How to keep crowdfunding entrepreneurs honest

Amy Merrick | Sep 12, 2018

Sections Economics

Crowdfunding platforms such as Kickstarter are vulnerable to misconduct by entrepreneurs who overpromise what they are capable of creating. Platforms could take a more active role in verifying the quality of finished products, making crowdfunding more efficient for both entrepreneurs and backers, according to research from Cornell University’s Elena Belavina and Wharton’s Simone Marinesi and Gerry Tsoukalas.

The structure of crowdfunding platforms makes them more appealing than traditional bank or VC financing to many entrepreneurs. Crowdfunding platforms typically have an all-or-nothing threshold: if backers pledge enough to reach a target set by the group seeking contributions, the project gets funded. If pledges fall short, the project receives nothing.

This structure offers entrepreneurs a means of inexpensive premarket testing, Belavina, Marinesi, and Tsoukalas write. “Somewhat paradoxically, the value of crowdfunding lies not so much in its ability to fund but rather in its ability to prevent funding—prevent the entrepreneur from investing more money in a project that has a negative expected profit,” they write.

But crowdfunding carries higher risks than traditional investing, as backers have no formal stake in the company they’re supporting and typically have access to much less information than a banker would. A product developer could abscond with the money, or a developer could run into technical problems that make delivering the promised product impossible. The developer might then release a substandard product—or nothing. 

Among the high-profile examples of failed crowdfunding efforts is Zano, a drone project that raised about $3.5 million on Kickstarter. The developers delivered only a few of the drones promised—and those didn’t work. popSLATE 2, a multifunction iPhone smart case, raised more than $1 million on Indiegogo in 2016. The company shut down without delivering the products after encountering major technical problems, and backers received no refunds.

Almost one in 10 funded Kickstarter projects failed to deliver its product, according to research conducted for Kickstarter in 2015 by Wharton’s Ethan Mollick, who surveyed 500,000 backers about project outcomes. Funders of failed projects received refunds only 13 percent of the time.

Platforms typically absolve themselves of responsibility, leaving all risk with project backers. Belavina, Marinesi, and Tsoukalas say this reduces the efficiency of crowdfunding platforms for both entrepreneurs and backers. Funders are wary of having their money misused with little recourse if entrepreneurs misbehave or fall short of promises. Kickstarter acknowledges this on its website: “Is a 9 percent failure rate reasonable for a community of people trying to bring creative projects to life? We think so, but we also understand that the risk of failure may deter some people from participating.”

The researchers find that more intervention would reassure project backers. One option would be to have crowdfunding platforms test products themselves, but the researchers acknowledge that doing so for every product would be expensive and time-consuming. 

Instead, they propose a two-step verification system. Once entrepreneurs exceed the all-or-nothing threshold, the platform would hold the money raised above the target in escrow until the product is released. A survey of backers would determine whether entrepreneurs delivered a product equal to or better than promised. If the survey results show that the product is deficient, an in-house testing team from the crowdfunding platform would follow up with an objective assessment. If both the survey results and the in-house tests find that entrepreneurs failed to deliver on their claims, the funds held in escrow would be used to refund backers. 

This verification process could make backers more comfortable with pledging their money, improving the crowdfunding experience for everyone.