listed in Section C of Annex I MiFID, they are
governed by the national securities laws implementing MiFID.
• If crowdinvesting platforms broker other investment contracts not
covered by MiFID, such as profit participating loans offered by
228 L. Klöhn
German crowdinvesting platforms, MiFID and its implementing rules

of national law do not apply. Crowdinvesting platforms are governed
by domestic bespoke regimes for investment firms operating outside
the scope of MiFID.
• If crowdinvesting platforms merely provide the investment service
of receiving and transmitting orders in transferable securities (such
as stocks and bonds) and units in collective investment undertak-
ings and/or of providing investment advice in relation to such finan-
cial instruments and are not allowed to hold client funds or client
securities, member states can opt to exempt them from MiFID’s
rules if the unregulated investment firm is allowed to transmit orders
only to investment firms authorized under MiFID, credit institu-
tions authorized under the European Capital Requirements
Directive (CRD), or certain other institutions (so-called Art. 3
exemption). If those firms are exempted under Art. 3 MiFID they
may be governed by domestic bespoke regimes for investment firms
operating outside the scope of MiFID (if such bespoke regimes
exist).
10.3.3.2 Capital Requirements
MiFID investment firms are subject to EU-wide capital requirement

regulation under Art. 15 MiFID, member states shall ensure that the
competent authorities do not grant authorization unless the investment
firm has sufficient initial capital. These requirements are governed by the
EU Capital Requirement Directive (CRD)24 and the EU Capital
Requirements Regulation (CRR).25 These requirements depend on the
nature of the investment service.
• The default capital requirement is EUR 730,000, comprised only of

certain so-called Equity Tier 1 items, Art. 28 CRD in connection with
Art. 26(1)(a) to (e) CRR.
• If an investment firm merely receives and transmits orders for financial
instruments and holds client money or securities, it shall have initial
capital of EUR 125,000, Art. 29(1) CRD.
• If an investment firm merely receives and transmits orders for financial

instruments and is not allowed to hold client money or securities, mem-
ber states may reduce this amount to EUR 50,000, Art. 29(3) CRD.
10.3.3.3 Anti-Money Laundering Regulation
Crowdinvesting platforms that operate under MiFID are subject to anti-

money laundering and anti-terrorist financing rules under the Anti-Money
Laundering Directive.26 If they operate outside MiFID, platforms can be
subject to the Anti-Money Laundering Directive if they provide certain
payment services within the meaning of the Payment Services Directive.27
10.3.3.4 R
egulation under the Distance Marketing
of Consumer Financial Services Directive
If the platform’s activity qualifies as concluding a distance contract for

financial services, its consumer clients have a right to obtain pre-
contractual information as well as a right of withdrawal within 14 days
without justification under the Distance Marketing of Consumer
Financial Services Directive.28
10.3.3.5 Data Protection
If platforms or issuers process personal data they will be governed by EU

data protection legislation, namely the European General Data Protection
Regulation.29
10.4 Laws of the Member States

10.4.1 Overview
As evidenced above, there is no uniform legal framework for crowdin-

vesting in Europe. The investment contracts offered are the key differen-
230 L. Klöhn
tiators for the applicable legal regimes. If start-ups offer investments in

transferable securities, these offerings are subject to the prospectus
requirement of Art. 3 Prospectus Directive unless an exemption applies.
Platforms brokering such investments are regulated by MiFID, unless
exempted under Art. 3 MiFID. If start-ups offer investment contracts
not covered by MiFID, the offers are subject only to the domestic
bespoke prospectus regimes. Investment firms brokering such
investments are governed only by domestic financial intermediary

regulation.
Thus, it is not surprising that there is a great variety of crowdinvesting
regulatory regimes in the European member states. It is impossible to
cover all those regimes, given the space constraints of this chapter.
Furthermore, the European Commission has put together a comprehen-
sive report on those regimes in its 2016 working document on crowd-
funding.30 Therefore, this chapter will be limited to the two member
states which seem to have the most relevant crowdinvesting markets in
Europe (as regards size), that is to the UK and to Germany. These two
countries have chosen almost antagonistic approaches to regulating
crowdinvesting, which makes them the ideal states to be featured in a
report on European crowdinvesting regulation.
10.4.2 United Kingdom
10.4.2.1 Prospectus Requirement
In the UK, the legislator of the Financial Services and Markets Act
(FSMA) has made use of the option provided by the Prospectus Directive
to exempt all offerings of securities to the public from the prospectus
requirement if the total consideration is less than EUR 5 million.31
Therefore, start-ups can issue transferable securities such as stocks and
bonds to the crowd without a prospectus as long as they raise less than
EUR 5 million within 12 months. This generous exemption from the
prospectus requirement reduces start-ups’ and platforms’ incentives for
regulatory arbitrage by designing investment contracts which would fall
outside the scope of the Prospectus Directive. Furthermore, crowdinvesting
platforms do not seem to gain much from designing such contracts,

because they would still be providing “financial promotions” covered by
the FSMA 2000 [see below at Sect. 10.4.2.2]. This is why UK crowd
investors usually obtain classic transferable securities, especially common
and preferred stock. The exemption from the prospectus requirement
applies regardless of whether securities are offered on a crowdinvesting
platform or other financial intermediary or directly by the issuer. However,
issuers may not market crowdinvesting securities directly to the public,
they need to rely on an FCA authorized person such as a crowdinvesting
platform.32
10.4.2.2 Platform Regulation
As start-ups offer transferable securities to the crowd, UK crowdinvesting

platforms provide classic financial services—usually the receipt and trans-
mission of orders—and therefore fall under the legislative provisions
implementing MiFID, namely the authorization requirement33 and the
organizational and conduct of business requirements of FSMA 2000.
Even if crowdinvesting platforms marketed only non-transferable securi-
ties or other investment contracts not covered by MiFID, they would
most likely be subject to the same rules as their activities would be con-
sidered “financial promotions” (Armour and Enriques 2017, 23).
The Financial Conduct Authority (FCA), the UK financial markets
regulator, issued a policy statement to specify those requirements for
crowdinvesting platforms in 2014.34 It has published a review of its regu-
latory regime in 201535 and is at the time of writing aiming to publish a
second review in early 2017.36
As platform regulation in the UK follows MiFID, the law contains a
general obligation to ensure financial promotions offered on the platform
are fair, clear, and not misleading.37 Platforms must ask their clients to
provide information necessary to assess whether the securities are appro-
priate, that is whether the investors have the necessary knowledge and
experience to understand the risks involved.38 In practice, platforms
require investors to answer a simple automated test about the character-
istics of equity crowdfunding investments, for which they provide guid-
ance (Armour and Enriques 2017, 23).
232 L. Klöhn
Statements by the FCA, however, suggest that platforms play a crucial

role in securing a sufficient level of investor protection under the UK
regime. In its 2015 review the FCA stated that “[w]e are particularly
looking to see that platforms are disclosing all relevant information to
enable potential investors to make informed decisions on whether or not
to invest.”39 Compare this with the mandate by Art. 5(1) Prospectus
Directive under which a prospectus shall contain “all information which
(…) is necessary to enable investors to make an informed assessment of
the assets and liabilities, financial position, profit and losses, and pros-
pects of the issuer and of any guarantor, and of the rights attaching to
such securities.” It seems as if according to the FCA’s interpretation, the
platforms’ disclosure duties under MiFID serve as a perfect functional
equivalent to the missing prospectus requirement. Put differently,
although start-ups are exempted from publishing a prospectus, the FCA’s
interpretation of MiFID (or the implementing provisions of the FSMA
2000) ultimately ensures investors are furnished with the same informa-
tion, that is all information necessary to assess the value of the offered
securities—however, not by issuers but by crowdinvesting platforms.
10.4.2.3 Investor Access
Investor access to crowdinvesting securities is restricted in the

UK. Platforms may market non-readily realizable securities, that is secu-
rities for which no liquid secondary market exists, only to certain types of
investors (see also Ridley 2016, 68 et seq.).40 These are
• professional clients, or
• retail clients who confirm that, in relation to the investment promoted,
they will receive regulated investment advice or investment manage-
ment services from an authorized person (“advised investors”), or
• retail clients who are venture capital contacts or corporate finance con-
tacts, or
• retail clients, who are certified or self-certify as sophisticated investors;
or
• retail clients who are certified as high net worth investors, or
• retail clients who certify that they will not invest more than 10% of
their net investible financial assets in unlisted equity and debt securi-
ties (i.e. they certify that they will only invest money that does not
affect their primary residence, pensions, and life cover) (“restricted
investors”).
Note that, unlike in the US, the UK regulation knows no single-issuer

limits but only an aggregate limit, that is for all non-readily realizable
securities as an asset class. In addition, there is only a relative (percentage-
wise) investment restriction, which means the absolute amount a single
retail investor can invest depends on the amount of his or her overall
investible financial assets. Finally, just like in the US, as a general rule,
platforms may rely on the information provided by the investor in a
“Restricted Investor Statement”.41 Therefore, investors seem to be able to
avoid investment limits by lying about the amount of their investible
financial assets.
10.4.3 Germany
10.4.3.1 Prospectus Requirement
Unlike in the UK, the German legislator has chosen not to make use of
the Prospectus Directive’s option to exempt all offerings with a consider-
ation of less than EUR 5 million from the prospectus requirement. The
small offer exemption provided by German law is available only to securi-
ties offerings of less than EUR 100,000 within a 12-month-period.42 The
same rule applies to firms offering investment contracts which do not
qualify as securities.43
The strict prospectus requirement gave German crowdfunding plat-
forms a strong incentive for regulatory arbitrage by designing investment
contracts not covered by German prospectus regulation. In November
2012, crowdinvesting platforms in Germany therefore began to broker
subordinated profit participating loans (partiarische Nachrangdarlehen)
to the crowd. These are hybrid investment contracts which are loan-
based but mimic features of equity. At the time of introduction to the
234 L. Klöhn
crowdinvesting market profit participating loans were outside the scope

of German prospectus regulation (Klöhn et al. 2016, 58 et seq.). They
had been existent before their introduction to the crowd, although there
is no reliable data about to what extent they had been used on the “grey”,
that is largely unregulated, German capital market. When the legislator
introduced a prospectus requirement for investments sold on this mar-
ket, profit participating loans were exempted for dubious reasons, never
made explicit during the legislative process.
By switching to profit participating loans, crowdfunding platforms
greatly increased their potential to earn fees. Before, they could collect a
maximum amount of (less than) EUR 100,000 per offer without trigger-
ing a prospectus requirement. After the platforms had introduced profit
participating loans, there was no limit as to the maximum amount to be
collected.
For reasons unrelated to crowdinvesting, the German parliament
introduced a prospectus requirement for offers of profit participating
loans in 2015 (Klöhn et al. 2016).44 Because the legislator did not want
to put an end to crowdinvesting, it also introduced a specific crowdin-
vesting exemption, under which firms could continue to offer profit par-
ticipating loans to the crowd under the following conditions:45
• The investments must be offered exclusively on a crowdinvesting plat-

form. Thus, the exception to the prospectus requirement does not
extend to issuers making direct offerings to the crowd.
• The crowdinvesting platform must be subject to regulatory oversight
either under the laws implementing MiFID or under the (much more
rudimentary) rules of the Trade Regulation Act (Gewerbeordnung). It
especially must be obliged to monitor the subscription limit described
below.
• The aggregate value of the offer must not exceed EUR 2.5 million. The
law does not specify a time period during which multiple offerings by
the same issuer will be aggregated when calculating the
2.5-million-limit.
Even when the offering is exempted from the prospectus requirement,

the issuer must prepare a so-called investment information sheet
(Vermögensinformationsblatt, VIB) which must contain the most essen-

tial information about the investment. The issuer must submit the
investment information sheet to the German Federal Financial

Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht,
BaFin) and make it available to every potential investor.46 The invest-
ment information sheet must contain a highlighted warning notice on
its first page stating: “The purchase of this investment is associated
with significant risks and can result in a total loss of the money
invested.”47 Every investor must confirm that he or she understood the
warning in writing or in an equivalent digital form, for example digital
signature.48
10.4.3.2 Portal Regulation
As start-ups offer investment contracts not covered by MiFID, German

crowdinvesting platforms do not fall into the regulatory scope of this
directive. Hence, their activities are not governed by the German law
implementing MiFID and they are not overseen by the federal securities
regulator BaFin. Instead they fall under the regulatory reach of the Trade
Regulation Act (Gewerbeordnung), an act not specific to securities issues
which also contains some rudimentary organizational and conduct of
business rules for financial intermediaries who are acting outside the
reach of MiFID. For the same reason, no capital regulatory requirements
apply to crowdinvesting platforms in Germany. Instead, they are required
to obtain professional liability insurance under the Trade Regulation
Act.49
10.4.3.3 Investor Access
The exemption from the prospectus requirement is granted on the condi-

tion that investors stay within certain subscription limits (for a compari-
son of the German and US regulation, see Bradford 2015b).50 Unlike the
UK, German law only limits the amount that an investor may invest in
one issuer (single-issuer limit), but not the amount that an investor may
invest in the entire crowdinvesting market (aggregate limit). The exact
236 L. Klöhn
amount of the subscription limit depends on the investor’s freely avail-

able assets and monthly net income:
• If the investor provides a statement that he or she has freely available

assets of at least EUR 100,000, he or she can invest up to a maximum
of EUR 10,000 in an issuer.
• If the investor does not have that amount of assets, the limit is twice
the investor’s monthly net income, but in any case not more than EUR
10,000.
• In all other cases (i.e. particularly if the investor does not provide the
statement on assets and income), the investor is limited to a maximum
investment of EUR 1000.
Crowdinvesting platforms have a duty to monitor that investors stay

within the subscription limits, they may however rely on the investor’s
information.51
10.4.4 Comparative Summary
As stated before, the UK and Germany offer two almost antagonistic

crowdinvesting regulatory regimes:
• UK law offers the maximum exemption from the securities prospectus

requirement allowed by the Prospectus Directive (the 5-million-limit)
while the German legislator only offers the minimum exemption
required by the Prospectus Directive (the 100,000-limit).
• In the UK, crowdfunding platforms broker transferable (non-readily
realizable) securities, while in Germany they broker investment con-
tracts not covered by the Prospectus Directive.
• In the UK, crowdfunding platforms are subject to the standard MiFID
regime implemented in the FSMA and the FCA’s Conduct of Business
Handbook, while in Germany they are only subject to some rudimen-
tary provisions of the Trade Regulation Act.
• In the UK, crowdfunding platforms are regulated by FCA, that is the
national Financial Markets Authority, while in Germany they are
overseen by the trade offices which have no specific expertise in the

financial markets sector.
10.5 C
rowdinvesting Contracts and (Other)
Market-Based Safeguards
10.5.1 Overview
As shown above there is no EU regulation which specifically addresses

crowdinvesting and the scope of application of EU securities laws govern-
ing securities offers to the public and financial intermediation is limited.
Furthermore, we have seen that there is a tremendous variety in crowdin-
vesting regulation regimes in the member states, as exemplified by the
two almost antagonistic regulatory landscapes of the UK and Germany.
All this might call for the European legislator to step in and create a level
playing field by passing detailed new rules. Such call, however, might
turn out to be premature. It has been pointed out in early economic
scholarship on securities regulation that issuers might have an incentive
to disclose all information relevant to investors without any legal obliga-
tion, simply because without such disclosure investors would “assume the
worst” and put their money into other ventures (Stigler 1964; cf.
Grossman 1981; Milgrom 1981). Also, even in the absence of any legal
obligation crowdinvesting platforms might have incentives to provide
investors with good investment opportunities by virtue of simple reputa-
tion mechanisms (see, e.g. Klein and Leffler 1981; Shapiro 1983; with
regard to crowdfunding Wilson and Testoni 2014, 10). Thus, before call-
ing for more detailed regulation, one should try to assess to what extent
such reputational and market mechanisms seem to be at work.
10.5.2 The Crucial Role of Crowdinvesting Platforms
When making this assessment, crowdinvesting platforms seem to be of

particular importance (on the role of portals see Anand 2014, sub IV.;
Heminway 2013). They are the only repeat players in the crowdinvesting
238 L. Klöhn
market acting as intermediaries between start-ups and investors. However,

they are much more than investment brokers. They fulfill three addi-
tional functions (see also Heminway 2013, 181 et seq.):
• They are gatekeepers, because they decide which start-ups can run
crowdfunding campaigns on their platforms.
• They are information intermediaries, because they reach out to start-
ups and tell them what information they must provide to investors.
Also, they usually channel communications between investors and
businesses in an investor-relations portal.
• Finally, they are drafters of investment contracts; they choose what types
of investment contracts start-ups offer to the crowd, and they design
the details of those contracts.
Crowdinvesting platforms’ profits depend on the amount of funds

that they manage to raise (Belleflamme et al. 2015). Increasingly, plat-
forms also participate in the future success of the companies, for exam-
ple on the basis of carried interest provisions (on the importance of
aligning the portal’s with investors’ interests, see Anand 2014, sub IV.).
Still, the bulk of their profits does not depend on the ultimate success
of the venture but on the success of the fundraising campaign.
Accordingly, platforms compete to broker fundings. Moreover, the
crowdinvesting market has characteristics that are typical of network
economies (Klöhn et al. 2018; cf. also Viotto 2015, 38). The more
investments a crowdinvesting platform brokers, the more attractive the
portal is for future campaigns and investments (Klöhn et al. 2018).
Accordingly, successful crowdinvesting platforms can increase their
profits even if the market volume remains stable (Klöhn et al. 2018). By
the same token, it becomes increasingly difficult for new crowdinvest-
ing platforms to enter the market (Klöhn et al. 2018).
There are three plausible scenarios regarding the implications of com-
petition between crowdinvesting platforms (Klöhn et al. 2018):52
• Race to the top: In the first scenario competition will lead platforms to
develop optimal financing agreements. These contracts consist of pro-
visions on which companies and investors would agree if they were
rational, fully informed, and could negotiate without transaction costs

(Klöhn et al. 2018).
• Race to the bottom: In the second scenario, platforms will create the
laxest contracts possible to attract start-ups and exploit investors. This
scenario is most likely if there are only a small number of companies
on the crowdinvesting market and a large number of potential inves-
tors “chasing deals” (Klöhn et al. 2018).
• No race at all or a race to nowhere in particular: In the final scenario,
contractual provisions will not change at all or only due to exogenous
factors (tax law, regulations, etc.). Platforms might also simply follow
the market leader by copying its contracts and thereby stifle the urge
to innovate (Klöhn et al. 2018).
There are good arguments in favor of each of these scenarios (Klöhn

et al. 2018). The race to the top scenario is supported by the fact that the
crowdinvesting market represents a two-sided market (see Viotto 2015,
38 et seq.). Platforms have to satisfy the demand of both start-ups and
investors to be successful. The nature of the companies seeking financing
by crowdinvesting supports the race to the bottom scenario. In its seed
stage, a start-up essentially consists of an idea which has not been tested
in the market. Assessing its true value is a task laden with much uncer-
tainty. Therefore, it is very difficult to distinguish between “good” and
“bad” start-ups, that is start-ups with potential for growth and manage-
rial integrity and start-ups with unrealistic ideas and self-enriching man-
agement (Klöhn et al. 2018). The final scenario is supported by the
present competitive situation of crowdinvesting markets in most
European countries, which is a duo- or oligopolistic structure (Klöhn
et al. 2018).
One of the major future tasks of law-and-economics scholarship in the
field of crowdinvesting is to gather empirical evidence which allows an
answer to the question: Which of the aforementioned scenarios is most
plausible? As of now there are only a few fact-based studies or hints as to
what this answer might be. The first is a study on financial contracting on
the German crowdinvesting market (see below Sect. 10.5.3). The second
are accounts of other market-based investor protection mechanisms (not
related to contract design) that have been developed by crowdfunding
240 L. Klöhn
platforms, especially in the UK, in the absence of specific legal obliga-

tions (see below Sect. 10.5.4).
10.5.3 Crowdinvesting Contracts in Germany
From a financial contracting point of view the German crowdinvesting

market is highly interesting. Remember that in Germany start-ups do not
offer transferable securities to the crowd (such as stocks and bonds) but
subordinated profit participating loans (see above Sect. 10.4.3.1).
Originally, these contracts were virtually unregulated. Even after the
introduction of a prospectus requirement for offering profit participating
loans to the public in 2015 they remain largely unregulated because start-
ups make use of the 2.5-million-exemption from that requirement,
because platforms brokering such investment are operating outside the
scope of MiFID and because these platforms are not overseen by the
German financial regulator BaFin but by the local trade offices who have
no specific expertise in the field of corporate finance.
The absence of regulation gave German crowdinvesting platforms the
opportunity to develop and experiment with new contractual designs. In
a recent study Klöhn et al. (2016b) provide an overview of the contrac-
tual terms which are currently being used as well as the development of
those terms. The most important results can be summarized as follows:
1. There is a tremendous dynamic in the market. From the beginning of

crowdinvesting in 2012 until today investment contracts have
undergone significant changes on every platform that has stayed in the
market.
2. In some respects, contract development follows the classical pattern
known from other markets with an oligopolistic structure, that is run-
ner-up firms have changed their standard contracts and adopted
clauses used by the market leader. Nevertheless, platforms do not seem
to just stick to these standards53 but keep revising their contracts and
experimenting with innovative ideas.
3. So, while there is evidence that crowdinvesting platforms are actually
using contractual design to compete, it is less clear whether this is a
race to the top or a race to the bottom. The relatively few insolvencies
of start-ups funded by crowdinvesting as well as estimates on the firm
survival, which show a higher survival rate of crowd-funded start-ups
compared with German start-ups in general (Hornuf and Schmitt
2016a), might support the race to the top thesis. On the other hand,
compared to the earnings of venture capital funds, absolute returns in
crowdinvesting seem to be low (Hornuf and Schmitt 2016a). In par-
ticular, to date, there have been only a few exit opportunities for crowd
investors.
10.5.4 Other Market-Based Safeguards in Europe
Crowdinvesting platforms have experimented with several mechanisms

beyond investment contract design to reduce the risk of misallocation of
funds and of outright fraud (Armour and Enriques 2017). These mecha-
nisms can be divided into three groups: (1) mechanisms to utilize the
collective wisdom of crowd investors, (2) mechanism to use VC or angel
investor backup and (3) pricing tools.54
10.5.4.1 Wisdom of the Crowd
One of the most obvious mechanisms to unleash the wisdom of the

crowd,55 which is commonly used by platforms all over the world, is to
initiate discussion about the risks and potential of the investment oppor-
tunity on an internet forum hosted by the platforms. Note however, that
in its 2015 review on UK crowdinvesting, the FCA reported that nega-
tive comments had been deleted from such forums on some sites.56
A mechanism along the same line, often used in practice not only in the
UK but all over Europe, is to let potential investors know not only the
aggregate amount of funding pledged by prior investors but also the indi-
vidual distribution (Armour and Enriques 2017, 43). This might send valu-
able information to the crowd because the more a single investor pledges,
the more careful his or her due diligence will have been (Armour and
Enriques 2017, 43). Along this line, a study of German crowdinvesting
242 L. Klöhn
platforms finds that, where such information is made available, large invest-
ments by a single investor are positively correlated with the number of
subsequent investments later the same day (Hornuf and Schwienbacher
2017a).
Finally, crowdinvesting platforms have experimented with restricting
investor access to individuals which are expected to be particularly sophis-
ticated or at least well-aware of the risks of crowdinvesting (for empirical
evidence on the correlation between the minimum investment and inves-
tor sophistication, see Hornuf and Schmitt 2016b). In Germany, the
crowdinvesting platform Innovestment started with a minimum invest-
ment per individual of EUR 1000 but later abolished this requirement,
possibly due to competitive pressure by other platforms using much
lower investment limits (the two leading platforms Companisto and
Seedmatch use investment limits of EUR 5 and EUR 250 respectively).
Just recently, however, Innovestment announced to raise the minimum
investment requirement to EUR 1000 again. In the US, AngelMD is an
investment platform which allows only medical professionals to invest in
medical start-ups (Armour and Enriques 2017, 44).
10.5.4.2 Angel Investor or VC Backup
Crowdinvesting platforms’ pay is usually tied largely to fundraising suc-

cess and only to a small extent to ultimate investment success. Therefore,
their incentives to screen start-ups before offering them to the crowd
might be suboptimal (Armour and Enriques 2017, 45). It is certainly not
easy for crowdinvesting platforms to signal the crowd that their screening
is reliable. As a possible remedy, platforms have designed models under
which members of the crowd invest alongside VC funds or angel inves-
tors at the same contractual terms. For example, the UK platform
SyndicateRoom, only lists companies that are already backed by profes-
sional business angels (Armour and Enriques 2017, 45).57
Also, in the UK some platforms have tried to make use of contractual
protection devices used by VCs to offer the crowd a more attractive
investment. For example, as Armour and Enriques (2017, 46) point out,
the platform Seedrs signs investment agreements in its capacity as crowd-
funders’ nominee. Those agreements furnish investors with pre-emption
rights, tag-along rights, and veto regarding important issues, “such as

