Do you know crowdfunding? In an online survey conducted primarily among entrepreneurs and students in the field of innovation and entrepreneurship, almost 50% answered “No”. Even cutting-edge innovator Google continuously suggested the authors of this thesis to check the spelling of “crowdfunding” when writing the thesis on Google docs. Further anecdotal evidence can be found in our classes and seminars. During our master program, we have been taught different ways how startup ventures can raise capital and have engaged in discussions with entrepreneurs and technology transfer officers. Crowdfunding was not mentioned. Yet, we remember our thesis advisor and innovation consultant Paco Conde of LTC saying that many of his clients, when thinking about innovation, primarily think of their production process thereby neglecting the importance of innovation at the financing (and distribution) stage. In July 2010, thus almost coinciding with the beginning of our studies at Barcelona Graduate School of Economics, the search term “crowdfunding” for the first time generated enough traffic to be spotted by Google Trends (Figure 1). Throughout the last year search volume has steadily increased, demonstrating growing interest and awareness of the topic. Crowdfunding in general and crowdfunding for startup companies in particular are nascent phenomena that made it to the headlines only recently but bear the potential to drastically change the way startup companies are financed today.

1. Crowdfunding
Funding Innovation through
Innovation in Funding
Niels Schlesier & Sergio Gutiérrez
MSc Economics of Science and Innovation, 2011
Barcelona Graduate School of Economics
Supervisor: Paco Conde, LTC Project (Barcelona).
1. INTRODUCTION
Do you know crowdfunding? In an online survey conducted primarily among entrepreneurs and students
in the field of innovation and entrepreneurship, almost 50% answered “No”. Even cutting-edge innovator
Google continuously suggested the authors of this thesis to check the spelling of “crowdfunding” when
writing the thesis on Google docs. Further anecdotal evidence can be found in our classes and seminars.
During our master program, we have been taught different ways how startup ventures can raise capital
and have engaged in discussions with entrepreneurs and technology transfer officers. Crowdfunding was
not mentioned. Yet, we remember our thesis advisor and innovation consultant Paco Conde of LTC saying
that many of his clients, when thinking about innovation, primarily think of their production process there-
by neglecting the importance of innovation at the financing (and distribution) stage.
In July 2010, thus almost coinciding with the beginning of our studies at Barcelona Graduate School of
Economics, the search term “crowdfunding” for the first time generated enough traffic to be spotted by
Google Trends (Figure 1). Throughout the last year search volume has steadily increased, demonstrating
growing interest and awareness of the topic.
Figure 1 Google Trends Search
Volume Index for “crowdfunding”,
July 2010-June 2011.
(Source: Google Trends)
Crowdfunding in general and crowdfunding for startup companies in particular are nascent phenomena
that made it to the headlines only recently but bear the potential to drastically change the way startup
companies are financed today. With this thesis we seek to give an overview of where the crowdfunding
phenomenon ideologically comes from, which form it currently takes and where crowdfunding for startup
companies may potentially go.
Therefore, the remainder of the thesis is organized as follows: Section 2 briefly comments on the me-
thodology. Section 3 introduces a definition and discusses the background and basic ideas of crowdfun-
ding. Section 4 explains changing paradigms that relate to crowdfunding. Section 5 analyses the current
crowdfunding market. Section 6 shifts the focus to the current regulatory environment. Section 7 is devo-
ted to the future of crowdfunding for startups. Section 8 concludes.

2. 2 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
2 Methodology propose a crowdfunding definition within the
Due to its short history, only very few data scope of high-growth startup financing. In simple
on crowdfunding for startup companies are terms, crowdfunding is “the financing of a project
available. In an attempt to collect primary data, or a venture by a group of individuals instead of
we have set up an online survey that was spread professional parties, [i.e. instance, banks, venture
through relevant LinkedIn groups, personal con- capitalists or business angels]. Individuals already
tacts and to potential multipliers such as the 22@ finance investments indirectly through their
Barcelona Incubation Center or the ESADE- savings —since banks act as intermediary. In con-
Creapolis network. Unfortunately, with only 99 trast, crowdfunding occurs [ideally] without any
responses out of which 46% had not heard about intermediary”. However, as we will see along this
crowdfunding before, the survey did not generate paper, crowdfunding faces some legal challenges
Sidenote 1 In Appendix 1, we provide enough data to draw conclusions from1. that oblige indeed to use some mediation.
a link and a password to the survey
results.
For the same reason as data scarcity, theoretical 3.2 Different kinds of investments
research on the topic has just begun. Where Investments in the crowdfunded venture can take
possible we will refer to research that focuses on different forms. Schwienbacher and Larralde
crowdfunding in general rather than aiming at (2012) propose three different stages: The lowest
startup companies. Since crowdfunding for star- level of engagement takes place when the crowd
tup ventures is driven by practitioners, weblogs donates money instead of investing. A well-
are one major sources of information. We have known example is the grassroots fundraising
also leveraged on relevant research from other campaign of Barack Obama during the 2008
fields. presidential campaign. Since crowdfunding
originated in the social and cultural sector and
already is at a more mature development stage
3 Definition and basic ideas than in the startup sector, donations still play a
3.1 Definition of crowdfunding major role. For the scope of this paper, they are,
Crowdfunding, particularly for startup com- however, of minor interest.
panies, is still in its early development stage.
Until now, the amount of theoretical research is At the next level, passive investments by the
limited. Thus, there is no agreed-upon standard crowd also do not offer any engagement in the
definition. invested project. Unlike donation, passive inves-
tments are, however, based on the expectation of
Reflecting that crowdfunding, by its name, is a return. Project owners seeking passive inves-
an effort of the crowd, Lawton and Marom tments do no offer active involvement. Rather,
(2010) use the crowd-generated definition cu- they are solely interested in raising money.
rrently available on Wikipedia, which describes Active investments on the other hand, actively
crowdfunding as “a collective operation, atten- involve the crowd, e.g. through requiring infor-
tion and trust by people who network and pool mal expertise, formal investor boards or votings
their money and other resources together, usually about product characteristics. Offering active
the Internet, to support efforts initiated by other investments is a way to access “smart money”, i.e.
people and organizations”. financial investments plus the promise to support
the project in some additional way. Investors,
Among the efforts taken at a theoretical level, who actively engage in the production process,
Kleemann et al. (2008) highlight the trade- yield valuable information about the market sen-
off factors involved in the phenomenon and timent and may help to select optimal consumer
describe crowdfunding as “an open call, essen- targets.
tially through the Internet, for the provision of
financial resources either in form of donation or The latter two forms include rewards for the in-
in exchange for some form of reward and/or vo- vestors either in kind or monetary. Rewards can
ting rights in order to support initiatives”. More take various forms from pre-ordering discounts
recently, Schwienbacher and Larralde (2012) at a discount to profit shares or equity in the

