Advantages and disadvantages of crowdfunding

Advantages and disadvantages of crowdfunding

Crowdfunding is a form of crowdsourcing and a specific type of alternative finance that allows individuals, entrepreneurs, or organizations to raise funds for their cause, business ventures, or projects from a large number of people.

A typical crowdfunding transaction has three components: the project initiator or creator who seeks to raise funds, the crowd that corresponds to the individuals or groups willing to support the initiator, and a platform controlled by a moderating organization that brings all parties together and enable the transaction to take place.

Since the appearance of websites such as IndieGoGo in 2005 and Kickstarter in 2009, among others, crowdfunding has not only gained mainstream traction but also has become an Internet-mediated transaction.

The Pros: The Advantages and Benefits of Crowdfunding

1. An Alternative Source of Funding

One of the primary benefits of crowdfunding is that it provides individuals or organizations with an alternative source of funding without the need to tap their own savings, seek loans from financial institutions, or enter into an agreement with angel investors or venture capitalists.

The fact that this type of funding uses the Internet means that fund seekers can find funders from around the world without the need to prepare technical documents to demonstrate the feasibility provide collateral, or enter into agreements with rigid terms.

In his book “The Wisdom of Crowds,” American journalist and author James Surowiecki noted that crowdfunding allows fund seekers to obtain early product reviews, measure market interest, and produce an accurate aggregate prediction about market performance.

2. Flexibility and Expansive Applications

The flexibility of application is another benefit. Crowdfunding is not confined in raising funds for entrepreneurial ideas or business ventures. For example, Kiva Microfunds enables individuals to fund not only low-income entrepreneurs but also students while GoFundMe and YouCaring allow fundraising for life events, medical expenses, and other charitable causes.

Crowdfunding also promotes engagement between fund seekers and funders. Platforms such as Kickstarter and IndieGoGo provide not only moderation but also a communication channel for project creator and the crowd. These two parties can work together to create an idea or product through value-added crowdsourced collaboration.

The separate studies of S. A. Macht and J. Weatherston, and J. Kaminski, C. Hopp, and C. Lukas noted that individuals seeking to put up a venture through crowdfunding benefit from having retained control and ownership over their business or products and gaining publicity through electronic word-of-mouth because of Internet-mediation.

3. Benefits to Funders or Investors

Another advantage of crowdfunding is that it provides individuals with several options to invest in a business venture or project. People seeking to put their money either on good cause or to grow further their assets can use available crowd-driven funding platforms to look for individuals, entrepreneurs, or organizations, as well as causes, ideas, or ventures that interest them.

There is also a benefit coming from reduced transaction costs. As noted above, available platforms provide an easy avenue for investors or funders to look for projects they want to support and fund. Hence, crowdfunding promotes participation from the public.

Crowdfunding essentially encourages individuals to invest while also supporting entrepreneurship. Remember that traditional sources of funding can be difficult. For instance, angel investors and venture capitalists focus primarily on technology-driven projects or ventures.

The Cons: The Disadvantages and Risks of Crowdfunding

1. Can Still Be Challenging

Note that traditional sources of funding require fund seekers to provide a compelling proposition as to why they should be supported. The same is true for crowdfunding. However, because this alternative type of funding is Internet-mediated, projects need to be engaging enough to generate publicity and public interest, thus attracting enough funders.

Fund seekers should also remember that a viral project would not essentially lead to an increase in funding. In fact, the study of J. Kaminski, C. Hopp, and C. Lukas revealed that in some cases, successful social media activity as evident from mass word-of-mouth could have a reverse causal effect to the success of the funding target.

Another study A. Agrawal, C. Catalini, and A. Goldfarb noted that crowdfunding could be inefficient. Opting for this alternative funding could mean foregoing the potential value and support that can come from an angel investor or venture capitalist. Furthermore, fund seekers need to manage their funders and maintain a close relationship with them. Doing so can be time-consuming.

2. Other Risks to Fund Seekers

There are also other more specific risks associated with crowdfunding. One involves potential intellectual property infringement. Fund seekers with innovative ideas are required to reveal details about such and in most cases, are also required to release their product during the early stages of funding and product development. Doing so exposes their intellectual properties to the risk of copy by existing or potential competitors.

Managing funds coming from different geographic locations, as well as managing commitments to these geographically dispersed funders also create financial burdens. For example, maintaining communication and transaction with them would require time and cost inputs. Offering royalty shares or equity options might be challenged by jurisdictional limitations.

Too much optimism or overestimation is another risk of crowdfunding. A. Agrawal, C. Catalini, and A. Goldfarb mentioned that fund seekers could oversell their ideas and funders could overcommit. These funders can put too much pressure on a particular fund seeker due to high and in some cases, unrealistic expectations.

3. Risks to Funders or Investors

Another disadvantage or problem with crowdfunding is that it is susceptible to abuse. There have been several instances in which high-profile projects turned out to be scams. Abuse stems from the fact that despite moderating platforms, there is no legal regulatory framework to govern crowdfunding. Concerns about fraud are a barrier to public engagement.

Herding or herd behavior is another risk for investors. An article by Daniel Isenberg published on the Harvard Business Review noted that people are prone to making rash decisions when investing without doing their due diligence. Like in any other investment channels, people usually invest on something using their emotion rather than financial logic. This fact makes them vulnerable toward scams.

Despite the fact that platforms provide the possibility of close collaboration between fund seekers and funders, information asymmetry is another disadvantage of crowdfunding. The shortcomings of funders to do their due diligence and the intentional habit of some fund seekers to withheld information create an asymmetry of information. Furthermore, A. Agrawal, C. Catalini, and A. Goldfarb noted that information asymmetry in crowdfunding increases as the distance between a fund seeker and funders widens.

FURTHER READINGS AND REFERENCES

  • Agrawal, A., Catalini, C. and Goldfarb, A. 2013. Simple Economics of Crowdfunding. NBER Working Paper No. 19133. DOI: 10.3386/w19133
  • Isenberg, D. 2012, April 23. The Road to Crowdfunding Hell. Harvard Business Review. Retrieved online
  • Kaminski, J., Hopp, C., and Lukas, C. 2018. Who Benefits from the Wisdom of the Crowd in Crowdfunding? Assessing the Benefits of User-Generated and Mass Personal Electronic Word of Mouth in Computer-Mediated Financing. Journal of Business Economics. 88(9), pp. 1133-1162. DOI: 10.1007/s11573-018-0899-3
  • Macht, S. and Weatherston, J. 2014. The Benefits of Online Crowdfunding for Fund-Seeking Business Ventures. Briefings in Entrepreneurial Finance. 23(1), pp. 1-14. DOI: 10.1002/jsc.1955
  • Surowiecki, J. 2004. The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations. New York: Doubleday. ISBN: 978-0-385-50386-0