winding-up the company, changing the business of the company, issuing
preference shares, transferring assets out of the company, making certain
loans, or increasing director salaries beyond an agreed level.”58 These
rights are exercised by the platform as nominee on investors’ behalf.59
10.5.4.3 Pricing Tools
Start-ups are extremely difficult to price. Given the far from perfect
incentives of crowdinvesting platforms to ensure that start-ups are valued
at appropriate levels (see above), crowd investors face an exceptionally
high adverse selection risk when making their investment decisions (see
Armour and Enriques, Chap. 12 sub 12.2.1.; Ibrahim 2015; Hurt 2015,
254). Moreover, most crowdinvesting platforms offer investments at a
take-it-or-leave-it price. This exacerbates the danger of herding among
crowd investors because on the platform websites investors can only
observe decisions to make an investment as opposed to decisions to
abstain from making an investment (Armour and Enriques 2017, 12
et seq.; Wilson and Testoni 2014, 7).
Some platforms have experimented with alternative pricing models. For
example, the German crowdinvesting platform Innovestment started with
an ambitious auction mechanism designed by an economics Ph.D. candi-
date writing his thesis about auction theory (see Hornuf and Neuenkirch
2017 for details on the auction mechanism and empirical evidence on the
characteristics which influence pricing; on the correlation between portal
design and investor types see Hornuf and Schmitt 2016b). In the UK,
Crowdcube60 provides a “price review” mechanism, which relies on the
bargaining power of investors willing to buy a relatively large stake in the
company (see Armour and Enriques 2017, 49 et seq. for details).
10.6 Outlook
So what should the EU do? Any section about the regulatory perspec-
tives in Europe must start with the realization that a full-blown harmo-
nization of the laws governing crowdinvesting is, at least for the next
244 L. Klöhn
ten years, simply not feasible. As the German experience shows, such
harmonization would require extending the European term of “finan-
cial instruments” (as within the meaning of MiFID) or “transferable
securities” (as within the meaning of the Prospectus Directive) to any
investment contract regardless of its exact legal structure, that is to
adopt a concept of “financial instruments” or “transferable securities”
similar to the concept of “security” which is predominant in the
US. This would be a huge step. It would significantly extend the reach
of European securities regulation to previously unregulated areas and
markets. The potential side effects of such step are almost impossible to
assess. Furthermore, there are several (at least on a national level) pow-
erful interest groups whose constituents rely on finance provided by
investments not governed by EU regulation (take the Federal Association
of Cooperatives in Germany) and who would no doubt strongly oppose
such regulation. Crowdinvesting is simply not important enough to
convince any decision maker in Brussels or Luxembourg to take this
step.
Given this—rather sobering—fact, one must realize that any attempt
to regulate crowdinvesting on the EU level will be limited to financial-
instruments-based or securities-based crowdinvesting. Market partici-
pants will be able to avoid such regulation by designing investment
contracts not covered by EU regulation, such as subordinated profit par-
ticipating loans in Germany. The most important implication is that
stricter regulatory requirements in the area covered by European law
(securities and financial instruments) will increase issuers’ and platforms’
incentives to avoid such regulation by designing investment contracts not
covered by EU law.
Taking into consideration that crowdinvesting platforms seem to be
experimenting with contractual clauses and other market-based solutions
to protect investors (see above Sects. 10.5.3 and 10.5.4), the best option
seems to be to not further regulate the market but to actually do the
opposite and liberate the market in order to create a level playing field for
securities-based and non-securities-based crowdinvesting.
• The first step towards such level playing field must be a reform of the
small offerings exemption in the Prospectus Directive. The proposal
for a new Prospectus Regulation goes into the right direction and cre-
ates a mandatory exemption for offers of a consideration below EUR
1,000,000 (as of today this limit is EUR 100,000).61 It prevents
member states from imposing disclosure requirements which would
constitute a disproportionate or unnecessary burden in relation to
such offers and thus increase fragmentation of the internal market.
This is the right approach, but the European legislator should go fur-
ther and exempt any securities offer to the public with a consideration
below EUR 2.5 million from the prospectus requirement. This pro-
posal is also supported by a recent study by Hornuf and Schwienbacher
(2017b), which indicates that exemptions from the prospectus require-
ment should be more extensive in countries with smaller angel and
venture capital markets—like it is the case in (continental) Europe—
as smaller firms seeking seed or early-stage capital raise inefficiently
low amounts of money when the exemptions are restrictive.
• The second step could be tailored exemptions from MiFID’s organiza-
tional and conduct-of-business requirements to lower market entry
barriers for crowdfunding platforms and to give crowdfunding plat-
forms more latitude to develop market-based investor protection tools.
For example, it is highly doubtful that the appropriateness test required
by MiFID has any significant effect on crowd investor protection in
the UK. Instead, EU law could require MiFID crowdinvesting plat-
forms to adopt investor protection measures specifically tailored to the
dangers of crowdinvesting (e.g. herding) if it seems probable that such
mechanisms would not be introduced by the platforms due to reputa-
tional and/or market pressure.
Notes
1. European Commission, Communication from the Commission to the
European Parliament, the Council, the European Economic and Social
Committee and the Committee of the Regions, Action Plan on Building
a Capital Markets Union, COM (2015) 468 final, 30.9.2015.
2. http://ec.europa.eu/finance/general-policy/crowdfunding/index_en.
htm.
246 L. Klöhn
3. Agendas, minutes, and meeting documents are available at: http://

ec.europa.eu/finance/general-policy/crowdfunding/index_en.htm.
4. European Commission, Green Paper, Long Term Financing of the
European Economy, COM (2013) 150 final, 25.3.2013.
5. European Commission, Communication from the Commission to the
European Parliament, the Council, the European Economic and Social
Committee and the Committee of the Regions, Unleashing the potential
of Crowdfunding in the European Union, COM (2014) 172 final,
27.3.2014 (for a discussion of the Directives mentioned in the
Communication as having potential impact on crowdfunding, see Gabison
2015 at pp. 376 et seq.). The European Supervisory Authorities (ESAs)
have also analyzed the crowdfunding market and its regulation and issued
opinions and advices within their respective areas of responsibility. In the
field of crowdinvesting the European Securities Markets Authority
(ESMA) published an opinion and an advice on December 18, 2014
(ESMA, Opinion on Investment-based crowdfunding of 18.12.2014,
h t t p s : / / w w w. e s m a . e u r o p a . e u / s i t e s / d e f a u l t / f i l e s /
library/2015/11/2014-1378_opinion_on_investment-based_crowdfund-
ing.pdf; ESMA, Advice on Investment-based crowdfunding of 18.12.2014,
h t t p s : / / w w w. e s m a . e u r o p a . e u / s i t e s / d e f a u l t / f i l e s /
library/2015/11/2014-1560_advice_on_investment-based_crowdfund-
ing.pdf.). The European Banking Authority (EBA) published an opinion
on crowdlending EBA, Opinion of the European Banking Authority on
lending-based crowdfunding, 26.02.2015, EBA/Op/2015/03, https://
www.eba.europa.eu/documents/10180/983359/EBA-Op-2015-
03+(EBA+Opinion+on+lending+based+Crowdfunding).pdf.
6. European Commission, Commission Staff Working Document,
Crowdfunding in the Capital Market Union, SWD(2016) 154 final,
3.5.2016.
3.5.2016, at p. 30.
3.5.2016, at p. 31.
3.5.2016, at p. 31.

3.5.2016, at p. 31.
11. European Parliament resolution of July 9, 2015 on Building a Capital
Markets Union (2015/2634(RSP)), para. 47.
12. European Parliament resolution of January 19, 2016 on stocktaking and
challenges of the EU Financial Services Regulation: impact and the way
forward towards a more efficient and effective EU framework for
Financial Regulation and a Capital Markets Union (2015/2106(INI)),
para. 22.
13. For an overview of the regulation of crowdfunding in a global context,
see Pekmezovic/Walker 2016 at pp. 397–445.
14. For an overview of the “major”, “emerging”, and “frontier” markets of
crowdinvesting outside the US, see Dehner and Kong (2014), p. 420
et seq.
15. Directive 2011/83/EU of the European Parliament and of the Council
of October 25, 2011 on consumer rights, amending Council Directive
93/13/EEC and Directive 1999/44/EC of the European Parliament and
of the Council, and repealing Council Directive 85/577/EEC and
Directive 97/7/EC of the European Parliament and of the Council
(Consumer Rights Directive), OJ (EU) No. L 304 of 22.11.2011,
pp. 64–88.
16. http://eurocrowd.org/about-us/code-of-conduct-2/.
17. Directive 2003/71/EC of the European Parliament and of the Council
of November 4, 2003 on the prospectus to be published when securities
are offered to the public or admitted to trading and amending Directive
2001/34/EC, OJ (EU) No. L 345 of 31.12.2003, p. 64.
18. Commission regulation (EC) No 809/2004 of April 29, 2004 implement-
ing Directive 2003/71/EC of the European Parliament and of the Council
as regards information contained in prospectuses as well as the format,
incorporation by reference, and publication of such prospectuses and dis-
semination of advertisements, OJ (EU) No L 149 of 30.4.2004, p. 3.
19. As amended by Directive 2010/73/EU of the European Parliament and
of the Council of November 24, 2010 amending Directives 2003/71/
EC on the prospectus to be published when securities are offered to the
public or admitted to trading and 2004/109/EC on the harmonisation
of transparency requirements in relation to information about issuers
whose securities are admitted to trading on a regulated market, OJ (EU)
No. L 327 of 11.12.2010, pp. 1–12.
248 L. Klöhn
20. For the US concept see SEC v. Howey Co. 328 U.S. 293 (1946), com-
pare, with regard to crowdfunding, e.g. Hurt (2015), p. 235 et seq.
of May 15, 2014 on markets in financial instruments and amending
Directive 2002/92/EC and Directive 2011/61/EU, OJ No L 173 of
12.6.2014, p. 39.
22. The terminology refers to the Lamfalussy Process, a legislative procedure
under which EU securities regulation is passed. For an overview see Walla
(2013), pp. 27–36.
23. For the obligations of crowdfunding portals regarding the provision of
information and their liability under US law, see Bradford (2015a).
of June 26, 2013 on access to the activity of credit institutions and the
prudential supervision of credit institutions and investment firms,
amending Directive 2002/87/EC and repealing Directives 2006/48/EC
and 2006/49/EC, OJ No 176 of 27.6.2013, p. 338.
25. Regulation (EU) No 575/2013 of the European Parliament and of the
Council of June 26, 2013 on prudential requirements for credit institu-
tions and investment firms and amending Regulation (EU) No
648/2012, OJ (EU) No L 176 of 27.6.2013, p. 1.
of October 26, 2005 on the prevention of the use of the financial system
for the purpose of money laundering and terrorist financing, OJ (EU)
No L 309 of 25.11.2005, p. 15.
27. Directive 2015/2366 of the European Parliament and of the Council of
November 25, 2015 on payment services in the internal market, amend-
ing Directives 2002/65/EC, 2009/110/EC and 2013/36/EU and
Regulation (EU) No 1093/2010, and repealing Directive 2007/64/EC,
OJ (EU) No L 337 of 23.12.2015, p. 35.
of September 23, 2002 concerning the distance marketing of consumer
financial services and amending Council Directive 90/619/EEC and
Directives 97/7/EC and 98/27/EC, OJ (EU) No L 271 of 9.10.2002,
p. 16.
29. Regulation (EU) 2016/679 of the European Parliament and of the
Council of April 27, 2016 on the protection of natural persons with
regard to the processing of personal data and on the free movement of
such data, and repealing Directive 95/46/EC (General Data Protection
Regulation), OJ (EU) No. L 119 of 4.5.2016, p. 1.

3.5.2016.
31. Section 85(5)(a), Schedule 11A, para 9 FSMA 2000.
32. Section 21 FSMA 2000.
33. Section 19 FSMA 2000.
34. FCA, The FCA’s regulatory approach to crowdfunding over the internet,
and the promotion of non-readily realisable securities by other media,
PS14/4, March 2014. For an overview of the FCA’s regulation, see
Ridley (2016) at p. 65 et seq.
35. FCA, A review of the regulatory regime for crowdfunding and the pro-
motion of non-readily realisable securities by other media, February
2015.
36. FCA, Call for input to the post-implementation review of the FCA’s
crowdfunding rules, July 2016; FCA, Feedback Statement, Interim feed-
back to the call for the post-implementation review of the FCA’s crowd-
funding rules, FS 16/13, December 2016.
37. FCA, Conduct of Business Sourcebook, 4.2.1R.
38. FCA, Conduct of Business Sourcebook, 4.7.7(3), 4.7.8(2), 10.2.
2015, para. 50 (emphasis added).
40. FCA, Conduct of Business Sourcebook, 4.7.7(2), 4.7.9–4.7.10.; see also
FCA, The FCA’s regulatory approach to crowdfunding over the internet,
and the promotion of non-readily realisable securities by other media,
PS14/4, March 2014, at p. 35 et seq.
41. FCA, Conduct of Business Sourcebook, 4.7.10.
42. § 3(1)(1) No. 5 Wertpapierprospektgesetz.
43. § 2(3) No. 3 lit. b) Vermögensanlagengesetz.
44. Small Investor Protection Act (Kleinanlegerschutzgesetz, KASG) of July 3,
2015, BGBl. I 2015, p. 1114 ff.
45. § 2a Vermögensanlagengesetz.
46. §§ 13, 14 Vermögensanlagengesetz.
47. § 13(6) Vermögensanlagengesetz.
48. § 15(3) Vermögensanlagengesetz.
49. § 34f(2) No. 3 Gewerbeordnung.
50. § 2a(3) Vermögensanlagengesetz. There is an exception from this require-
ment for investors who are corporate entities.
250 L. Klöhn
51. See § 16(4) Finanzanlagenvermittlungsverordnung, FinVermV and §