3. 3 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
startup. Different forms of financial rewards will 1. Collaboration permits to combine each
be discussed in sections 5 and 6. other’s knowledge and resources.
2. Openness allows people to contribute freely
Turning from the dimension of the involvement to different projects.
to the type of investments, financial support, 3. Participation is increased thanks to the ease
the crowd can also contribute in kind. Platforms of access.
such as GrowVC (see Appendix 2) allow parti-
cipation as ‘expert’. Under this scheme, valuable In line with Lee et al.’s arguments, Kleemann et
consulting inputs count as investments. In this al. (2008) underline the importance of the “Web
respect, we can find in the literature (Schwienba- 2.0 prerequisite” for the development of the
cher & Larralde, 2012) cases where the inputs in crowd:
professional services have reduced the need for
cash initially calculated: benoot.com, a tourism- 4. From the social point of view, the Web 2.0
related French website, had the goal of raising allows for an easier gathering of people who
€90,000 (divided in 300 shares of €300). Since share a common interest.
some people in the crowd was actively collabora- 5. From the economic point of view, the abili-
ting with them in the development of the site — ty of anyone to create content and upload it
in exchange for shares— but also helping spread on the web, for public viewing and sharing.
the word on the internet. Given that they were
getting from the crowd services that otherwise Motivation is also a key element to understand
would had being commissioned to ‘normal’ the inner workings of the crowd. Kleemann et al.
suppliers— their cash needs decreased and they claim that participants in crowdsourcing projects
were able to stop the process at €55,800. have both an intrinsic motivation (that relates to
the pleasure or fun of doing the particular task)
3.3 The origin of crowdfunding: and an extrinsic motivation (particularly, external
Web 2.0 and crowdsourcing reward —money and goods— career benefits,
Crowdfunding has its roots in the advent of the learning, recognition or even dissatisfaction with
social web and its capacity to leverage on massive current products —prosumer2 behavior).
Sidenote 2 In this context prosumer groups of individuals to perform certain tasks:
can be thought of as converse to the crowdsourcing. The term itself was coined by Jeff Establishing the relation between crowdsourcing
consumer with a passive role, denoting
an active role as the individual gets
Howe and Mark Robinson in the June 2006 issue and crowdfunding is fairly intuitive and only
more involved in the creation and of Wired Magazine. takes a stone’s throw: substitute effort and con-
development process. tent by money and the crowd turns from a source
Kleemann et al. (2008) provide a good scholar into a fund.
definition for the phenomenon: “Crowdsourcing
takes place when a profit oriented firm outsour- 3.4 Risk, moral hazard,
ces specific tasks essential for the making or sale and information asymmetry in the
of its product to the general public (the crowd) crowdfunding setting
in the form of an open call over the Internet, Crowdfunding involves also certain information
with the intention of animating individuals to and uncertainty problems, similar to those in the
make a [voluntary] contribution to the firm’s traditional settings but slightly different in their
production process for free or for significantly impact.
less than that contribution is worth to the firm.”
One prime example is Wikipedia, where a large The sharing of risk in crowdfunding is explained
enough number of individuals exerting a multitu- in the same way as in traditional funding setting.
de of little efforts can produce a huge amount of According to Schwienbacher and Larralde (2012)
high-quality content. equity investments are “a way to spread risk over
different people” while debt financing makes “the
Social web —or Web 2.0—, the context which entrepreneur, provided he is the only shareholder,
enables the crowd has, according to Lee et al. bear the risk alone”. Since the amounts invested
(2008), three main characteristics: in crowdfunding tend to be rather small, the

