Why You Flock to Crowdfunding Projects Like Sheep
Crowdfunding is never truly certain. You don’t know who you’re funding, for a start. In a crowdfunding project, creators/entrepreneurs try to mitigate your concerns through marketing. Updates, videos, and any other promotional means.
Uncertainty is part and parcel of financing, as any VC would know. In crowdfunding this is even more pronounced as the creators are likely to be new entrepreneurs.
Despite this element of the unknown, backers choose to place their faith in the creator. Creators keep coming to crowdfunding platforms, knowing that they are able to secure funding from a large pool of people. This is somehow able to occur, despite the presence of information asymmetry.
What is Information Asymmetry?
Investopedia defines Information Asymmetry as a situation where “one party to an economic transaction possesses greater material knowledge than the other party.”
Investopedia notes that almost all economic transactions involve information asymmetries. Information asymmetry itself is not harmful, however it can lead to “adverse selection” where one party in a negotiation has essential information that the other party lacks.
An even more dangerous outcome is known as “moral hazard”, where a party intentionally acts on this information asymmetry for their own personal gain – such as by running off with your money.
Information Asymmetry and Crowdfunding Behaviour
In the context of crowdfunding, information asymmetry often means that a project creator has more knowledge than the buyer about a project. In order to convince a potential backer, creators need to disclose information that is relevant. Updates, personal profiles, any achievements; all of these and more help to build up a reputation and instill trust.
Data on crowdfunding platforms reveals that it is common to see an initial burst of funding in a campaign’s early stages. The activity then tapers off into a slow, steady pattern before a sudden spike as the campaign draws to a close. Numerous sources attribute it to the “sense of urgency” however we believe that herding behavior is at play here as well.
Campaigns often have no middle ground – either they hit above and beyond their funding targets, or they never take off. Research in the paper “Information Cascades among Investors in Equity Crowdfunding” by Vismara find that contributions in early days are instrumental in attracting other investors. Meanwhile, researchers such as Agrawal from University of Toronto point out that is likely due to the way funders correspond current funding amounts to quality. (Simple Economics of Crowdfunding, page 22). It went on to describe this as a form of “herding behaviour”.
Herding Behaviour and Due Diligence
Traditional financing methods rely on face-to-face interactions and personal relationships as a form of due diligence. This does not exist in crowdfunding. Instead, creators disclose information, and rely on (or take advantage of) trust to receive funding.
Unlike traditional investors backers in a typical crowdfunding model do not have as much incentive to spend resources investigating projects. The amounts involved are generally lower. The value is instead in the number of crowd funders, which means a greater number of individuals and perspectives.
This mode of validation is not perfect, for it can lead to an information cascade. It has already been demonstrated that the amount of funding a project has collected can influence new contributions. Funding a project is trust-based, and the mere fact that a project is receiving funding can be taken as a seal of approval from earlier backers. This can be manipulated by a savvy (or malicious) project creator. Sometimes the crowd can also get it wrong, as this one couple in Singapore found out.
Crowdfunding and Reputation
Crowdfunding is where it is today because of the combined efforts and brains of all of us as a community. This study [harnessing the wisdom of the crowd] found even “imperfectly informed investors” perform “as well as a perfectly informed agent.” In fact, the study goes as far as to suggest that “naïve investors (…) will collectively invest more in good projects than bad projects.” This opens the doors to much more diverse aspects crowdfunding, which models today have yet to fully unlock.
We can argue that all the marketing and promotional efforts done by crowdfunding projects, are done so for the sake of building reputation. Reputation is lasting, and powerful in influence. It is something that any user online requires to cultivate, in order to give off quality signals.
Current crowdfunding models facilitate the transaction between two parties but has yet to fully take advantage of a user’s reputation – or take it into account for decisions. Decision making is a “noisy” process. More needs to be done to truly remove information imbalance and unlock the full potential of crowdfunding. This is what HZ Capital Group has set out to change, and we look forward to bringing you the results.