31(6) Wertpapierhandelsgesetz.
52. On regulatory competition on the level of national regulators and poten-
tial regulatory options, see Pekmezovic and Walker (2016), p. 446 et seq.
53. The two market leaders—measured by the amounts of funds raised—are
the crowdinvesting platforms Companisto and Seedmatch.
54. Along the same line Armour and Enriques (2017), p. 42: (1) mecha-
nisms that try to leverage more effectively the collective wisdom of the
crowd, by reducing the possibility of inappropriate herding, (2) adapta-
tion of contractual protection devices used by VCs and angel investors,
(3) attempts to make more use of customized versions of investor protec-
tion mechanisms used in traditional IPO markets.
55. For first evidence on the wisdom of the crowd with regard to funding
decisions, see Mollick and Nanda (2016).
2015, para. 51.
57. https://www.syndicateroom.com/about-us/about-syndicateroom.aspx.
58. https://www.seedrs.com/learn/blog/investors/trends-insights/
small-investors-equity-crowdfunding.
59. https://www.seedrs.com/learn/blog/investors/trends-insights/
small-investors-equity-crowdfunding.
60. For empirical data on the crowdfunding campaigns on CrowdCube in
2014, see Gabison (2015), p. 403 et seq.
61. Council of the European Union, Regulation of the European Parliament
and the Council on the prospectus to be published when securities are
offered to the public or admitted to trading, Confirmation of the final
compromise text with a view to agreement, 2015/0268 /COD),
16.12.2016.
References
Anand, Anita I. 2014. Is Crowdfunding Bad for Investors? Canadian Business
Law Journal 55: 215–229.
Armour, John, and Luca Enriques. 2017. The Promise and Perils of Crowdfunding:
Between Corporate Finance and Consumer Contracts. Working Paper (on file
with the author).
Belleflamme, Paul, Nesrine Omrani, and Martin Peitz. 2015. The Economics of
Crowdfunding Platforms. Information Economics and Policy 33: 11–28.
Bradford, Steven. 2015a. Shooting the Messenger: The Liability of Crowdfunding
Intermediaries for the Fraud of Others. University of Cincinnati Law Review
83: 371–411.
———. 2015b. Regulating Investment Crowdfunding: Small Business Capital
Formation and Investor Protection. Zeitschrift für Bankrecht und
Bankwirtschaft/Journal of Banking Law and Banking 27: 376–382.
Dehner, Joseph J., and Jin Kong. 2014. Equity-Based Crowdfunding Outside
the USA. University of Cincinnati Law Review 83: 413–443.
Gabison, Garry A. 2015. Equity Crowdfunding: All Regulated but Not Equal.
DePaul Business & Commercial Law Journal 13: 359–409.
Grossman, Sanford J. 1981. The Informational Role of Warranties and Private
Disclosure About Product Quality. The Journal of Law & Economics 24:
461–483.
Heminway, Joan MacLeod. 2013. The New Intermediary on the Block: Funding
Portals under the Crowdfund Act. UC Davis Business Law Journal 13:
177–205.
———. 2014. How Congress Killed Investment Crowdfunding: A Tale of
Political Pressure, Hasty Decisions, and Inexpert Judgments that Begs for a
Happy Ending. Kentucky Law Journal 102: 865–889.
Hornuf, L., and M. Neuenkirch. 2017. Pricing Shares in Equity Crowdfunding.
Hornuf, Lars, and Matthias Schmitt. 2016a. Success and Failure in Equity
———. 2016b. Does a Local Bias Exist in Equity Crowdfunding? The Impact
of Investor Types and Portal Design. Max Planck Institute for Innovation &
Competition Research Paper No. 16-07.
3. Business Angels, ed. Hans Landström and Colin Mason, 381–397.
Cheltenham, UK: Edward Elgar.
———. 2017a. Market Mechanisms and Funding Dynamics in Equity
Crowdfunding. Journal of Corporate Finance. http://www.sciencedirect.com/
science/article/pii/S0929119916302450. Accessed 20 Feb 2017.
———. 2017b. Should Securities Regulation Promote Equity Crowdfunding.
Hurt, A. Christine. 2015. Pricing Disintermediation: Crowdfunding and
Online Auction IPOs. University of Illinois Law Review 1: 217–262.
252 L. Klöhn
Ibrahim, Darian M. 2015. Equity Crowdfunding: A Market for Lemons?

Minnesota Law Review 100: 561–607.
Klein, Benjamin, and Keith B. Leffler. 1981. The Role of Market Forces in
Assuring Contractual Performance. Journal of Political Economy 89: 615–641.
Klöhn Lars, Lars Hornuf, and Tobias Schilling. 2018. Financial Contracting in
Crowdinvesting—Lessons from the German Market. German Law Journal.
Forthcoming.
Lars, Klöhn, Lars Hornuf, and Tobias Schilling. 2016. The Regulation of
Crowdfunding in the German Small Investor Protection Act: Content,
Consequences, Critique, Suggestions. European Company Law 13: 56–66.
Milgrom, Paul R. 1981. Good News and Bad News: Representation Theorems
and Applications. The Bell Journal of Economics 12: 380–391.
Mollick, Ethan, and Ramana Nanda. 2016. Wisdom or Madness? Comparing
1533–1553.
Pekmezovic, Alma, and Gordon Walker. 2016. The Global Significance of
Crowdfunding: Solving the SME Funding Problem and Democratizing
Access to Capital. William & Mary Business Law Review 7: 347–458.
Ridley, David. 2016. Will New Regulation on Crowdfunding in the United
Kingdom and United States Have a Positive Impact and Lead to Crowdfunding
Becoming an Established Financing Technique? Statute Law Review 37:
57–76.
Shapiro, Carl. 1983. Premiums for High Quality Products as Returns to
Reputation. The Quarterly Journal of Economics 98: 659–680.
Stigler, George J. 1964. Public Regulation of the Securities Markets. Journal of
Business 37: 117–142.
Viotto, Jordana. 2015. Competition and Regulation of Crowdfunding
Platforms: A Two-Sided Market Approach. Digiworld Economic Journal 99:
33–50.
Walla, Fabian. 2013. Process and Strategies of Capital Markets Regulation in
Europe. In European Capital Markets Law, ed. Rüdiger Veil, 25–43. Oxford:
Bloomsbury UK.
Wilson, Karen E., and Marco Testoni. 2014. Improving the Role of Equity
Crowdfunding in Europe’s Capital Markets. Bruegel Policy Contribution 2014
(09): 1–14.
Lars Klöhn holds a professorship for civil and business law at Humboldt
University of Berlin. He has published several scholarly articles on corporate,
banking, and capital markets law. He is inter alia co-editor of ZBB, a leading
German banking and capital markets law journal, and a regular advisor to the
German Legislature and the German Ministry of Finance in matters related to
capital markets and banking law.
11
Individual Investors’ Access
to Crowdinvesting: Two Regulatory
Models
John Armour and Luca Enriques
11.1 Introduction
In recent years, a new source of finance, “crowdinvesting”, has become
available to smaller firms, typically start-ups and early-stage ones. It con-
sists of raising capital via the internet from a large number of individuals,
each typically contributing a small sum in exchange for an equity interest
in the firm. Crowdinvesting is channeled through a web-based portal,
which aggregates business plans from fund-seekers and permits potential
investors to browse projects on offer.
Crowdinvesting is one of the riskiest asset classes individual investors
may access. Issuers in these markets have usually no track record.
Because the market is relatively new, that is also true for the online plat-
forms which may in theory act as gatekeepers and develop a reputation
for screening good investment opportunities. And, unless alternative
J. Armour (*) • L. Enriques

Faculty of Law, University of Oxford, Oxford, UK

https://doi.org/10.1007/978-3-319-66119-3_11
256 J. Armour and L. Enriques
information aggregation mechanisms are developed, there is a high risk

that individuals will make investment decisions based on what other
individuals have done before them (i.e., “herding”) rather than on a col-
lective, uncoordinated effort to understand the merits of the invest-
ment, such as can be seen in IPO markets (via the bookbuilding process)
and in secondary equity markets.
Given the small amount of capital typically raised by a firm pursuing a
crowdinvesting call, this mode of fundraising is only likely to be viable if
the rigor of “ordinary” securities regulations is relaxed. With issuers aim-
ing to raise a few hundred thousand dollars on average,1 the compliance
costs of fully applicable securities regulations would otherwise swallow
too large a chunk of the money raised (Pope 2011). Hence, the choice by
many jurisdictions of providing for exemptions and special, more lenient
rules for crowdinvesting (Weinstein 2013).
The US and European jurisdictions have approached policymaking in
this area from opposite starting points. To make crowdinvesting viable in
the US, exemptions and relaxations of existing rules had to be devised
anew. The US Congress expressed desire to facilitate crowdinvesting with
the JOBS (Jump-Start Our Business Startups) Act of 2012: first, this Act
made crowdinvesting available as a source of capital for US businesses by
removing obstacles to the setup of crowdinvesting platforms limiting
access to accredited investors (i.e., high net worth individuals who are
presumed capable of understanding the risks, or failing that, of affording
access to professional advice). Several such platforms now exist: the larg-
est four among such restricted-access platforms (EquityNet, Angelist,
Fundable, and Crowdfunder) are estimated to have raised together more
than USD 575 million in 2014 (Massolution 2015). Then, in October
2015, the Securities and Exchange Commission introduced rules facili-
tating the operation of crowdfunding platforms for retail investors, fun-
draising from whom had previously required compliance with the rules
for general offerings (Securities and Exchange Commission 2015).
In Europe, the framework was of course less uniform, given the lower
degree of uniformity in securities regulation. But Member States could
provide for (partial) exemptions from MiFID rules on investment firms
and investment services and also dispense issuers from complying with
Individual Investors’ Access to Crowdinvesting… 257
the disclosure rules in the Prospectus Directive, because of its exemption

for small offerings.
As a result, crowdinvesting via (exempt) public offerings has been bur-
geoning in Europe for both retail and professional investors, while in the
US it has until very recently been relegated to platforms only accepting
accredited investors as funders. It is presently too early to tell whether the
new SEC rules for retail crowdinvesting will lower the burdens of securi-
ties regulation enough to allow platforms open to retail investors to
thrive.
This chapter first identifies the features that make crowdinvesting par-
ticularly risky for individual investors (Sect. 11.2). Next, it describes the
regulatory framework in two main jurisdictions (the US and the UK)
which approached the phenomenon from a different status quo (Sect.
11.3). Finally, it offers some tentative thoughts on how, and how strictly,
to regulate crowdinvesting (Sect. 11.4).
11.2 The Perils of Crowdinvesting

Crowdinvesting is one of the riskiest (non-leveraged) investment classes
a retail investor can access. Not only is the typical funded firm a start-
up or an early-stage business which, as such, presents the three central
problems of financing (uncertainty, information asymmetry, and
opportunism in the form of agency costs) in an extreme form (Gilson
2010, 901). It is also the case that the usual mechanisms by which retail
investors are protected before and after they decide to invest are unavail-
able in the crowdinvesting setting. To understand the extent of the risk
they run, it is worth highlighting how crowdinvesting compares, in
terms of risks for retail investors, with investing in an IPO. Before
doing that, however, it is worth asking whether, in the presence of other
forms of early-stage financing, like angel investing, venture capital
(“VC”), and other forms of crowdfunding, none of which particularly
lends itself to the exploitation of financial backers, crowdinvesting is
doomed to attract bad-quality start-ups, that savvy investors would
always refuse to fund.
11.2.1 Adverse Selection?
While going public can be a natural move for successful companies, as it

provides liquidity for existing and prospective investors, some have
expressed the concern that only “lemons” will resort to crowdinvesting
(Dorff 2014, 496–497).
First, where the VC industry is well developed and angel investor net-
works are available, “good” start-ups should have no problem finding
backing from such financiers. Assuming that VCs and angel investors do
their job well, that is, that they will indeed finance all projects deserving
funding, only those projects that are not worth financing will be left to
seek crowdinvesting (Hurt 2015). Or, similarly, if “good” start-ups make
their pitch on a crowdinvesting platform, angel investors and VCs may
“cherry pick” them, thanks to their specialized knowledge of the field
compared to the crowd, and fund them entirely after having the offering
removed from the platform, so that investors will only have access to the
worst projects (Ibrahim 2015).
A second concern is that innovative start-ups’ success will most often
rely on keeping information about the venture secret, lest larger-shoulder
competitors exploit the idea behind it and deliver the innovation first
and/or more effectively (Ley and Weaven 2011, 96–97). Crowdinvesting
requires an entrepreneur to publicize sensitive information about his
product (as opposed to conveying such information to selected individu-
als like angel investors and VCs) at a much earlier stage than is typical for
an IPO: the risk that the innovative value of the idea will be destroyed by
disclosing it is thus much greater. Hence, again, the risk that only “bad”
projects that deserve no funding will enter the crowdinvesting market.
Finally, if that is not an issue, one may wonder why, then, an entrepre-
neur would not choose reward crowdfunding rather than crowdinvest-
ing, given that the former will not require the entrepreneur to share in the
venture’s profits with the crowdfunders and also has the advantage of
providing the entrepreneur with valuable information about demand for
his product (Armour and Enriques 2017).
None of these concerns, however, is so serious as to warrant the con-
clusion that the crowdinvesting market is bound to be a market for
“lemons”. To start with, angel investor networks and VCs may be very
active in (some areas of ) the US and in some other high-tech clusters.