4. 4 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
risk borne by individual investors is lower than (they may not be specialized) and also the past
in traditional investment form. One practical performance of the entrepreneur (out of the pla-
example of how crowdfunding platforms address tform) and many other pieces of value-relevant
the risk of loss, is discussed in the first case study information might be missing.
on Grow VC (Appendix 2).
The same authors argue that entrepreneur might
Regarding moral hazard, traditional investors be even more reluctant to disclose information
tackle this issue e.g. by the use of several finan- to this type of investors, due to their number and
cing rounds, milestones, or due diligence. In the lack of professionalism. At the same time, the
crowdfunding setting the same elements can be disclose of this information in public setting and
combined with a constant flow of information the number of people that have access to it is so-
between entrepreneur and investors by leve- mehow directly related to the investment levels.
raging in the capacities of the social web. It is Schwienbacher and Larralde also argue that Idea
also important to highlight, that in networked stealing may further be particularly strong here,
environments the incentives for moral hazard be- since the entrepreneur needs to disclose sensible
havior decrease since entrepreneurs are strongly information to a wider audience than under
observed by their investors. If the effort is not traditional forms of fundraising. However a well-
high enough, this will circulate quickly among designed screening process can decrease the risk
investors and other people on the platform. Once involved in this operation.
the reputation of an entrepreneur decreased,
future investments are likely to decrease signifi- Lawton and Marom (2010) present a potential
cantly. solution to this problem. They propose a sequen-
tial model in which entrepreneurs initially only
With regard to the state of information asym- expose a little part of their idea. As the intensity
metry in the crowdfunding setting, when of interactions between the crowd and potential
striking a deal the parties engaged in a deal may investors increases, thus the audience decreases,
not have the same level of information (Myers & the entrepreneurs publish more information,
Majluf, 1984; and Naranayan, 1998). In this res- thereby decreasing the information asymmetry.
pect, Schwienbacher and Larralde (2012) point At the same time, with a smaller audience, it
out that in crowdfunding information asymme- becomes easier, to protect the idea, e.g. through
try may be more acute, since the investors may a non-disclosure agreement. This process is
not have so much information about the industry illustrated below.
Amount of Lots of information
information disclosed to few people
Figure 2 Decreasing the information
asymmetry through sequentially
increased disclosure. (Source: Adapted
from Lawton and Marom, 2010)
Amount of Lots of information
information disclosed to few people
Audience size
Little information
to many people
Amount of Lots of information
information disclosed to few people
Audience size
Little information
to many people
Audience size
Little information
to many people

5. 5 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
3.5 Meet the crowd As early as 1907, Galton found evidence that the
According to Lawton and Marom (2010), “one of median estimate of a group can be more accurate
the most important components in the struc- than estimates of experts (Galton, 1907). Further
ture of a networked crowd is formed by affinity investigating this effect, Surowiecki (2004) finds
groups, which can be loosely defined as a group that the aggregation of information in groups,
of people with similar interests or motivations.” results in decisions that are often better than they
The crowd, being enabled by a globally accessible could have been if made by any single member of
technology, i.e. the internet, is regarded as incre- the group. Hence, the funding crowd would be
dibly diverse. This diversity (enriched by different more efficient than a few equity investors alone.
cultures, points of view, backgrounds, etc.) is key However, crowds, and more specifically networ-
when trying to explain its capabilities such as ac- ked crowds, face complex forces that undermine
curate predictions. This effect is called “Wisdom this ‘wisdom’ quite easily. Drawing from the
of the Crowds”. Relatedly, one can also speak of fields of psychology, sociology and social and
“madness of crowds” at times, when an uncoor- network economics we review some explanations
dinated crowds lead to sub-optimal outcomes. of the sources of this undermining.
The current financial crisis is one example. Both
topics the wisdom of the crowd and the process As mentioned, the basic argument is that the
of undermining it will be carefully analyzed in crowd needs a sufficient level of diversity of
following pages. opinions in order to be wise (Surowiecki, 2004).
This necessary diversity is narrowed by social in-
Although there is no clear average internet user, fluence (“knowledge about estimates of others”),
the profile of individuals engaging in higher level making subjects’ predictions and valuations
internet activities such as crowdsourcing has converge (Lorenz, Rauhut, Schweitzer & Hel-
some common features. According to Brabham bing, 2011). Lorenz et al. argue that the effect is
(2008) who investigated users of IStockPhoto, weakened in three different ways:
the so-called ‘web elite user’ is middle-to-upper
class, highly educated, married, middle-aged, 1. The “social influence effect” diminishes
white man with high speed Internet connec- the opinion diversity of the crowd without
tion. Even though there are no data available, improvements of its collective error.
it is rational to assume that the average startup 2. The “range reduction effect” moves the
crowdfunder would be even less diverse, with position of the truth to peripheral regions
a larger proportion of business-minded, highly of the range of estimates so that the crowd
educated, high income types. This collides becomes less reliable in providing expertise
frontally with the theoretical, widely regarded for external observers.
diversity of the crowd. The crowd, greatly diverse 3. The “confidence effect” boosts individuals’
in principle, can indeed be culturally, socially and confidence after convergence of their estima-
economically biased to a great extent. As we will tes despite lack of improved accuracy.
see in section 5, e.g. 60% of the startup-oriented
crowdfunding sites are located in Anglo-Saxon Social influence among human group members
countries. The lack of diversity has important may trigger individuals to revise their estimates
implications for the effectiveness of the crowd in for various reasons:
developing certain tasks which will be analysed
in the next section. • The belief that others may have better
information.
3.6 Analyzing the ”Wisdom • Peer pressure toward conformity.
of the Crowd” effect • Inclination to adjust their opinion to those
Understanding the capabilities, formation logic of others so that they gradually converge
and behavior of the crowd is key to paint a richer toward consensus.
picture of crowdfunding and also has implica-
tions for a more effective design and implementa- Another concept that tries to explain the
tion of crowdfunding platforms. narrowing of diversity, thus making the crowd

