Tuesday, September 17, 2013

Incentive and Investment: The Future of Crowdfunding and Venture Capital

Over the course of the last year, Kickstarter has risen to prominence as one of the easiest and most effective ways to fund projects and ideas. By relying on the collective wisdom of crowds, Kickstarter tends to fund projects which are generally recognized by would-be investors as good ideas. The market forces at work here are generally no different than those which govern the more established, more institutional market for venture capital. It's no secret that financial incentive is a great motivator for producing discerning analysis and careful decision-making. 

However, there are several variables that separate Kickstarter projects from venture capital investing. Most of these involve reducing the barriers to entry for small-time investors. An analogy to political fundraising is appropriate: large institutions may dominate funding in federal elections (particularly for the presidency), but it would be impractical for these institutions to devote time and resources supporting candidates for state and local offices. Nevertheless, funding is no less important for those candidates - and in fact, campaign dollars spent there have a much greater impact on the race.

As this analogy implies, one of the most important characteristics of Kickstarter is the reduction of scale. Kickstarter has a dedicated section of their website to projects with goals of $1,000 or less. Such projects are easy to participate in: Even $5 makes substantial headway towards the overall goal. Those who pledge can stomach such a small amount without serious consideration of the implications if the project should fall through. The reduction of scale unlocks a large cross-section of people who otherwise wouldn't be an available source of funds for managers of small to mid-sized projects.

Another critical component - arguably the most important component - of Kickstarter's success is the reduction of risk for the investing party. Kickstarter relies on the concept of assurance contracts to fund projects: contributions are contingent upon the project being fully funded. This effectively reduces the risk of investing for each individual, ensuring that their money will not be squandered by a project which is only partially funded. The expected value of a person's donation might be calculated as some function of the remaining amount necessary to fund the project and the remaining time available to do so.1 As such, the individual puts an expected value of less than their full pledge amount at risk: the full amount if the project is funded, but nothing otherwise.

These factors (combined with a well-designed interface that allows for media, sharing, and inquiry) have led to tremendous success for Kickstarter, with over $650 million in successful project dollars to date since 2009. Various direct competitors exist, including IndieGoGo, which offers project managers the option to take unsuccessful project dollars at a higher fee, making the economics a bit different. However, this still pales in comparison to the established venture capital market, which encompasses tens of billions of dollars annually:

Can Kickstarter (et al.) tap into the venture capital space? Generally speaking, the things that have made it effective have also largely precluded it from doing so. While assurance contracts play into the risk-averse nature of small investors, it does so at the expense of the upside that venture capital investors have come to expect. Institutions are drawn to different economics for much the same reason as they are drawn to presidential politics rather than the smaller races: They are attractive precisely because the stakes (and thus, the rewards) are high. Large-scale investors mitigate their risk by commanding large sources of capital and reducing their variance through diversification, thereby absorbing the large losses they might sustain on any single project.

Competition for venture capital would require a combination of private equity economics (read: upside) with the lower barriers to entry and approachability of sites offering assurance contract funding. Legal barriers have historically been problematic in achieving this; however, the recent passage of the JOBS Act appears to open the doors to direct startup equity investment to a significant degree. The SEC's implementation of the bill has been slow to date, but shows promise in opening up a potentially huge crowdfunding market. Sites such as Wefunder and Crowdfunder have already begun promoting and attracting would-be investors, among others.

What are the implications of this potential new environment for the existing venture capital and assurance contract crowdfunding markets? While it would be compelling to believe that an equity investment crowdfunding model could dwarf them and even render them nonexistent, a stratification likely will develop in which all can co-exist to a large extent. Institutional investors will have the capacity to fund large projects, the risk tolerance to handle higher risk / higher reward plays, and a decided advantage in the desirability of their participation, which can be leveraged to raise yet more money or to increase efficiency. Assurance contracts will provide a successful avenue through which to fund those projects with less upside - arts, niche products, etc. - with little risk for the many available investing parties.

And the direct crowdfunding model? Its success hinges on how well information is distributed, how accessible the founders of projects are, successful marketing, and the confidence inspired by the transparency of commercial fund managers in reporting results to investors. None of this is insurmountable, and seems only to be a question of which provider can best deliver. Venture capital investing may very well expand in the way that stock investment expanded in the wake of the internet. Which of course, is not to say that it will result in an efficient outcome; only, perhaps, a more exciting one.

1 - An interesting future topic might be an estimation for expected value of a Kickstarter donation; it would require longetudinal data on a large number of projects to estimate relative rates of success based on time-to-completion and percent-to-completion variables.

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