Both angel investors and, to a lesser degree, VCs tend to invest in ven-
tures that are based in the same geographic area (Wong et al. 2009,
227–228; Ibrahim 2010, 730): especially with the prospect of more
intense border controls on immigration in some of the most developed
countries, we cannot expect all talented entrepreneurs in the world to
migrate to where VCs and angel investors operate. In many countries
outside the US, these professional investors networks are much less well-
developed and external finance much harder for start-ups to access
(Hornuf and Schwienbacher 2017).
In addition, even start-ups in the country where angel investor and VC
markets are most well-developed have experienced gaps in the financing
cycle. As Oranburg (2015) has documented, a number of start-ups have
no problem finding angel investors who will fund their early seed stage,
but may run out of cash before they are large enough and at a sufficiently
mature stage of product development to attract VCs. At this interim stage
in which it is especially difficult to further tap angel investors, who gener-
ally prefer to engage in first rounds of financing with other start-ups than
pouring more money in one they have previously funded. Crowdinvesting
may well bridge the financing gap between early-stage and VC
financing.
Second, cherry-picking on crowdinvesting platforms by angels and
VCs seems unlikely to become a frequent phenomenon. Both of these
players typically receive a much larger number of investment proposals
than they accept (Morrissette 2007, 59) and, as mentioned already, tend
to invest in ventures based in the same geographical area. Entrepreneurs
based in those areas will either have proposed their investment to VCs
and angel investors before entering the crowdinvesting markets or will
simply be uninterested in those sources of capital.
In fact, there might be various reasons why founders may prefer the
crowdinvesting market to angels (and VCs). To start with, VCs and angel
investors provide not only capital but also business and strategy advice,
for which they will get compensated, however implicitly, in the form of a
higher return on their investments and correspondingly, a higher cost of
capital for the founders (Ibrahim 2015). An experienced serial
entrepreneur, or one with an extremely simple business idea (think of an
app or a video game), may simply not need those services. Further, there
are strings, whether visible or invisible, attached to the involvement of
VCs and, to a lesser degree, angel investors. Venture capital firms rou-
tinely negotiate a number of governance rights which limit the entrepre-
neur’s freedom of action and may even put them in control (Fried and
Ganor 2006). Angel investors, while relying as often on informal as on
formal mechanisms, still heavily monitor ex post the ventures they fund,
thereby reducing entrepreneurs’ freedom of action (Ibrahim 2008,
1431–1433).2 Crowdinvesting allows entrepreneurs to obtain funding
with hardly any strings attached. It may also avoid the risks inherent to
staged financing, which is typical of VC investing, and precisely that VCs
will take a less positive view of the venture at stage 2 than at stage 1, not
because any new negative information has emerged about the venture but
simply because the market as a whole has become less “hot” or optimistic
(Nanda and Rhodes-Kropf 2013): the crowd’s lack of financial sophisti-
cation, together with the hype which may go together with crowdinvest-
ing in a booming technology market, may help the entrepreneur secure
enough capital to rule out the financing risk stemming from the staged
financing constraint.
In addition to that, while feedback on the product from the crowd-
funding community may be more common in the reward than in the
crowdinvesting setting, one cannot rule out that interactions with crowd-
investors help the entrepreneur improve the product, the production pro-
cess, or more likely corporate finance and managerial aspects of the
venture. Similarly, crowdinvesting may be an effective marketing tool
itself both to find financiers in a later round and to create product aware-
ness (Belleflamme et al. 2015, 40–41).
The risk that competitors appropriate the entrepreneurial idea by tak-
ing advantage of information disclosed on the crowdinvesting platform is
real. But, while emulation by competitors thanks to crowdinvesting dis-
closures may be a concern for some projects, some business ideas may be
described in the pitch without giving away information that competitors
can profit from (Agrawal et al. 2014) or may be difficult to replicate, for
example because their success may critically be linked to the founder’s
personality or unique skillset (Hornuf and Schwienbacher 2016).
Finally, reward crowdfunding cannot be used for each and any entre-
preneurial project: Sergei Brin and Larry Page could have never “pre-
sold” their search engine or the related services. In addition to
advertising-based business models, any business-to-business venture
would also be an unlikely candidate for reward crowdfunding. And even
business-to-consumer ventures may find it hard to raise sufficient capital
via reward crowdfunding if a lot of capital is required to fund the business
(Belleflamme et al. 2014).
To conclude on this point, the idea that crowdinvesting will only
attract lemons (i.e., fraudsters and low-quality, negative NPV projects)
seems unpersuasive.3 For sure, crowdinvesting will not cater to each and
every kind of venture, but there is no reason not to think that entrepre-
neurs will make use of it for good projects as well.
11.2.2 Market Pricing and the Risk of Herding
The big challenge with investing in an innovative start-up is how to know

what to pay. There is no market for the firm’s product—indeed, in most
cases there is not even (yet) a product—and so profitability forecasts are
at best guesstimates of likely production costs and market size. In the case
of a traditional IPO, however, this challenge is met by aggregating the
assessments of as many different sophisticated investors as possible,
through the mechanism of market pricing. The initial IPO will follow a
bookbuilding process: an investment bank will set the price based on
informed investors’ estimates of the likely value of the securities. Retail
investors can then free ride on sophisticated investors’ informed choices.
After the IPO, secondary market trading acts to aggregate investors’
assessments of the price relevance of publicly available information into
the market price extremely rapidly. This makes the market price the best
available estimate of the securities’ value, based on publicly available
information. Ongoing disclosure obligations for public companies ensure
that the set of publicly available information supports informed pricing.
A liquid and informationally efficient secondary market, in turn, makes
investment in the primary market, ex ante, less risky.
In the case of crowdinvesting, it is very uncommon, albeit not unheard

of (Hornuf and Neuenkirch 2017), to use a bookbuilding process or any
auction mechanism akin to that. The issuer directly targets retail inves-
tors. Platforms typically give investors access to information about the
company’s (self-produced) valuation, its business plan, the target amount,
and the percentage of equity it represents based on the valuation; in addi-
tion to that, information is provided about how much funding the crowd
has already committed, and how many (and, unless they prefer anonym-
ity, which) investors have already committed to funding (or declared an
intention to fund). Theory suggests that, rather than serving to aggregate
information, the sequential arrival of investors is likely to engender herd-
ing. In an ordinary secondary market, investors assess their own valuation
of the security against that reflected in the market price, which adjusts
depending on demand. In the crowdinvesting setting, where a secondary
market does not exist or is highly illiquid, the price typically does not
change in response to demand. Investors therefore draw inferences about
the price from the level of observed demand. Put intuitively: “if lots of
others have invested, they must think this is a good opportunity, at this
price”. An investor who lacks the information necessary to assess the
quality of the project might then trust the “wisdom” evidenced by the
decisions of the investing crowd.
The problem is that most of the other investors might equally be bas-
ing their investment on what everyone else has done. In addition, studies
of early investment in crowdfunded projects report that the initial inves-
tors are disproportionately likely to be friends and family of the founders
(Agrawal et al. 2010). This likely injects an element of bias into the initial
signal of support. Success may be a consequence not of attracting
“knowledgeable” investors at the outset, but rather of founders being part
of a large social network (Colombo et al. 2015).
11.2.3 Reputation
The very nature of the projects as start-ups means that, in most cases, no
reputation can be pledged to investors. Nor are there any gatekeepers
who can pledge their own reputation to overcome this constraint as
e ffectively as underwriters or securities lawyers in ordinary IPOs on pub-

lic equity markets (Coffee 2006). It is, again, the absence of a secondary
market that creates a long time lag between crowdfunders’ investment
and an objective, albeit imperfect, assessment of the offering’s pricing and
available disclosure. In other words, while informed traders, securities
analysts, and private and public enforcers of securities regulations provide
an immediate, or at least timely, feedback on the IPO’s quality, no such
mechanism can work out as expediently for crowdinvesting offerings.
Therefore, the room for opportunism on the part of the offerors (and the
platforms themselves) at the offering stage is much wider. Of course, like
reputational intermediaries generally, in the long run platforms stand to
gain more from establishing a record of good-quality offerings on their
portals. But the presence of fringe operators taking advantage of the
crowdfunding hype is a reasonable concern.
11.2.4 Governance
Those who invest in an IPO do so in the shadow of a framework of cor-

porate law rules, stock exchange listing requirements, corporate gover-
nance best practices, and market and legal institutions that together
reduce the risk of ex post expropriation on the part of those who retain or
obtain control over the company (Black 2001). While such direct and
indirect protections vary across jurisdictions and industries, and also
widely diverge in their effectiveness depending on a company’s ownership
structure, it is a truism that the higher visibility that comes from having
a stock exchange listing, from being subject to mandatory disclosure
rules, and from having daily trading on the shares reduces the risk of
expropriation. By contrast, a non-listed start-up will be under no such
scrutiny other than, if at all, by the crowd and the crowdinvesting plat-
form. Whether and to what extent contractual solutions are offered that
can substitute for the absence of all those protections (including corpo-
rate law protections, given the tendency of all jurisdictions to provide for
more flexible rules in the absence of a listing) will crucially depend on
whether the platform acting on behalf of the investing crowd will bargain
for such protections.
Financiers of ventures that are similar to crowdfunded ones in terms of

uncertainty, information asymmetry, and opportunism risk typically
obtain joint or effective control of the company and its future financing
decisions as a condition for their investment. In fact, as noticed before,
one of the reasons why crowdinvesting may be appealing to entrepre-
neurs is that they retain a much higher degree of control over their firm
than after letting an angel investor or a VC in. Correspondingly, crowd-
investors run a much higher risk of ex post opportunism, especially as
regards the dilution of their equity claims in successive financing rounds.
While even shareholders in a listed corporation run the risk of dilution
once the listed corporation taps capital markets again, such a risk is argu-
ably much lower where a secondary market exists that at least provides a
yardstick for the pricing of the newly issued shares. Similarly, in the
absence of a secondary market, crowdfunders will also have a much
harder time finding a buyer for the rights to subscribe new shares, even
assuming (which may well not be the case) that they are entitled to those
rights and that, if so, they are allowed to sell them.
11.3 Regulatory Treatment

of Crowdinvesting: The UK and the US
Approaches
This raises a stark policy question: should securities laws be relaxed for
crowdinvesting? Advocates make two key points. First, start-up firms are
good for the economy. They are disproportionately associated with
innovation (as measured by patent applications and R&D spend) and job
creation (Hall 2011; Kogan et al. 2012). Hence relaxations of securities
law rules that apply to other firms in favor of start-ups may generate
social benefits.
In response to this, others point out that securities laws exist to protect
investors. Relaxing the rules in relation to start-ups—arguably the riskiest
types of issuer out there—would become a magnet for those willing to
part gullible investors from their money, with predictably sour conse-
quences (Hazen 2014). The “dot-com bubble” showed that even with the
benefit of securities laws, small investors could be led astray spectacularly;

arguably, matters can only be worse if those protections are not in place.
As an outcome of this tension, and the political risks that any choice in
this area entails (either stifle crowdinvesting, denying investors the oppor-
tunity to finance the next Google, or make “fraudinvesting” feasible,
exposing individual investors to losses from unscrupulous promoters), it
is perhaps unsurprising that the pre-existing regime for offerings of this
kind dictates how strict regulations are that are specifically targeted to
crowdinvesting.
To illustrate, we compare the regulation of crowdinvesting in two
jurisdictions, the UK and the US, that started out as polar opposites in
this area. In the US, no such offering could be made to the public with-
out compliance with burdensome disclosure regulations—that is, an ini-
tial prospectus and then continuing disclosure. The costs of compliance
with such obligations acted as a de facto prohibition on crowdinvesting.
Meanwhile, European securities laws permitted Member States to apply
a “small offering exemption”. Pursuant to this, the UK imposed no real
disclosure burden on crowdinvesting. At the same time, crowdinvesting
platforms were considered investment services providers in both jurisdic-
tions and both, though with a time lag between the two, chose to provide
for special, less burdensome rules for platforms specializing in the crowd-
investing business.4
11.3.1 The UK Framework
The EU legal framework, to which the UK is still bound until “Brexit”

becomes effective, has always contained an exemption from prospectus
requirements for small offerings. That exemption has proved instrumen-
tal to make crowdinvesting offerings possible within the EU.
More precisely, the EU Prospectus Directive does not apply to offer-
ings of less than EUR 5 million in a 12-month period,5 thus allowing
Member States, if they see fit, to leave smaller offerings (including via
crowdinvesting campaigns) exempt from prospectus requirements. The
Prospectus Directive also explicitly prohibits prospectus rules from apply-
ing below offerings of EUR 100,000 in a 12-month period. The UK has
followed the directive and implemented the EUR 5 million offering size
limit.6
At the same time, if the securities offered on the crowdinvesting plat-
form qualify as “financial instruments”,7 which is usually the case, then,
under the framework set out in the Markets in Financial Instruments
Directive (“MiFID”),8 crowdinvesting portals need to be authorized as
performing investment services or activities, because they usually engage
at the very least in the business of receiving and transmitting crowd-
funders’ orders relating to financial instruments (European Securities and
Markets Authority 2014, 16).9 In particular, according to ESMA,
crowdinvesting platforms are required to conduct an assessment of