6. 6 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
less wise, is homophily which is the tendency of on networks built by traditional methods –e.g.
agents in some networks to connect to others si- meetings, congresses, and personal introduc-
milar to them in parameters such race, education, tions. The potential of the used methods used
religion (and possibly professional background are somehow limited.With the advent of the
in the case of crowdfunding); (Lazarsfeld & information technologies and, more specifically,
Merton, 1954). the development of the internet a better way to
gather, discuss, interact, organize and decide was
Also important is the concept of diffusion and put in the hands of people and companies. The
imitation as studied by Bass (whose model digital agora has the same use as the ancient one,
describes the process of how new products get but is by far more powerful: more agile, with the
adopted as an interaction between users and capacity of reach many individuals at the same
potential users) and Rogers (whose theory seeks time but, more importantly, an unprecedented
to explain how, why, and at what rate new ideas capacity to create larger economies of scale than
and technology spread through cultures [or also ever before. The internet is rapidly disrupting the
network clusters in the case of crowdfunding]. structure of many industries by a flow of creative
destruction never seen before: transport, com-
munications, retail, and publishing all are going
4. Changing paradigms through severe changes.
“Society rearranges itself —its worldview—; its In this new state, traditional institutions that
basic values; its social and political structure; its have enabled certain processes, not only demo-
arts; its key institutions. Fifty years later there is a cratic but also legal, financial and those created
new world. And the people born then cannot by citizens themselves in a more direct way,
even imagine the world in which their own parents become obsolete. These formerly necessary
were born.” institutions incurred in huge inefficiencies, e.g.
in the form of transaction costs or due diligence
Quote from the book “The Crowdfun- processes.
ding Revolution”, by Kevin Lawton and
Dan Marom.
Institutions are not the end but the means that
societies figured out to solve different challenges.
Because of the explosion of the digital era these
Societies have been using institutions as tools to institutions have become somehow obsolete.
deal with different problems since the wake of Because of social networking, institutions such
civilizations. To give an example, to implement as VC are no longer the only way to get the right
democracy, citizens vote, elect representatives, amount of money for an enterprise. Through the
and these take the will of the people to an insti- use of crowdfunding platforms, micro contribu-
tution (namely, congress or senate). Ideally, this tions by a far larger group of people can equal,
created institution provides the means to elicit in total, the money that a group of wealthy
people desires and manage a country accordingly. investors allocates through an investment fund.
When it comes to allocation of capital, countries Besides this quantitative factor there are others
rely on their financial sectors to invest money. that make of crowdfunding a powerful tool. In-
This money is saved previously by different teraction with a massive group of people provides
individuals and companies and is invested in a great amount of information about the state of
the most valuable enterprises, projects, etc. In the markets which is very difficult to reach in the
this respect commercial banks provide cash for traditional setting.
individuals and small companies and, typically,
Venture Capital Funds, place the money if its 4.1 The Trust Economy
investors in risky projects with the potential of The network and possibilities provided by
yielding high returns. The reach of these ventures a crowdfunding platform are much larger
was somehow limited consisting only on per- than those of traditional ‘investing relations’.
sonal “face-to-face” interactions and leveraging Crowdfunding e.g. provides enhanced partner

7. 7 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
searching capabilities, expert advice, and the based of free market and individual freedom
opportunity to build a collaborative ecosystem. rights. The key elements fit perfectly the bill for
However, due to several factors, strong and trust- crowdfunding:
worthy relationships are harder to build in this
online environment (Hoffman, Novak, & Peral- 1. allows and supports the development and
ta, 1999). But the fact that members’ behavior is accumulation of rational science;
‘observed’ by the crowd eliminates the incentives 2. channels the personal pride into non-
for wrongdoing to a great extent as observed by destructive forms and the people focus on
Mao (Mao, 2011) in his manifesto “Sharism”, and economic wellbeing;
supported by extensive research in the field of 3. allows regular change and refreshment of
behavioral economics. the social leadership.
Another important implication for the use of In this framework, Fukuyama proposes inter-
Web 2.0 for funding ventures is that the likeliho- personal trust and social virtues as a conduit for
od of two strangers exhibiting trust depends on economic growth and prosperity. The author
social, legal, biological and economic environ- develops a scheme where the advantages of high
ments, namely, those of the ‘hybrid environment’ trust are:
created from the crowdfunding platform and the
country where the transaction, operations and 1. lower administration costs, higher institu-
enforcement happens. In connected environ- tional reliability;
ments, trust, built by the use of market-driven 2. large and efficient organizations;
institutions, rather than just legal frameworks,
will provide the stability needed to carry on Crowdfunding is a collaborative effort. Accor-
with economic actions (Hoffman, Novak, & ding to La Porta et al. (1997), trust is a strong
Peralta, 1999). GrowVC, for example, argues driver for cooperation, especially in large organi-
that by increasing the levels of trust, the need zations, or transferred to crowdfunding in large
for legal counseling decreases thus increasing networks.
Sidenote 3 For further information the efficiency of the system and its growth rate3.
on Grow VC refer to the case study This argument is clearly in line with abundant Fukuyama (1995) also points out that personal
(Appendix 2).
research around the topics of trust and growth, and institutional networks are means of trust
from which we provide some insights with impli- generation and that their trust-producing ability
Sidenote 4 In a crowdfunding environ- cations for crowdfunding. depends on their rules. Ideally, they should be
ment the role of the press is carried out simple, transparent, coherent, and applied with
by the crowd itself.
Crowdfunding networks can be seen as a form of consequence.
economies. Not enclosed in national boundaries
but rather acting as a meta-entity that potentially However, the most useful research to understand
spans across different countries. Crowdfunding the crowdfunding phenomenon so far may be
can be also seen as the purest way of free market ‘Neuroeconomics of Trust’. Zak (2005) argues
capitalism, where formal institutions, transaction that neoclassical economic theory -agents always
costs are and public intervention are rather light. try to maximize their profits- does not apply very
much to certain observed behaviors. Instead,
These networks are self-regulating environments. persons as social animals, care strongly about
However lack of trust, because of the implica- what people think about them. In the heavily
tions, can be a downside when trying to promote networked environment of crowdfunding, this
economic growth of these networks. Trust in an element is key to retain the favor of the crowd
economic environment, both offline and online, and succeed socially and, thus, economically.
is a key factor for its sustained growth, as discus- Moreover, increased trust reduces transaction
sed by many authors. costs. Under this framework, Zak recommends
trust-building policies including education which
Fukuyama (1995) argues that best way of promo- strongly improves the quality of institutions,
ting economic growth is the liberal capitalism press freedom and civil liberties4.

