The promise of reward crowdfunding

• Author: María‐Isabel Sáez‐Lacave,María Gutiérrez‐Urtiaga
• Published date: 01 September 2018
• DOI: http://doi.org/10.1111/corg.12252
• Date: 01 September 2018

SPECIAL ISSUE ARTICLE

The promise of reward crowdfunding

María Gutiérrez‐Urtiaga

1

|María‐Isabel Sáez‐Lacave

2

1

Universidad Carlos III de Madrid and ECGI,

Spain

2

Universidad Autónoma de Madrid, Spain

Correspondence

María Gutiérrez‐Urtiaga, Department of

Business Administration, Universidad Carlos III

de Madrid, 28903 Getafe, Madrid, Spain.

Email: maria.gutierrez@uc3m.es

Funding information

Comunidad de Madrid and the EU's European

Social Fund, Grant/Award Number: S2015/

HUM‐3353 EARLYFIN‐CM; European

Regional Development Fund, Grant/Award

Number: FEDER UNC315‐EE‐3636

Abstract

Research Question/Issue: We study reward crowdfunding (RC), the most innova-

tive segment of the crowdfunding market, where, instead of a debt or equity contract,

fund providers are promised some good or service in the future in exchange for their

contribution to the funding of the investment project under a contract that does not

penalize the creator's failure to deliver. The existing economic and legal literature is

puzzled by the platform's use of this seemingly inefficient contract where a standard

pre‐sale contract would appear to work better.

Research Findings/Insights: Counterintuitively, we prove that the no‐penalty con-

tract is the optimal contract between creators of unknown talent and early adopters

of their products when creators can benefit from being discovered as talented and

from the goodwill generated by delivering on their promise to early adopters.

Theoretical/Academic Implications: Our analysis contributes to understanding RC

by showing that the no‐penalty RC contract, far from being an inefficiency, is a con-

tractual innovation specifically designed for talent discovery. We also contribute to

the literature on relationship contracts, showing that even in a one‐shot game, it is

possible to sustain a contract in the desire to build a reputation that will be useful

in a future contract with a third party.

Practitioner/Policy Implications: Our analysis has important policy implications on

how backers should be protected. Standard measures of consumer or investor protec-

tion may be counterproductive.

KEYWORDS

Corporate Governance, Reward Crowdfunding, Best Efforts, Presale Contract, Talent Discovery

1|INTRODUCTION

Extremoduro is a legendary Spanish rock band ranked number 6 on

Rolling Stone's “50 Greatest Spanish rock bands”. It was founded by

Robe Iniesta in 1987 in Plasencia, a small town in the region of Extre-

madura. In 1989 the band was able to finance its first studio album

offering ballots which, for an amount of 1,000 pesetas (€6), could be

exchanged for a copy of their first album if it was ever recorded.

Advertising by word of mouth, they managed to raise 250,000

pesetas, which was just enough to pay for the studio production of

their first album “Transgressive Rock”. The band paid tribute to their

initial backers by listing all their names on the back cover of the album.

Although this happened many years before the internet, it is a very

good example of a successful reward crowdfunding (RC) campaign,

where a creator of unproven talent offers early followers a reward in

order to raise the funds needed to launch the product on a wide scale.

Interestingly, the example also illustrates the similitude of this type of

fund‐raising with long‐existing pre‐selling funding schemes, raising the

question of which is the real novelty that RC offers for the financing of

new ventures.

Crowdfunding (CF) provides entrepreneurial finance. It is an

example of the new forms of small financing that have developed

since the 1980s, as explained by Newman, Schwarz, and Ahlstrom

(2017). In particular, CF falls within the general categories of micro‐

finance—because most of the projects financed are small—and

fintech—because it uses an internet‐enabled platform technology as

Received: 31 July 2017 Revised: 19 June 2018 Accepted: 19 June 2018

DOI: 10.1111/corg.12252

Corp Govern Int Rev. 2018;26:355–373. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg 355

the only intermediary between the entrepreneur and the providers of

funds. According to Metrick and Yasuda (2009), because of severe

asymmetric information and moral hazard problems, it is very difficult

for entrepreneurial ventures to raise either debt or outside capital, and

when they have access to venture capital (VC), this usually requires

giving up control of the venture. Agrawal, Catalini, and Goldfarb

(2013) and Belleflamme, Lambert, and Schwienbacher (2013) present

CF as a viable alternative for entrepreneurs to raise outside capital

without losing control of their ventures. CF allows entrepreneurs to

raise funds from a large number of small investors. This can be done

using standard debt and equity contracts but also relying on customer

financing.

