How crowdfunding became a credible way to sound out your market

As of January 2017, 61 per cent of the $2.5 billion raised through Kickstarter was collected by startups that produced tech, design or gaming products

This argument explains why firms that develop consumer products involving a high degree of demand uncertainty, such as gadgets and computer games, have the most to gain from crowdfunding. After all, high prior uncertainty implies crowdfunding campaigns are likely to both fail and raise funds multiple times over the target with a high probability. Yet, as of January 2017, 61 per cent of the $2.5 billion raised through Kickstarter was collected by startups that produced tech, design or gaming products.

In our research, we showed that learning about demand mitigates the well-known moral hazard problem, whereby startups may be tempted to divert the funds they raise through crowdfunding platforms, instead of delivering the products as promised. If a startup can see high consumer demand for their product during their crowdfunding campaign, they are more likely to push ahead with its development, expecting it to sell well. Indeed, we showed the higher the funds raised during a short crowdfunding campaign, the fewer incentives there are for entrepreneurs to divert them.

Our model suggests certain project characteristics can incentivise entrepreneurs to deliver: investors should be more confident when campaigns have ambitious targets, are short, and are on prominent third-party platforms.

While demand uncertainty itself is sufficient to create value, startups can learn additional things about consumer preferences from a crowdfunding campaign — such as whether a buyer prefers a red or blue watch, say, or which new levels they like in a smartphone game – which creates even more value.

Pre-selling through crowdfunding platforms can be a credible consumer survey

Crowdfunding success can also open access to venture capital and angel investment; a company’s participation in crowdfunding may alleviate the moral hazard and asymmetric information problems that prevent a firm obtaining financing from traditional outside financiers. Indeed, there are many examples of firms doing so, such as Kinsa, which raised about $140,000 for a ‘smart’ ear thermometer via Indiegogo, after which it received multiple seed rounds and a $9.6 million Series A from a group of investors including Kleiner, Perkins, Caufield and Byers.

Investing can still be risky. There have been high-profile crowdfunding flops, such as Central Standard Timing, which raised $1 million on Kickstarter to produce the “world’s thinnest watch” before filing for bankruptcy in 2016. Because entrepreneurs receive funds from a crowdfunding campaign in advance of the completion of their product, there is a risk investors will not receive their desired product.

Yet, cases of failure and fraud are small in number when compared with projects that deliver. Analysis by Professor Ethan Mollick of Wharton School found that 65 per cent of Kickstarter projects delivered on time, while only nine per cent failed to deliver their rewards.

Our model highlights why a low failure rate is unsurprising. The opportunity to learn about demand itself creates powerful enough incentives for entrepreneurs to prefer to invest and deliver, instead of resorting to short-term gains by diverting funds.