8. 8 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
5 Status quo: the crowdfunding well recognized that attracting external finance
environment for startup ventures at the very initial stages of a venture is one of
The rising interest in crowdfunding as a way to the biggest challenges of entrepreneurs (Cosh,
fund startup companies does not come out of Cumming, & Hughes, 2009). In the aftermath
the blue. It can be traced back to two funda- of the financial crisis, the global venture capital
mental trends. As described in earlier sections, industry currently recovers from a severe slump.
the rise of the internet and its evolution from a According to Dow Jones VentureSource (2010)
source of information to an arena of interaction total investment in the United States fell by 36%
and networking was a necessary condition for in 2009. Outside the U.S. the picture was even
entrepreneurs, investors, and experts to link up bleaker with a fall of 51%. In the first quarter
with each other. of 2010 the worldwide VC investment made a
return, increasing by 13%. One trend, however,
Crowdfunding originated as a funding mecha- seems to be persistent. Venture capital funds seek
nism for cultural and social projects and only less stormy waters and shift their investments
recently started to diffuse into a business-orien- from the startup and early stage towards later
ted direction. This leads to the second driver stages of the funding process. According to
behind the increasing interest in crowdfunding: Knowledge@Wharton (2010), the VC funds’
a shortage in traditional funding. Before the continuous growth in size and number increa-
internet enabled niche interests to gather online, ses competition for large venture investments.
funding a project like the Catalan film [No-Res] The need to invest larger sums goes in line with
that criticizes Barcelona’s ongoing gentrification coming on board later in a startups life-cycle. Be-
in the district Colònia Castells, might have sides this economic argument, VCs also usually
been a major obstacle. Donation from directly have minimum threshold investments beyond
involved people would probably be the major the capital needs of early stage ventures (Bhidé,
source. By applying crowdfunding, the project 1992). The consequences are twofold: while com-
not only receives inter-regional attention but petition keeps valuations of later stage ventures
widens the reach of potential donors to anyone inflated, the interest in early stage investments
interested in Barcelona, gentrification or urban decreases. Lawton and Marom (2010) connect
documentaries. The shortage in funding argu- the latter to the exponentially increasing rate of
ment also partly explains why crowdfunding for technological change and conclude that “chasing
financing startup companies and strictly profit- later-term deals is in some ways, an attempt at
oriented projects increasingly gets traction. It is chasing history”.
Figure 3 The Rate of Change
(Source: Adapted from Lawton and RATE OF
Marom, 2010). CHANGE
Twitter
Internet Browser Google Facebook
TIME