whether the investment is appropriate for the investor (id., 14–15).
Within this framework of European rules, the UK’s Financial Conduct
Authority (“FCA”) has established a flexible regime for crowdinvesting
platforms. Section 19 of the Financial Services and Markets Act 2000 (as
amended) requires crowdinvesting intermediaries to be authorized by the
FCA if they conduct regulated activities. Activities that crowdinvesting
platforms may only undertake with such authorization include arranging
deals in investments10 and carrying out financial promotions. In particu-
lar, financial promotions, defined as “invitation[s] or inducement[s] to
engage in investment activity”,11 clearly encompass crowdinvesting
offerings.
Under MiFID, all financial promotions must be “fair, clear and not
misleading”.12 In 2013, the FCA introduced specific consumer protec-
tion rules governing the sale of crowdinvesting securities (Financial
Conduct Authority 2014). The main elements of these rules are restric-
tions on the persons to whom crowdinvesting offerings of non-readily
realizable securities may be offered and a requirement that the crowdin-
vesting platform assess whether the product is appropriate for the client.13
In practice, this assessment is conducted by means of a simple multiple
choice questionnaire carried out as part of the investor’s process of sign-
ing up for an account with the platform. Platforms provide “investment
guides” which investors are encouraged to study as a means of preparing
to take these tests.14
Such securities may only be offered to certain sophisticated investors
or to retail investors who certify that they have not invested, and will not
invest, more than 10% of their net assets (excluding the value of their
home) in non-readily realizable securities.
11.3.2 T
he US: The Long-Awaited Crowdfunding
Exemption
Under Title III of the JOBS Act,15 the US Congress provided for a small
offering exemption for crowdinvesting and directed the SEC to imple-
ment a framework of rules to govern such offerings. While the JOBS Act
required the SEC to have crowdinvesting rules in place by the end of
2012, it was not until October 2013 that its “Regulation Crowdfunding”
was proposed.16 These proved contentious, and as a result it was October
2015 before the SEC adopted its final crowdinvesting regulations, which
eventually came into force on May 16, 2016.
Title III of the JOBS Act added a new Section 4(a)(6) to the US
Securities Act of 1933,17 which provides an exemption from registration
of a crowdinvesting offering under the 1933 Act if certain conditions are
met. These conditions include a limit on the amount of capital raised of
USD 1 million per 12-month period, limits on the amount a single
investor may invest per issuer (rather than in the asset class as a whole)
based on his or her income and net worth,18 a requirement that investors
understand the risks of crowdinvesting, and a requirement that transac-
tions are conducted through an intermediary registered with the SEC as
either a broker or a new type of regulated entity called a “funding
portal”.
Regulation Crowdfunding also requires that only a single intermediary
is used for a crowdinvesting offering, and that all information in relation
to the offering is available “online only” in order to ensure that the collec-
tive opinion of the crowd is equally available to all potential investors.19
Section 4(a)(b) of the Securities Act requires crowdinvesting issuers to
file certain specified disclosures with the SEC and provide these to poten-
tial investors and the crowdinvesting platform. Such required disclosures
include information on the issuer’s directors, officers, and principal share-
holders,20 a description of its business and business plan,21 the purpose
and intended use of proceeds of the offering,22 the price of the securities
or the method for determining the price,23 the target offering amount,
the deadline to reach it, regular progress updates,24 and a description of
the ownership and capital structure of the issuer as well as any risk factors
related to the offering.25 Further, crowdinvesting issuers must provide a
complete set of financial statements prepared in compliance with US
GAAP for the last two years or the period since the issuer’s inception,
whichever is shorter.26 In each case, these financial statements must be
certified by the issuer’s CEO. For offerings of more than USD 100,000,
they must also be reviewed by an independent public accountant, who,
in the case of offerings of more than USD 500,000, must also audit the
statements.27 The issuer must also provide a narrative discussion of its
historical results, liquidity, and capital resources,28 and must file annual
reports with the SEC following a completed crowdinvesting offering.29
In addition, the SEC has used its discretion to propose further items
that must be disclosed,30 including the amount of compensation the
issuer is paying to the intermediary31 the material terms of any debt
finance it has raised,32 and details of certain related-party transactions.33
The investor may not transfer securities issued in a crowdinvesting
transaction for a period of one year, with certain limited exceptions such
as resales to the issuer or to accredited investors, but are freely transferable
thereafter.34
To avoid conflicts of interest, brokers and funding portals, as well as
their directors, officers, and partners, are prohibited from having (or
accepting as payment) any financial interest in any issuer using their ser-
vices.35 Regulation Crowdfunding also requires an intermediary to take
measures to reduce the risk of fraud in crowdinvesting transactions on its
platform. Such measures include having a reasonable basis for believing
that the issuer is in compliance with relevant regulations and has estab-
lished means to keep accurate records of holders of the securities it
offers.36 The intermediary must deny access to the platform for issuers
that it believes may present a potential fraud risk.
Crowdfunding investors may bring actions against issuers for material
misstatements or omissions in the offering documents,37 and the SEC has
indicated that “it appears likely” that crowdinvesting intermediaries
would be treated as issuers under the statute’s liability provision.38 The
SEC has not clarified its position in its final rules indicating that the
determination of an “issuer” liability for intermediaries will depend on

the specific circumstances of the matter in question.39 Intermediaries
have an incentive to conduct due diligence on potential issuers before
deciding whether to allow them to list their securities for sale on their
platform.
The SEC’s own estimates of the costs associated with a crowdinvesting
offering suggest that the framework established by Regulation
Crowdfunding may be unappealing for potential issuers seeking to raise
smaller amounts. The fixed costs for required filings for offerings up to
USD 100,000 were estimated at USD 2,500 and intermediaries were
expected to charge between 5 and 15% of the amount raised, which
means that fees for an offering seeking to raise USD 100,000 may be as
high as 17.5% of the capital raised.40 This may make smaller crowdinvest-
ing offerings less attractive to investors.41
Issuers may therefore consider other exemptions from registration
under the Securities Act. For example, following amendments pursuant
to Section 201(a) of the JOBS Act, Rule 506(c) under the Securities Act
now allows offerings (of unlimited size) to use general solicitation and
advertising, as long as all purchasers are accredited investors,42 a regula-
tory innovation that has contributed to the success of crowdinvesting
platforms only accessible to such investor class (Ibrahim 2015).
An additional limit to crowdinvesting stems from the US regulation of
investment companies (Oranburg 2015, 443).43 If the practice prevailing
among angel investor syndicates were to be followed also in the context
of crowdinvesting, investors would not directly hold shares in the crowd-
funded venture, but rather hold certificates in a vehicle which in turn
would hold those shares. However, for such a vehicle not to be subject to
the burdensome regulatory requirements of the Investment Companies
Act of 1940, the vehicle must have no more than 100 beneficial owners.44
Hence, it might be difficult to combine investment from a genuine
crowd, in which each individual contributes small amounts, with an
effective tool to minimize the costs of interactions between the entrepre-
neur and the crowd.
Table 11.1 summarizes the regulations of crowdinvesting in the US
and the UK and, in addition, provides information about their cross-
border aspects.
Table 11.1 US and UK crowdinvesting regulations—summary

UK US
Size thresholds EUR 5M USD 1M
Portals subject to authorization Yes Yes
Mandatory disclosure Non-itemized Itemized
Financial reporting requirements No Yes
Appropriateness filter Yes Yes
Limits to retail investors Yes, per asset class Yes, per issuer
Resale restrictions No Yes
Periodic disclosure obligations for issuers No Yes
Collective investment rules apply to No Yes
crowdinvesting vehicle, when present
Open to foreign issuers Yes No
Open to foreign investors Yes Yes
Open to foreign portals Yes, subject to Yes, subject to
MiFID rules conditions
11.4 T
he Fine Line Between Throwing
the Baby out with the Bathwater
and Giving Fraudsters Free Rein
In Sect. 11.3, we described the regulatory framework on crowdinvesting
in the US and the UK. In a companion paper, we show how, both in the
US (for offerings reserved to accredited investors) and in Europe, crowd-
investing platforms are experimenting with solutions to avoid adverse
selection problems and ensure a minimum quality of the offerings, at the
very least in terms of self-imposed disclosure requirements (Armour and
Enriques 2017). Market experimentation may provide support for a
“wait-and-see”, minimalist approach to the regulation of the sector. A
minimal-intervention approach, like the UK’s, would still aim to ensure
that potential investors understand the risks of crowdinvesting, for exam-
ple by conditioning their access to the platform upon correct completion
of a questionnaire.45 The requirement, common to both the US and the
UK, that retail investors may only invest a limited proportion of their
income or net worth into crowdinvesting also seems a sensible restriction
on retail investor participation in the market.
More risk-averse (or market-mistrusting) policymakers may be less
persuaded by a laissez-faire, experimentation-friendly regulatory environ-
ment, and impose obligations on fundraisers and platforms more similar
to those that apply to securities offers and investment (broker-dealer)

services providers under “regular” securities regulations: the menu would
include a list of items to be disclosed, a general antifraud provision with
liability rules favoring plaintiffs, a public enforcement apparatus, and
conduct of business rules for platforms, possibly making them subject to
strict liability. This appears to be US policymakers’ approach to
crowdinvesting regulation, the high fixed costs of which entail the risk of
precluding retail investors’ access to crowdinvesting altogether by freez-
ing supply.
The differing policy choices of the UK and the US as respects crowd-
investing appear to be path dependent. The UK’s openness to this inno-
vative form of alternative finance derives from pre-existing rules that
made smaller offerings, such as crowdfunding ones, exempt from offer-
ings rules. In contrast, the more cautious approach in the US can be
traced to the previously applicable and prohibitively costly regulatory
environment under the Securities Act.
In the US, supply of crowdinvesting opportunities will be curbed by
the continued imposition of disclosure rules which, though less onerous
than the general disclosure regime, nevertheless still impose high compli-
ance costs. In the UK, there is no other restriction to supply than the
platforms’ willingness to screen issuers for quality with a view to estab-
lishing reputational capital and issuers’ and platforms’ liability in case of
financial promotions that are not “fair, clear and not misleading”. Only
time will tell which system will work best to facilitate effective capital
formation via crowdinvesting in the long run. Yet, given the highly
dynamic and competitive features of the market for crowdinvesting plat-
forms, one common sense policy suggestion can be made: regulations in
this area should have a sunset clause, thereby signaling policymakers’
commitment to revise rules once the phenomenon is better known or has
evolved in a way that could not be possibly predicted.
Notes
1. The figure for the UK’s most popular platform is GBP 440,242 (USD
559,855). See https://www.crowdcube.com/infographic (accessed on
December 5, 2016).
2. Angels’ investing styles vary significantly: while the overall picture is one
of less formal arrangements than in the case of VCs, still some angels
adopt the same protective measures that are common in VC investment
contracts. See Ibrahim (2008, 1420–1425).
3. The available empirical evidence on the incidence of fraud in reward
crowdfunding platforms shows that it is a contained phenomenon.
Cumming et al. (2016) find that actual or suspected fraud occurred in
0.01%of initiated projects per year. One may well question, though,
whether that is a good predictor of the incidence of fraud on crowdin-
vesting platforms.
4. See SEC, Crowdfunding, 78 Fed. Reg. 66,428, 66,458 n. 309 (to be
codified in scattered parts of 17 C.F.R.); Financial Conduct Authority
(2013).
5. Article 1(2)(h) Prospectus Directive [2003] O.J. L 345/64 (as amended)
(the “Prospectus Directive”).
6. Financial Services and Markets Act 2000 (“FSMA”), Section 85(5)(a),
Schedule 11A, para 9.
7. Annex I, Section C, of MiFID 2 defines financial instruments to include
transferable securities. Transferable securities are defined in Art. 4(1)(44)
to include securities negotiable on the capital market, such as shares in
companies.
8. Markets in Financial Instruments Directive [2004] O.J. L 145/1
(“MiFID”).
9. MiFID allowed member states to carve out an exemption for crowdin-
vesting platforms under Article 3, and at least two member states have
apparently done so. Id., p. 19, para 57. Such an exemption is premised
on the platform not holding client funds or securities, not providing any
investment service except the reception and transmission of orders, and
transmit such orders only to other authorized firms. Art. 3 MiFID. While
this exemption remains in MiFID 2, a new Art. 3(2) therein requires
member states to apply to them rules and regulations equivalent to
MiFID 2 in many respects, including conditions for authorization and
supervision and conduct of business obligations.
10. Art. 25, The Financial Services and Markets Act 2000 (Regulated
Activities) Order 2001, SI 2001/554 (available at http://www.legisla-
tion.gov.uk/uksi/2001/544/article/25/made).
11. FSMA 2000 s. 21.
12. FCA’s Conduct of Business Sourcebook (“COBS”) 4.2.1R., implement-
ing Art. 19(2) MiFID (now Art. 24(3) MiFID II).
13. COBS 4.7.7R. Clients could also be advised under COBS 4.7.8R, so

that the suitability of the crowdfunding is assessed by the firm or another
authorized firm, although that would likely be uncommon in the case of
crowdfunding.
14. The tests are not onerous. Typical questions might be of the following
form: “Most early-stage and many growth-focussed businesses: (a) suc-
ceed; (b) break even; (c) fail.” (Taken from sign-up questionnaire at
Seedrs, a UK platform: see https://www.seedrs.com/signup/investor-
profile/quiz).
15. Jumpstart Our Business Startups Act, Pub L. No. 112–106, 126 Stat.
306 (2012) (the “JOBS Act”).
16. Proposed Rule: Crowdfunding, 78 Fed. Reg. 66,428, November 5,
2013.
17. 15 U.S.C. 77a et seq. (the “Securities Act”).
18. Under 17 CFR § 227.100(2), the maximum investment for an investor
in a single issuer is determined as follows. If the investor has both annual
income and net worth of less than USD 100,000, a limit of USD 2,000
or 5% of annual income or net worth, whichever is greater, applies. If
either the investor’s annual income or net worth exceeds USD 100,000,
a limit of 10% of annual income or net worth, whichever is greater, but
not to exceed USD 100,000, applies. (The JOBS Act actually stipulated
these limits, but did so in a logically inconsistent way, which required the
SEC to clarify its position in its final Regulation Crowdfunding).
19. 17 CFR § 227.100, 17 CFR § 227.203.
20. Section 4A(b)(1)(B) of the Securities Act, 17 CFR § 227.201(b), 17
CFR § 227.201(m)(2).
21. Section 4A(b)(1)(C) of the Securities Act, 17 CFR § 227.201(d).
22. Section 4A(b)(1)(E) of the Securities Act, 17 CFR § 227.201(i).
23. Section 4A(b)(1)(G) of the Securities Act, 17 CFR § 227.201(m)(4).
24. Section 4A(b)(1)(F) of the Securities Act, 17 CFR § 227.201(g).
25. Section 4A(b)(1)(H) of the Securities Act, 17 CFR § 227.201(m).
26. Section 4A(b)(1)(D) of the Securities Act, 17 CFR § 227.201(t).
27. Ibid.
28. Section 4A(b)(1)(D) of the Securities Act, 17 CFR § 227.201(s).
29. Section 4A(b)(4) of the Securities Act, 17 CFR § 227.202.
30. The SEC was given discretion under Section 4A(b)(1)(I) of the Securities
Act to require additional disclosure for the protection of investors and in
the public interest.
31. 17 CFR § 227.201(o)(1).