We consider RC as the most innovative segment of the

crowdfunding market. RC is fundamentally different from both debt

and equity crowdfunding because the provider of funds does not

buy a financial security. But it is also different from charity since, in

exchange for the money given, the provider of funds is promised some

good or service in the future. Interestingly, and depending on the

money provided, the promise can range from a promotional T‐shirt

to a full unit of the good or service that is being funded. Nevertheless,

the promise is very vague because the contract between the creator,

who is raising money, and the backer, who provides the funds, only

states that the creator must make his/her “best‐efforts”to deliver

the good or service, but there is no specification of any compensation

whatsoever if the promise is not kept. Therefore, this is a contract

according to which the fund's provider does not get a right over the

potential outcomes from the venture he is financing in any state of

the world. We will refer to this arrangement as the no‐penalty

contract.

1

At first sight, this contractual arrangement seems to

generate huge moral hazard costs and to make funding very difficult.

One could argue that the no‐penalty contract is based on trust and

reputation, like other contracts where state verification or enforce-

ment of penalties is not possible. But this does not seem sustainable

in a one‐shot game, where most of the creators raising funds may

never come back to the market. In this one‐shot game, the creator

would be expected to behave in an opportunistic manner and not

deliver the good. Anticipating the potential for this type of behavior,

backers may be deterred from giving funds in this setting, leading to

market failure. This poses a puzzle for understanding (and regulating)

the RC market.

In this paper we offer a solution to this puzzle by presenting a

one‐shot model of RC where the no‐penalty contract is found to be

the optimal contract between a creator of unknown talent, who wants

to be discovered by the wider market as highly talented, and early

adopters of the product. We contribute to the literature on CF

showing the importance of the innovative contractual arrangements

offered by the RC platforms in the context of a market for talent

discovery.

We model RC as the first stage of a game where a creator is dis-

covered to be talented when early adopters support his RC campaign.

There is a second stage of production where, if the creator was

successful in the RC campaign, he can capitalize on the discovery of

his talent by selling to late adopters and benefiting from goodwill

generated in the delivery to the early adopters.

2

Introducing penalties

for non‐delivery in the crowdfunding stage makes funding easier

because penalties induce a higher probability of delivery. But the

higher delivery rate for all ability levels makes the information on the

creator's ability that the funding provides to the market a weaker

signal. This, in turn, reduces the chance of “being discovered”and

accessing second stage benefits. In particular, as the penalty increases,

the creator will need to raise a higher amount of funds in the RC

campaign to be able to prove to the market that he is talented. But,

as the amount of funds that have to be raised increases, the probabil-

ity that the campaign is successful decreases, and this reduces the

possibilities of accessing the second stage production level. We prove

that this game has a corner solution were the platform fixes the

penalty at zero, i.e. it has a solution were the no‐penalty contract is

optimal. This equilibrium obtains when only creators perceived as

having very high quality are considered talented enough to access

the second stage but the benefits from the second stage and the

goodwill coming from delivering to the early adopters are high. In this

case talent discovery is very valuable and the no‐penalty contract is

optimal to preserve the talent discovery function of the RC market.

Interestingly, the equilibrium of the game only resembles the

actual features of the RC market when the benefits from scaling up

projects are large, making talent discovery valuable.

3

In this case the

optimal contract includes no penalties for non‐delivery, and a very

low rate of projects can get funding but, among the projects that get

funding, there is a high delivery rate, and a high probability of the

funded projects being scaled up afterwards. When the continuation

benefits are low, the equilibrium becomes a standard pre‐sale market

with high penalties in case of non‐delivery and with a higher number

of projects getting funds from backers and a high probability of deliv-

ery but not many projects being scaled up afterwards.

Our paper makes three contributions. First, it contributes to the

theoretical literature in RC by proving that the no‐penalty contract is

the optimal contract that allows for talent discovery in the RC market.

Previous theoretical models of RC have either focused on the use of

crowdfunding for market testing under uncertain aggregate demand

(Chemla & Tinn, 2017; Strausz, 2017) or on the use of all‐or‐nothing

funding schemes in the contracts offered by the platforms (Chang,

2016; Ellman & Hurkens, 2014). These papers usually assume the RC

contract to be a standard pre‐sale contract or argue that the no‐

penalty contract is an inefficiency. To the best of our knowledge, we

are the first to argue that the no‐penalty RC contract, far from being

an inefficiency, is a valuable contractual innovation suitable for talent

discovery. Second, we also contribute to the theoretical literature on

relational self‐enforcing contracts sustained in a repeated game when

the value of future interactions is high enough (Klein & Leffer, 1981;

MacLeod, 2007). Our contribution is to show that it is possible to sus-

tain a self‐enforcing contract even in a one‐shot game if one party can

build a reputation that will be useful in a future contract with a third

party. Finally, our analysis also makes an important contribution to

the practice of RC by highlighting the legal problems that the plat-

forms will face to exempt the no‐penalty contract from the application

of consumer protection rules that impose warranties upon the seller

for product failure. The rest of the paper proceeds as follows. The next

section explains how RC works. In the literature review section, we

discuss the existing literature on RC. The model is presented in the

following section. We then have a section where we discuss the key

356 GUTIÉRREZ‐URTIAGA AND SÁEZ‐LACAVE