9. 9 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
The initial funding stages are traditionally the plethora of microcredit initiatives that aim
Sidenote 5 For further information on home to Family & Friends, personal savings and to fuel entrepreneurship in developing coun-
Diaspora, refer to Appendix 3. business angels but the declining engagement tries. Smarter Money lists 19 of these platforms,
of venture capital funds leaves a gap crowdfun- among them powerhouses such as Kiva which
Sidenote 6 http://www.smartermoney. ding platforms might tap into. The potential of has already connected more than one million
nl this gap becomes clearer when reflecting that entrepreneurs and lenders and channeled loans
according to a University of Dartmouth study worth more than $200M.
Sidenote 7 For a study of a truly “only 1% to 2% of all business plans presented to
international crowdfunding platform either angels or VCs receive funding” (Center for The geographic pattern raises an interesting
that addresses startup founders refer
to Appendix 2.
Private Equity and Entrepreneurship, 2005). issue. Agrawal et al. (2011) show that that average
Since the use of crowdfunding for entrepre- distance between a crowdinvestor and the project
Sidenote 8 Smarter Money does not neurial ventures is very young - according to owner is approximately 3,000 miles 9. While this
list VC4Africa which, however, would be Belleflemme et al. (2010) it dates back only to confirms the bias towards a regional scope also
assigned to the Netherlands.
2007 - market data are scarce. To date Belleflem- from the investors’ perspective, it contradicts tra-
Sidenote 9 The study of Agrawal et al. me et al. is the only study yielding empirical data ditional theory and empirical observations which
(2011) is based on data from Sellaband, on the topic. Focusing on crowdfunded projects predict that investors in early stage entrepre-
a crowdfunding platform to finance
the production of music. Although the
and ventures and projects instead of intermediary neurial ventures tend to be local; e.g. Sorenson
platform does not allow investing in platforms, their study finds that about 60% took and Stuart (2001), Zook (2002), Mason (2007).
startups, the authors still extrapolate- place in Anglo-Saxon countries. The sample did More specifically, Sorenson and Stuart (2005)
their results to this field.
not show a tendency towards certain industries find that the average distance between the lead
Sidenote 10 Brazilean platform but covered a wide range including e.g. infor- VC and the firm they finance is about 70 miles.
Ikermart was removed due to its beta mation and communication technologies, sport, Accounting for business angels, Sohl (1999)
stadium and no detailed information.
journalism and movies. The median targeted and Wong (2002) report that they also tend to
funding sum was about € 100,000 and entrepre- locate in rather close proximity to their targeted
neurs raised around € 28,500 (median). Bearing ventures.
in mind outliers such as Diaspora5 or the IPod
Nano-based wristwatch LunaTik that raised 3,000 miles Crowdinvestor — Entrepreneur (avg. distance)
nearly $1M through Kickstarter, these numbers
indicate that crowdfunding primarily appeals to
Figure 4 Average distance between entrepreneurs during the seed and early stages of
70 miles VC — Entrepreneur (avg. distance)
Investors and Entrepreneurs. their venture.
(Source: the authors)
Turning to the platforms, the crowdfunding blog
Smarter Money6 currently lists 217 crowdfunding Thus, while most crowdfunding platforms
platforms, 31 of which are exclusively dedicated directed at startups are still act within national
to investing in startups. Most of the platforms boundaries, they bear the potential to overcome
only emerged in 2010 and some of them still distance-related frictions often faced in the finan-
run as beta versions. Looking at geographic cing of entrepreneurial ventures. One crowdfun-
patterns, it turns out that although enabled by ding example that illustrates the international po-
the World Wide Web, crowdfunding companies tential is discussed in Appendix 4. The primary
for startups still largely operate with a national obstacle towards a truly global crowdfunding
or regional scope 7. The origin of the platforms environment, namely regulatory inconsistencies,
reflects Belleflemme et al.’s findings. Approxi- will be discussed in the next section.
mately 60% of startup-oriented crowdfunding
platforms are located in Anglo-Saxon countries Finally, the market of crowdfunding platforms
and serve these markets. Furthermore, South for startup companies can be divided according
African and Brazil are the only countries to host to the investment structure. There are three
startup crowdfunding platforms outside North major channels through which investors can earn
America, Europe and Australia 8. Concluding that a return on their investments: equity, interest
crowdfunding for entrepreneurial purposes is a on loans and revenue shares. Figure 5 shows the
first world phenomenon would, however, neglect financing means of the Smarter Money sample10.

10. 10 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
While six platforms offer various ways to invest, a cial transactions as a given, the dichotomy does
majority of 54% employs equity-based crowdfun- not end here. Despite initial efforts during the
ding. world financial crisis from 2007 to 2010, financial
regulation remains fragmented as a largely na-
tional undertaking. Reflecting the high mobility
of money, this may be criticized as a general
Various
Figure 5 Financing structure of shortcoming. Certainly, it is a major obstacle if
6
startup-oriented crowdfunding crowdfunding is to unfold its entire potential
platforms. (Source: the authors)
Bonds 1 that yields beyond national borders.
16 Equity
Profits share 4
Remaining at the national level, the United
3 States are of particular importance for the future
development of startup-oriented crowdfunding.
Debt
Not only do the United States regularly appear
among the top entrepreneurial economies and
rank third in the Global Entrepreneurship and
Differences in the structure of the financing mo- Development Index, they are also particularly
dels are due to different objectives and, leading strong in startup skills and new technologies; Acs
to the following section, reflect the regulations of & Szerb (2009) and Acs & Szerb (2010). Further
the countries where the crowdfunding compa- reasons are the sheer size of their economy and
nies are based. Again, entrepreneurship-oriented that about 40% of startup-oriented crowdfun-
microcredit platforms such as Kiva but also ding platforms according to the Smarter Money
peer-to-peer lending platforms that give business list are based in United States.
loans, e.g. Lending Club, are not included.
At its current state, U.S. American law allows
crowdfunding through donation, debt-based
6 Status quo: the regulatory instruments and revenue shares but prohibits
environment of crowdfunding equity-based crowdfunding. Since equity inves-
One reason why crowdfunding originated as a tments are widely regarded as the most appro-
form of fundraising for artists and peer-to-peer priate structure to fund startups – after all, this is
social lending was shortage in funding. A second what Business Angels and VCs do at a larger scale
line of reasoning is related to the regulatory stan- – the progress of crowdfunding for startups is
dards for online transactions that aim at earning slowed down. Equity-based crowdfunding is also
a ROI and legal issues regarding equity issuance regarded as superior to debt because shares the
and multiple investors in private companies. risk between the entrepreneur and the investor
While in-kind rewards or non-interest microcre- and thereby aligns incentives (Schwienbacher &
dits evoke less regulatory interest, crowdfunding Larralde, 2012). More specifically, two regulatory
for startups embodies a risk of loss and potential interventions prevent crowdfunding as a mecha-
profits. nism of equity-investing: First, Section 12 (g)
of the Securities Exchange Act of 1934 requires
In crowdfunding two antagonistic paradigms private companies to disclose their finances to
clash with each other and will have to amalgama- the S.E.C. once 500 or more individuals have
te to allow international scalability and larger- invested (S.E.C., 2009). The adverse effect on
scale investments: On the one hand crowdfun- crowdfunded ventures, e.g. Diaspora with its
ding derives its strength from libertarian and 6,479 backers, is obvious. Goldman Sachs has
largely unregulated crowd phenomenon that recently increased public awareness of this regu-
was described earlier. On the other hand, and as lation when setting up a Special Purpose Vehicle
opposed to crowdsourcing, the defining element for high net worth individuals to invest in Fa-
of crowdfunding for entrepreneurial ventures is cebook at a pre-IPO stage; e.g. Davidoff (2011).
usually a financial investment and thus applicable Second, Section 4 (2) of the same Act basically
to strict regulations. Taking regulation of finan- excludes the large parts of the crowd from inves-

