By Kevin Berg Grell PhD, CrowdFunding Beat Sr. Guest Editor,
This article was first published in Wired Innovation Insights and an abridged version was published in West Journal. The post is the first in a series where APEN Designsbridge academic research with entrepreneurial readership.
When crowdfunding campaigns fail, they don’t even come close; when crowdfunding campaigns succeed, they do so with a very low margin. Although the funding mechanism is somewhat nascent, the Twin Peaks in funding volumes (just above 0% and 100% of the relevant funding goals) is a persistent finding. These peaks have implications for marketers as well as for entrepreneurs, and in this article we explore a couple of explanations and implications worth noting before venturing into crowdfunding.
To those unfamiliar with this subject: Crowdfunding refers to fundraising efforts where the fundraiser uses an open call to communicate funding need, use of proceeds, and to share relevant pitching materials (videos, investor decks, etc.).
The open call format and recent innovations in payment processing have enabled online platforms such as Kickstarter.com to offer this fundraising mechanism with very low entry barriers for individual contributions. Crowdfunders can sometimes participate with as little as a single buck, and for this reason crowdfunding is often described as “small contributions in large numbers.”
The rules of the game on Kickstarter are straightforward. You let everyone know how much you are looking to raise and what you offer in return. Then you let the members of the crowd decide (individually) whether they wish to pledge funds to your project or not. If the initial funding goal is not reached, all pledges are withdrawn and you receive nothing. This is called a threshold-pledge-system, all-or-nothing, “fixed funding” and a couple of other names depending on which platform we are looking at, but the system is basically the same.
Obviously, an open pre-selling opportunity like this screams MARKET TESTING to any product developer, and crowdfunding has indeed been embraced for that reason. In a period where venture capitalists seem to have lost the appetite for e.g. hardware development, platforms such as Kickstarter.com are booming with projects in this category.
The naive marketer’s approach to crowdfunding volumes goes something like this: The market potential (say gross revenues from sales in the first year after product launch) is correlated to the pre-selling revenues from your crowdfunding campaign. Estimate this correlation based on similar campaigns. Scale up to account for the fact that the audience for your campaign is only a fraction of your market. So the “net-net” is basically that you need to scale up whatever funding volume, your campaign can generate, and voila… you’re done.
Unfortunately, establishing the linkage between crowdfunding volumes and market potentials is not as simple as that. Even after you’ve managed to estimate the scaling factors, you’re still faced with one last challenge: the dynamics of crowdfunding!
In Journal of Business Venturing Professor Ethan Mollick takes a deep dive into 48,526 crowdfunding projects from Kickstarter.com. The scope of Prof. Mollick’s research, The Dynamics of Crowdfunding: An Exploratory Study is to understand the underlying success-drivers of crowdfunding campaigns… and the results indicate that successful campaigns are not just trivial signals of market interest. A quick glance at the histograms of pledge levels can confirm this.
If crowdfunding volumes were pure signals of market interest, we would expect these pledge levels to be independent of funding goals. The histograms show the exact opposite. If you are successful there is 50% chance that you will get “exactly” what you ask for (up to a 10% over-funding as indicated by the green bars in the chart).
Furthermore, pledge levels for unsuccessful campaigns do not even come close to their funding goals. You either make it or you don’t, and there’s no middle ground. This is not what one would expect for a signal of market interest. And it is indeed rarely the outcome of traditional market analyses.
So why do we see these patterns? There at least three candidate explanations worthy of attention.
Self-funding Let’s get the nasty one out of the way first. When a campaign owner is close to the funding goal, but can see that time is running out (the typical campaign will run for 30-40 days), what prevents him/her from pledging up to the 100% mark and at least get some of the revenues that was intended?
Two things actually. The fee on payment processing and the platform’s own commission typically means that the campaign owner would be charged 8-10% of the pledged funds. For larger projects this amount will be substantial, and unless the rewards are priced high enough to counter for this added cost, self-funding does not seem viable. In addition to the sheer economics of this decision, platforms such as Kickstarter.com do everything they can to discourage self-funding. For instance, campaign owners cannot use the same address, credit cards, or name for pledges as they did when signing up.
Prof. Mollick’s research indicates that self-funding is less of a problem than what one might think. Had it been a problem, we would expect to see it occur more frequent for campaigns with relatively low funding goals. These campaigns would be “cheaper” to push over the finish line, and in turn we should find that the average pledge level for unsuccessful campaigns should be lower for smaller campaigns. Mollick’s research show the exact opposite!
Time preferences Another possible explanation is the time preference of money. It is a somewhat rudimentary observation that people (in this case crowdfunders) need an incentive to postpone consumption. When you pledge on a crowdfunding campaign your funds are (in a sense) reserved, and out of your current budget. In practice you can withdraw your pledge from the campaign, so this effect should not matter that much, but the time-preference of money is known to apply even when it shouldn’t.
If a campaign is far from its goal, there is a good chance that the campaign will fail, and hence the pledges will just be returned. In that sense, an increased likelihood of success becomes self-enforcing, because the risk of locking up funds for no reason becomes less likely. However, the time-preference cannot explain why successful campaigns only reach their goals with a small margin.
Preference shiftsA more intriguing idea is that the Twin Peaks occur because individual preferences shift at the point where the success or failure is no longer uncertain. One could easily imagine that pledges at large are made from individuals who want to see an impact of their contribution. If this is the case, we should expect to see that pledge levels stagnant just before a funding goal is reached, and we should expect to see acceleration in pledges when the uncertainty peaks.
This is odd! Whenever uncertainty is included in an economic model it is done so to understand uncertainty aversion, and not uncertainty shopping! BUT it would actually explain why early traction is such a strong predictor of success. It would explain why pledge volumes stagnant midway through a campaign’s (short) lifespan (I will address this phenomenon in a later article); and for the purpose here, it would explain the Twin Peaks of crowdfunding. To the best of my knowledge, this idea has not received an academic treatment yet.
If you are about to launch a campaign…
Nerdy talk aside, if you are venturing into crowdfunding and wish to make use of the mechanism for market (and/or) product validation; general marketing; startup financing; or something else, then be aware of the Twin Peaks. Crowdfunding gets a lot of attention because of the highflyers (e.g. Coolest Cooler, Pebble watch, OUYA), but be aware that these are extreme cases, and that successful crowdfunding, for most campaign owners means getting what you asked for with a low margin.
- Don’t undershoot when setting your funding goal; i.e. don’t speculate!
- Understand what’s at stake — you have to be able to deliver based on the funding you secure.
- Secure early traction.