32. 17 CFR § 227.201(p).
33. 17 CFR § 227.201(m)(5).
34. Section 4(a)(3) of the Securities Act, 17 CFR § 227.501.
35. Section 4A(a)(11) of the Securities Act, 17 CFR § 227.300.
36. Section 4A(a)(5) of the Securities Act, 17 CFR § 227.301. The interme-
diary is entitled to rely on representations from the issuer, absent knowl-
edge, or indications to the contrary.
37. Section 4A(c) of the Securities Act.
38. Proposed Rule: Crowdfunding (n. 16), 66,499.
39. Crowdfunding, Final Rule, 80 Federal Register 71,387, 71,478.
40. Crowdfunding, Final Rule, 80 Fed. Reg. 71,387, 71,500. Estimates
by SeedInvest, a crowdfunding platform, are even higher: if one raises
one million dollars via Title III crowdfunding, the cost of the offering
will be USD 250,000. See https://www.seedinvest.com/blog/jobs-act/
crowdsourcing-title-iii-crowdfunding-cost-model.
41. For example, in the case of an issuer raising USD 100,000 under
Regulation Crowdfunding with fees in the region of USD 17,500, the
equity actually contributed to the issuer’s operations would be USD
82,500 and it would need to increase in value by USD 17,500/USD
82,500, or 21.2%, before the value of issuer’s equity would reach the
valuation of USD 100,000 where equity investors would break even.
42. Section 201(a) Jumpstart Our Business Startups Act, Pub. L. No. 112-
106, 126 Stat. 306 (2012) (codified in 15 U.S.C. §77d). “Accredited
investor” is defined in Rule 501 under the Securities Act, 17 CFR
§230.501, to include among others any corporation with assets over
USD 5million and any individual with either a net worth exceeding
USD 1 million or an income above USD 200,000 in the two most
recent years and a reasonable expectation of reaching the same income in
the current year.
43. Within the EU (and therefore, currently, in the UK) an investment vehi-
cle acting as the crowdinvestors’ nominee would seem not to qualify as
an Alternative Investment Fund as defined in the Alternative Investment
Fund Management Directive. According to this Directive, Alternative
Investment Funds are defined as “collective investment undertakings,
including investment compartments thereof, which: (1) raise capital
from a number of investors, with a view to investing it in accordance
with a defined investment policy for the benefit of those investors; and
(2) do not require authorisation pursuant to Article 5 of Directive
2009/65/EC (the UCITS Directive) (Article 4(1)(a))”. While ESMA’s

guidelines clarify that it is enough to raise capital from more than one
investor for capital raising to be from a “number of ” them, they also
define the term “defined investment policy” in a way that appears to be
inconsistent with the mere purchase and holding of securities issued by
an individual company in order to exercise the related rights on behalf of
investors. See ESMA (2013, 7). Consistent with this interpretation,
examples exist of European crowdfunding platforms that use investment
vehicles that are not registered as AIFs (see Armour and Enriques 2017).
44. 15 U.S. Code § 80a–3(c)(1).
45. See above, n 14.
References
Agrawal, Ajay, Christian Catalini, and Avi Goldfarb. 2010. Entrepreneurial
Finance and the Flat-World Hypothesis: Evidence from Crowd-Funding
Entrepreneurs in the Arts. NET Institute Working Paper No. 10-08.
———. 2014. Some Simple Economics of Crowdfunding. Innovation Policy
and the Economy 14: 63–97.
Armour, John, and Luca Enriques. 2017. The Promise and Perils of
Crowdfunding. Between Corporate Finance and Consumer Contracts.
Modern Law Review (forthcoming).
585–609.
Black, Bernard S. 2001. The Legal and Institutional Preconditions for Strong
Securities Markets. UCLA Law Review 48: 781–855.
Coffee, John C. 2006. Gatekeepers: The Professions and Corporate Governance.
Oxford: Oxford University Press on Demand.
2016. Disentangling Crowdfunding from Fraudfunding. Social Science
Research Network. https://ssrn.com/abstract=2828919. Accessed 20 Feb
2017.
Dorff, Michael B. 2014. The Siren Call of Equity Crowdfunding. Journal of

Corporate Law 39: 493–524.
European Securities. 2014. Opinion: Investment-Based Crowdfunding. http://
www.esma.europa.eu/system/files/2014-1378_opinion_on_investment-
based_crowdfunding.pdf. Accessed 20 Feb 2017.
European Securities and Markets Authority. 2013. Guidelines on Key Concepts
of the AIFMD. https://www.esma.europa.eu/sites/default/files/library/2015/
11/2013-611_guidelines_on_key_concepts_of_the_aifmd_-_en.pdf. Last
modified 13 Aug 2013.
Financial Conduct Authority. 2013. The FCA’s Regulatory Approach to
Crowdfunding (and Similar Activities). www.fca.org.uk/static/documents/
consultation-papers/cp13-13.pdf. Last modified Oct 2013.
———. 2014. Policy Statement 14/4, The FCA’s Regulatory Approach to
Crowdfunding Over the Internet, and the Promotion of Non-Readily
Realisable Securities by Other Media: Feedback to CP13/13 and Final Rules.
http://www.fca.org.uk/static/documents/policy-statements/ps14-04.pdf.
Last modified Mar 2014.
Fried, Jesse M., and Mira Ganor. 2006. Agency Costs of Venture Capital Control
in Startups. New York University Law Review 81: 967–1025.
Gilson, Ronald J. 2010. Locating Innovation: The Endogeneity of Technology,
Organizational Structure, and Financial Contracting. Columbia Law Review
110: 885–917.
Hall, Bronwyn H. 2011. Innovation and Productivity. National Bureau of
Economic Research. http://www.nber.org/papers/w17178.pdf. Accessed 20
Feb 2017.
Hazen, Thomas Lee. 2014. Crowdfunding or Fraudfunding? Social Networks
and the Securities Laws—Why the Specially Tailored Exemption Must Be
Conditioned on Meaningful Disclosure. North Carolina Law Review 90:
1735–1770.
Hornuf, L., and M. Neuenkirch. 2017. Pricing Shares in Equity Crowdfunding.
Investing for the Masses? In Handbook of Research on Venture Capital, ed.
C. Mason and H. Landström, vol. 3, 381–397. Cheltenham: Edward Elgar
Publishing.
———. 2017. Should Securities Regulation Promote Crowdinvesting. Small
Business Economics 49: 579–593.
Hurt, Christine. 2015. Pricing Disintermediation: Crowdfunding and Online

Auction IPOs. University of Illinois Law Review: 217–261.
Ibrahim, Darian M. 2008. The (Not So) Puzzling Behavior of Angel Investors.
Vanderbilt Law Review 61: 1405–1452.
———. 2010. Financing the Next Silicon Valley. Washington University Law
Review 87: 717–762.
———. 2015. Equity Crowdfunding: A Market for Lemons? Minnesota Law
Review 100: 561–607.
Kogan, Leonid, Dimitris Papanikolaou, Amit Seru, and Noah Stoffman. 2012.
Technological Innovation, Resource Allocation, and Growth. National
Bureau of Economic Research. http://www.nber.org/papers/w17769.pdf.
Ley, Andy, and Scott Weaven. 2011. Exploring Agency Dynamics of
Crowdfunding in Start-Up Capital Financing. Academy of Entrepreneurship
Journal 17: 85–110.
Massolution. 2015. 2015CF. The Crowdfund Industry Report. http://reports.
crowdsourcing.org/index.php?route=product/product&product_id=54.
Morrissette, Stephen G. 2007. A Profile of Angel Investors. Journal of Private
Equity 10: 52–66.
Nanda, Ramana, and Matthew Rhodes-Kropf. 2013. Investment Cycles and
Startup Innovation. Journal of Financial Economics 110: 403–418.
Oranburg, Seth C. 2015. Bridgefunding: Crowdfunding and the Market for
Entrepreneurial Finance. Cornell Journal of Law and Public Policy 15:
397–452.
Pope, Nikki D. 2011. Crowdfunding Microstartups: It’s Time for the Securities
and Exchange Commission to Approve a Small Offering Exemption.
University of Pennsylvania Journal of Business Law 13: 973–1002.
Securities and Exchange Commission. 2015. SEC Adopts Rules to Permit
Crowdfunding-Proposes Amendments to Existing Rules to Facilitate
Intrastate and Regional Securities Offerings. October 30. https://www.sec.
gov/news/pressrelease/2015-249.html. Accessed 07 Mar 2017.
Weinstein, Ross S. 2013. Crowdfunding in the U.S. and Abroad: What to
Expect When You’re Expecting. Cornell International Law Journal 46:
427–453.
Wong, Andrew, Mihir Bhatia, and Zachary Freeman. 2009. Angel Finance: The
Other Venture Capital. Strategic Change 18: 221–230.
John Armour is Professor of Law and Finance at Oxford University and a

Fellow of the British Academy and the ECGI. He has held visiting posts at the
University of Chicago, Columbia Law School, the University of Frankfurt, the
Max Planck Institute in Hamburg, the University of Pennsylvania, and Sydney
University Law School. Armour has published widely in the fields of corporate
law and financial regulation. His books include Principles of Financial Regulation
(OUP, 2016) and The Anatomy of Corporate Law (OUP, 3rd ed. 2017). He is an
Executive Editor of the Journal of Corporate Law Studies and the Journal of Law,
Finance and Accounting.
Luca Enriques is the Allen & Overy Professor of Corporate Law at the Faculty
of Law of Oxford University and a Fellow of the ECGI. He is a coauthor of The
Anatomy of Corporate Law and of Principles of Financial Regulation. He has pub-
lished several articles in major European and US reviews and journals, including
the Journal of Economic Perspectives, the Cornell Law Review, and the Harvard
Business Law Review. He has held visiting positions at the University of
Cambridge, IDC Hertzliya, Harvard Law School, and other universities and he
has been commissioner at the Italian S.E.C. (Consob) between 2007 and 2012.
Index1
A Australian Small Scale Offerings

Accredited investor, 70, 71, 115, Board (ASSOB), 43, 110
188–192, 196, 210, 256, 257,
268–270, 274n42
Adverse selection, 32, 48, 59, 65, B
74n17, 81, 85, 117, 243, Backer, viii, x, 3–6, 16–23, 30, 31,
258–261, 270 34–36, 39, 40, 45, 46, 57, 58,
All-or-nothing, 14, 19, 45, 73n5, 60,–63, 65, 66, 72, 74n17, 81,
111, 155, 176n7 85, 86, 93, 94, 134–139, 142,
Altruism, 6, 17, 20, 46 143, 145, 146, 149n1, 149n2,
Angel investor, 21, 70, 71, 144, 151, 151–176
241–243, 250n54, 258–260, Blockchain, 106
264, 269 Bookbuilding, 45, 256, 261, 262
See also Business angel Borrower, xi, 2, 3, 5, 20, 65, 79–97, 103,
AngelList, 16, 69–71 104, 109, 116, 117, 124, 125
Antifraud, 208, 209, 271 Business angel (BA), 12, 13, 50n4,
Anti-money laundering, 229 58, 59, 66–71, 75n19, 112,
Auction, 45, 90, 116, 125, 153, 243, 113, 242
262 See also Angel investor
Note: Page numbers followed by ‘n’ refer to notes.