11. 11 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
tments in private companies by requiring them as crowdfunding platforms, trust will replace
to “have enough knowledge and experience in regulatory standards as the most important
finance and business matters to evaluate the risks stability safeguard. To foster international best
and merits of the investment (the “sophisticated practice sharing and discussion on the future sha-
investor”), or be able to bear the investment’s pe regulation of crowdfunding, Lawton founded
economic risk” (S.E.C., 2009). When this the International Organization of CrowdFun-
regulation was introduced, in the aftermath of ding Commission (IOCFC) on LinkedIn.
the Wall Street Crash of 1929, legislators aimed
to protect unsuspecting investors from fraud. While reform efforts still go into different
Almost eighty years later, these restrictions put a directions, public actors have recently picked up
halt on equity-based crowdfunding in the most the ball. Responding to a letter of Congressman
important economy. Darrell Issa, Chairman of the Committee on
Oversight and Government Reform, Mary
Efforts to update the backward legislation are Schapiro, Chair of the S.E.C., writes that “the
well in place and take different forms. On a staff are taking a fresh look at the [SEC] rules to
practical level, platforms such as Profounder develop ideas for the Commission about ways to
switched to the second best alternative and offer reduce the regulatory burdens on small busines-
revenue shares of funded ventures instead of ses capital formation in a manner consistent with
equity. Others, such as GrowVC are registered investor protection.” Among these regulatory
in Hong Kong and limit their funding side to burdens, she namely mentions the 500-rule
experienced startup investors and entrepreneurs. (Schapiro, 2011).
Another solution is discussed in the VC4Africa
case (Appendix 4) where the final investment Meanwhile, Dutch authorities have taken the lead
contract takes a rather traditional form while the by allowing a new kind of investment vehicle rather
due diligence and networking engages the crowd. than applying new regulation. In nutshell, the
On the legal side, several initiatives stimulate le- mechanism works as follows: Startup companies
gislative change through petitions and discussion. place their equity in a cooperative holding com-
Most prominently, the Crowdfunding Campaign pany (CHC) that acts as one single shareholder.
to Change Crowdfunding Law jointly with the Members of the CHC can invest in the company
Sustainable Economies Law Center submitted a through their membership units in the cooperative.
“Petition for rulemaking: Exempt securities offe- Once the startup has raised its investment target,
rings up to $100,000 with $100 maximum per the membership units are transferred to a second
investor from registration” in July 2010. Another cooperative set up by the venture itself. Since the
petition initiated by serial entrepreneur Sherwo- first platform exclusively acts as a mechanism
od Neiss proposes an exemption framework for for facilitating the transaction between the investors
Sidenote 11 The ‘Autoriteit Financiële small businesses with revenues below $5M and and the entrepreneur, it is not applicable to AFM11
Markten’ (AFM) is the Dutch counterpart individual investments below $10K. Educational regulations; (Espoti, 2011).
to the S.E.C.
For further information on the mecha-
measures for crowdinvestors and eliminating the
nism refer to http://www.symbid.com. 500-rule add to the more sophisticated approach It will be interesting to observe which direction
than the first petition. However, applying for the regulation takes. Financial services provider
exemptions is not regarded as the silver bullet by have shown their ability to innovate around
all crowdfunding advocates. Lawton and Marom regulatory barriers many times. Crowdfunding
(2010) fear that arbitrary exemptions will hinder itself can be regarded as a disruptive innovation
crowdfunding from unfolding its entire potential that challenges the current startup financing and
and could rather be “a form of self-inclined pre- regulatory system. It is to be seen whether the
vention.” They call for best practices instead and lack of consistent regulation will foster fur-
claim that “regulation should follow crowdfun- ther innovation in the crowdfunding sector or
ding leadership, and not the other way around”, whether it will put a brake on its future develop-
i.e. they believe in self-regulation. This paradigm ment. Whatever shape a new form of regulation
mirrors Hoffman et al.’s (1999) proposal accor- will take, it will heavily influence the future of
ding to which in connected environments, such crowdfunding.

12. 12 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
7 Quo vadis: future scenarios to prepare their exit. The hybridization scena-
Crowdfunding is currently experiencing a boom. rio can end in a win-win-win situation. Given
New platforms pop up almost on a daily basis the current environment where seedfunding is
and startup-oriented crowdfunding is the latest scarce and equity-based crowdinvestments are
trend within the trend. Considering the very complicated in most countries, variations of this
young phase of the industry, it does not take a scenario are the most likely future development.
fortune teller to predict further growth in the Figure 6 illustrates the involvement of crowdfun-
short-term future. Shifting perspectives towards ding in the different funding stages. Already
the mid-term, there are, however, a few scenarios today, no two crowdfunding platforms are the
worth taking a look at. same. This diversity might well lead to multi-
Crowdfunding
Figure 6 The Hybridization Model. 10,000K —integrated with other
Stock exchange.
(Source: The authors and Smarter forms of financing.
Private equity.
Money).
1,000K
Venture capital firms
100K
Informal
investors
20K
F&F
Prepare Start Growth Consolidation
The central question for the future development staged crowdfunding processes involving diffe-
is connected to the prior chapter: What shape will rent platforms. A company like Diaspora that
the future regulation of crowdfunding have? In a successfully raised first round capital through
favorable legal environment crowdfunding might investments that grant only in-kind rewards,
revolutionize startup funding. However, strict top- might at a later stage transfer their project to a
down limitations might as well turn crowdfunding platform that offers non-dilutive debt or equity-
into just one more source of capital. based investments. Moving between platforms,
however, requires rigorous standards. However,
Lawton and Marom (2010) develop one scenario the current fragmented, incoherent regulatory
called hybridization. In this model old and new framework that forces crowdfunding platforms
ways of funding merge with each other. Both to build around pre-internet laws is a major obs-
GrowVC and VC4Africa indicate where the tacle. Another prerequisite for the multi-staged
future may lie. VCs and angel investors tap the crowdfunding approach is for certain platforms
crowd to screen new ideas, outsource due diligen- to become able to fund larger amounts than they
ce or get contacts beyond their Rolodex and the do today, i.e. the crowdfunding ecosystem has to
crowdfunding platforms reach out to profes- become more heterogeneous than today. Again,
sionals as a signal our expertise and scalability hybridization may help here.
of their projects. Entrepreneurs, finally, benefit
from a wider choice of funding options and can Another potential advancement is coined as the
use crowdfunding as an indicator of the market “rolling close” funding model. Crowdfunding
potential while using professionals at a later stage gathers a group of investors and could, thanks

13. 13 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
Crowd-sourced Crowd-sourced IP
Public Equity Exchange
valuation platform & competitive diligence platform
Publicly trade vehicle
for crowd-funded startup Social networking site #1
investments.
Crowdfunding Crowdfunding Private equity
platform #1 platform #2 exchange
Startup G
Startup A Startup C Startup E Startup H
Startup B Startup D Startup F
Figure 7 Startups as an asset class.
(Source: adapted from Lawton and
Marom, 2010).
to broadband internet connections, happen in in crowdfunded startups. Here, crowdfunded
real-time. Using the rolling close funding model, includes various processes besides the actual
in the future, entrepreneurs could take money funding, such as diligence, valuation, or team-
from investors one-at-a-time. Y-Combinator has building. With regard to the capital allocation
pioneered this model in Silicon Valley and is cu- decisions within these new vehicles, Lawton
rrently hugely successful. According to its foun- proposes several groundbreaking mechanisms:
der Paul Graham, rolling close funding “requires “decisions could stem from prediction markets,
less reliance on a lead investor, takes less time out classic human oriented investment thinking, or
of product development, and gives investors less even a democratic vote from the shareholders”.
room to drag things along or collude” (Gannes, In a final consequence, the vehicles would open
2010). That being said, Y-Combinator neither investments in startups to the general public even
uses an online platform nor does it involve the beyond the degree crowdfunding already does.
crowd. Combining both strands might be one Figure 7 illustrates the proposal.
future innovation.
While the latest scenario obviously requires
Finally, crowdfunding visionary Kevin Lawton fundamental ideological and legal changes, it is
presents an idea how startups, thanks to certain to say that crowdfunding will grow in
crowdfunding, might turn into an asset class scale and outreach. The future is uncertain and
(Lawton & Marom, 2010). Thanks to “increa- thus prone to unpredictable events. Crowdfun-
singly transparent seed-stage mechanisms which ding, however, is present and future and thus
tend to also be inherently computer accessible”, here to stay.
Lawton proposes that professional investors
will not only co-invest with the crowd, as in
the hybridization model. On top, he sees other
private equity forms injecting money directly
into crowdfunded startups and publically traded
vehicles will be created with a charter to invest

14. 14 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
8 Conclusion
Crowdfunding for startups is undoubtedly an
exciting phenomenon. It does nothing less than
turning the traditional model on its head. His-
torically, the “smaller” investors only enter when
companies become large enough to get listed on
a stock exchange. With crowdfunding, they can
access innovative startups during their very initial
phase.
Throughout this paper we have introduced the
crowdfunding phenomenon by showing its
ideological sources. While there is no eventual
agreement on the wisdom of the crowd, one
thing is certain: irrespective of its “mental” ca-
pacity, the crowd is here to stay. Social networks
continuously change human behavior and have
already disrupted various industries.
At its current stage, crowdfunding is almost as
diverse as the crowd itself. While GrowVC is
often cited as a best practice, it is to be seen if one
of the current models excels. The major impact
of external interventions, namely regulation,
has been stressed and will continue to affect the
potential of crowdfunding.
While the future form of crowdfunding remains
highly uncertain, the current growth increases
the probability that one future breakthrough
innovation will be crowdfunded. If the “next big
thing”, maybe even Diaspora, is crowdfunded,
awareness and thus importance will rise. At the
same time, and this risk also relates to Diaspora, a
major failure would probably sustainably decrea-
se the enormous potential of crowdfunding.
This potential was illustrated in three cases that
show different facets of crowdfunding for startup
companies.
In any case, the growing number of crowdfunded
ventures will yield massive amounts of data that
allow future research. Do crowdfunded ventures
outperform traditionally funded ones? How are
decision rights distributed among investors in the
crowd? How do entrepreneurs optimally leverage
the input of the crowd? And does crowdfunding
foster entrepreneurship beyond the innovation
clusters?

15. 15 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
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18. 18 Crowdfunding Funding Innovation through Innovation in Funding Niels Schlesier & Sergio Gutiérrez
Appendix
APPENDIX 1: Online crowdfunding survey
Link: https://www.surveymonkey.com/sr.aspx?sm=e77ogJZ0P5C9iwP2fchtBKGe73DtElaOCIV2d5EFsCw_3d
Password: mesi_thesis_nssg