1

https://doi.org/10.1007/978-3-319-66119-3
280 Index
C E
Capital Markets Union (CMU), Entrepreneur, ix, x, 12–24, 31, 32,
219–221, 245n1, 247n11 34, 36, 45, 46, 58–69, 71–72,
Capital Requirements Directive 73n5, 74n9, 74n10, 74n14,
(CRD), 228–229 75n18, 79–97, 103–125, 144,
Capital Requirements Regulation 151, 152, 154, 169, 171–174,
(CRR), 228 258–260, 264, 269
Charity, 3, 4, 16, 20, 154 Equity crowdfunding, x, 5, 13, 33,
Community benefit, 58, 60–63, 72, 48, 49, 74n16, 92, 106,
74n10 108–111, 113, 114, 139, 148,
See also Reward 231
Companisto, x, 45, 67, 242, 250n53 See also Crowdinvesting
Compliance, 106, 205, 206, 208, European Securities and Markets
225, 256, 265, 268, 271 Authority (ESMA), 246n5,
Crowdcube, x, 32, 44, 48, 64, 266, 275n43
67–71, 91, 92, 110, 112, 243,
250n60
Crowdinvesting, vii, ix, 2, 15, 58, F
85, 185, 221, 255–275 Facebook, 4, 22, 24, 57, 109
See also Equity crowdfunding Failure, 20, 22, 30, 59, 60, 82, 84,
92, 93, 111, 133, 135–139,
144–148, 172, 222
D Financial Conduct Authority (FCA),
Data protection, 229 231, 232, 236, 241,
Disclosure, 22, 66, 95, 112, 152, 249n34–249n36, 249n40,
185–187, 190, 192, 195–204, 250n56, 266, 272n4, 272n12
206, 207, 210, 211, 223, 232, Financial Services and Markets Act
237, 245, 257, 260, 261, 263, (FSMA), 230–232, 236, 266
265, 267, 270, 271, 273n30 Fintech, 103–125
Donation, 4, 151, 154, 168 Fraud, 3, 23, 59, 79–95, 97n7,
Donation-based crowdfunding, x, 2, 138, 139, 174, 188, 204,
4, 6, 14–16, 18, 30, 35, 36, 205, 209, 210, 241, 268,
110, 170, 185, 188, 221 272n2, 272n3
Due diligence, 23, 30, 33, 65–67, 71, Funding Circle, xi
72, 109, 110, 206, 241, 269 Funding dynamics, 18
Dynamics, 18, 20, 45, 65, 89, 109, See also Dynamics
112, 124, 151–176, 240, 271 Funding gap, 2, 12, 14, 15, 23, 32,
See also Funding dynamics 49, 105
Index
281
G J
Germany, x, 14, 45, 49, 69, 74n16, Jumpstart Our Business Startups Act
79, 91, 92, 148, 230, (JOBS Act), x, 91, 114, 141,
233–237, 240–242, 244 144, 174, 188, 192, 256, 267,
Governance, 35, 108, 260, 269, 273n18, 274n42
263–264
K
H Keep-it-all, 19, 45, 73n5, 112,
Herding behavior, 15, 19, 23, 171, 176n7
174, 175, 204 Kickstarter, viii, x, 3, 5, 15, 16,
36, 46, 48, 50n4, 57,
63–65, 74n14, 81, 82,
I 86, 87, 94, 97n8, 97n12,
Indiegogo, x, 15, 19, 87, 112, 133, 135–146, 148,
176n6, 176n7 149n1, 152–157, 159,
Information asymmetry, 11, 13, 23, 160, 163–170, 172–175,
29, 31, 32, 35, 44, 59, 62, 64, 176n2, 176n7
67, 71–73, 75n18, 80–81, 84,
93, 95, 104, 110, 222, 257,
264 L
Information cascade, 45, 67, 112, Lender, 5, 30, 32, 34, 35, 60, 65,
171 82–85, 88–91, 93, 105–109,
Initial Coin Offerings (ICO), 2 116, 117, 124, 125, 188
Initial public offering (IPO), 13, 34, Lending Club, 1, 16, 90, 187
44, 45, 47, 48, 50n2, 250n54,
256–258, 261, 263
Intermediary, 2, 12, 34, 44, 85, M
96n1, 105, 186, 190–196, Marketplace lending, 1, 90,
201, 203–207, 209, 210, 222, 103–125
225, 230, 231, 235, 238, 263, Markets in Financial Instruments
266–269, 274 Directive (MiFID), 224–232,
Intrastate regulation, 186, 187, 234–236, 240, 244, 245,
206–209 255, 256, 266, 270, 272n7,
Investment limit, 193–195, 205, 272n9
207, 210–211, 233, 242 Moral hazard, 13, 32, 48, 59, 66, 68,
Investor, ix, 3, 11, 30, 58, 79, 107, 81–85
144, 151, 185, 219, 255 MyMicroInvest, 69, 70
282 Index
N Reward-based crowdfunding, viii, x,

Neuer Markt, 79 2, 3, 5, 6, 12–17, 21, 36, 46,
48, 50n4, 57, 65, 80, 85–87,
110, 133–149, 156, 169–171,
P 185, 188
Platform, 2, 12, 30, 79, 105, 139, Rule 506(b), 187–193, 208, 210
152, 186, 221, 255 Rule 506(c), 188, 189, 192, 210,
Portal, ix, x, xi, 1–3, 41, 45, 57, 59, 211n3, 269
60, 62, 63, 65–67, 69–71,
75n18, 75n20, 108, 115, 192,
203, 207, 208, 235, 237, 238, S
243, 255, 263, 266–268, 270 Securities Act, 186–188, 192,
Portfolio, 17, 68, 69, 71, 88, 109, 206–209, 211n1, 211n9,
113, 114, 117, 194 214n112, 267, 269, 271,
Post-campaign, 34, 48, 49, 73 273n30, 274n42
Pricing, 45, 61, 72, 241, 243, Securities and Exchange Commission
261–264 (SEC), 94, 115, 185–189, 191,
Prospectus, x, 5, 34, 187, 208, 209, 192, 197, 202, 203, 206–209,
222–225, 227, 230–236, 240, 211n1, 211n9, 256, 257, 267,
244, 245, 247n17–19, 268, 273n18, 273n30
250n61, 257, 265 Securities Exchange Act, 197, 202
See also Securities prospectus Securities prospectus, x, 5, 236
Prospectus Directive, 223–225, 230, See also Prospectus
232, 233, 236, 244, 257, 265 Security, x, 4, 5, 18, 114, 115,
Prosper, 65, 75n20, 79, 88–91, 93, 185–190, 192, 193, 195–200,
94, 96n5, 110, 152, 187 202–210, 211n1, 214n112,
222–224, 227–233, 235–237,
240, 244, 245, 247n17,
R 247n19, 248n22, 249n34,
Race to the bottom, 239, 241 249n35, 249n39, 250n56,
Race to the top, 238, 239, 241 250n61, 256, 257, 261–269,
Reward, 14, 16–19, 30, 35–44, 48, 271, 272n7, 272n9, 275n43
61, 65, 74n10, 74n14, 85, 86, Seedmatch, x, 67, 242, 250n53
94, 95, 110, 133, 135–139, Seedrs, x, 66, 70, 242, 273n14
143, 148, 149n2, 151, 152, Signal, 5, 19, 20, 29–49, 50n1,
155–157, 167, 168, 174–176, 50n2, 59, 61, 65, 75n18, 82,
258, 260, 261, 272n3 109, 110, 113, 120, 148, 152,
See also Community benefit 171, 174, 242, 262
Index
283
Signaling, 29–50, 113, 271 115, 117, 119, 152–154, 174,

See also Signal 185–215, 221, 224, 233, 235,
Small and medium sized enterprises 242, 244, 247n14, 248n20,
(SMEs), 103–125, 219, 220 248n23, 256, 257, 259,
Supranational regulation, 221 264–271
SyndicateRoom, 69, 70, 242
V
T Venture capital (VC), 11, 13–15, 19,
Two-sided markets, 3, 239 21, 49, 50n4, 58, 68, 69, 71,
107, 109, 114, 118, 120, 122,
123, 125, 144, 151, 232,
U 241–243, 245, 250n54,
United Kingdom (UK), x, 32, 34, 257–260, 264, 272n2
49, 66, 91, 97n8, 117,
230–233, 235–237,
240–243, 245, 257, W
264–271, 274n43 Wisdom of the crowd, 3, 15, 65,
United States (US), x, 3, 15, 48, 70, 109, 204, 241–242, 250n54,
79, 81, 89, 91, 94, 105, 114, 250n55

Douglas Cumming, Lars Hornuf (Eds.) - The Economics of Crowdfunding - Startups, Portals and Investor Behavior-Palgrave Macmillan (2018)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Douglas Cumming, Lars Hornuf (Eds.) - The Economics of Crowdfunding - Startups, Portals and Investor Behavior-Palgrave Macmillan (2018)

Uploaded by

Copyright:

Available Formats

The Economics of Crowdfunding

Startups, Portals, and Investor Behavior

For academics, practitioners, and government policymakers, this book provides

It is important that we recognize and respond to the opportunities and chal-

Max Planck Institute for Innovation and

Center of Finance, University of Regensburg

ISBN 978-3-319-66118-6 ISBN 978-3-319-66119-3 (eBook)

Library of Congress Control Number: 2017956103

© The Editor(s) (if applicable) and The Author(s) 2018

Cover illustration: venimo / Alamy Stock Photo

Printed on acid-free paper

This Palgrave Macmillan imprint is published by Springer Nature

The “crowd” has attracted considerable attention from many academic

problems. Lambert, Ralcheva, and Roosenboom (Chap. 4) take a close

Max Planck Institute for Innovation and Dietmar Harhoff

This book studies crowdfunding as a new financing tool in the entrepre-

Crowdlending is another subcategory of crowdfunding where loans are

Toronto, Canada Douglas Cumming

This book evolved as part of the research project “Crowdinvesting in

Part I Startups 9

2 Crowdfunding as a New Financing Tool 11

3 Signaling to Overcome Inefficiencies in Crowdfunding

4 The Crowd–Entrepreneur Relationship in Start-Up

5 Fraudulent Behavior by Entrepreneurs and Borrowers 79

Part II Market Structure 101

6 Fintech and the Financing of SMEs and Entrepreneurs:

Part III Backers and Investors 131

7 Crowdfunding as a Font of Entrepreneurship: Outcomes

8 Crowdfunding Creative Ideas: The Dynamics of Project

Part IV Recent Regulatory Efforts 183

9 The Regulation of Crowdfunding in the United States 185

10 The Regulation of Crowdfunding in Europe 219

11 Individual Investors’ Access to Crowdinvesting:

Fig. 1.1 Global crowdfunding market by segment volume, USD

Table 2.1 Differences in motivation between professional and

Crowdfunding has experienced tremendous growth and developed into a

© The Author(s) 2018 1

5 2.85 2.68 2.50

size. According to Massolution (2016), donation-based crowdfunding

incentives to consider the performance of their investors. Under the new

might also be driven be irrational herding. Some early contributions from

Under the reward-based crowdfunding model, backers are promised a

has developed in all segments of crowdfunding, little research exists that

Herzenstein, Michal, Utpal M. Dholakia, and Rick L. Andrews. 2011a. Strategic

Douglas Cumming is Professor of Finance and Entrepreneurship and the

Lars Hornuf is Professor of Finance at the University of Bremen. He was a

© The Author(s) 2018 11

but high-growth companies. These start-ups may then receive funding

entrepreneurial activities and entrepreneurs who are more likely to benefit

2.2 The New Financing Cycle

Germany, making it a potentially credible alternative to venture capital

information through the aggregation of individual preferences is often

2.3 The Crowd as Financier

2.3.1 Profiles and Motivations of Crowdfunders

The main objective of an entrepreneur who relies on crowdfunding is to

Table 2.1 Differences in motivation between professional and nonprofessional

crowdfunding or crowdinvesting/crowdlending). While professional

Although the backers may be motivated by various reasons and the

of crowd support. This leads to specific dynamics during the campaign in

2.4 The Entrepreneur as Fundraiser

The first goal for an entrepreneur using crowdfunding is to raise fund-

2015; Mollick 2013; Vismara 2016). Moreover, this stream of literature

2.5 Concluding Remarks

Toronto, Canada Douglas Cumming

Part I Startups 9

2 Crowdfunding as a New Financing Tool 11

3 Signaling to Overcome Inefficiencies in Crowdfunding

4 The Crowd–Entrepreneur Relationship in Start-Up

5 Fraudulent Behavior by Entrepreneurs and Borrowers 79

Part II Market Structure 101

6 Fintech and the Financing of SMEs and Entrepreneurs:

Part III Backers and Investors 131

7 Crowdfunding as a Font of Entrepreneurship: Outcomes

8 Crowdfunding Creative Ideas: The Dynamics of Project

Part IV Recent Regulatory Efforts 183

9 The Regulation of Crowdfunding in the United States 185

10 The Regulation of Crowdfunding in Europe 219

11 Individual Investors’ Access to Crowdinvesting:

2.2 The New Financing Cycle

2.3 The Crowd as Financier

2.3.1 Profiles and Motivations of Crowdfunders

2.4 The Entrepreneur as Fundraiser

2.5 Concluding Remarks

3.2 Signaling in Entrepreneurial Finance

3.3 Signals in Crowdfunding

3.3.1 Signals from Proponents to Crowd-Funders

3.3.2 Other Types of Signals

4.2 Tapping the Crowd to Get Financed4

4.3 Tapping Other Types of Investors

4.3.2 The Role of Sophisticated Investors

s ubsequently failed. This suggests that the monitoring and value-adding

4.3.3 The Role of Syndication

investor matchmaking website, offers investment syndicates in which

5.2 Asymmetric Information and Fraud

5.2.1 Adverse Selection

5.2.2 Moral Hazard

5.3 Empirical Evidence on Fraud

5.3.1 Reward-Based Crowdfunding