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Navigating the Crowdfunding Landscape

Online peer-based fundraising tools have the potential to disrupt traditional investing models, but entrepreneurs and investors must overcome existing cultural and government barriers.

Bottom Line: Online peer-based fundraising tools have the potential to disrupt traditional investing models, but entrepreneurs and investors must overcome existing cultural and government barriers.

In 2012, Eric Migicovsky had an idea. The recent engineering graduate had been trying to drum up investment to develop his concept of a “smartwatch,” a device that could connect to an iPhone or Android and provide athletes with real-time messages, music control, and distance calculations. But Migicovsky could raise only US$375,000 from angel investors — not enough to meet his R&D needs. So he decided to take a different approach, and turned to crowdfunding website Kickstarter. Within 24 hours, people had chipped in to raise the entirety of his $100,000 fundraising goal.  He gathered almost $10.3 million in the next three months to fund the release of the Pebble watch in 2013.

With stories like Migicovsky’s, it’s easy to see why the recent emergence of crowdfunding platforms — which enable Internet users to provide monetary backing to entrepreneurial or philanthropic projects — has been compared to the ascendance of venture capitalists in the 1990s. The World Bank estimates that about 1,000 crowdfunding platforms operate worldwide, and that the global market will be worth $93 billion by 2025. People in more than 175 countries have pledged money to Kickstarter projects alone, proof of the Internet’s ability to connect far-flung startups and investors.

But the factors shaping the impact of crowdfunding on innovative activities go far beyond a well-designed website or a compelling social media campaign. According to a new study by Nir Kshetri at the University of North Carolina at Greensboro, crowdfunding could seriously alter the financial landscape — but entrepreneurs, investors, and stakeholders must understand how cross-cultural social and political practices will shape their ability to exploit this rapidly growing practice.

For one thing, crowdfunding is mostly a U.S. phenomenon. As of 2013, U.S.-based crowdfunding platforms were responsible for 72 percent of the global industry; the U.K. and the rest of Europe trailed far behind. In many economies that boast admirable technological capabilities — including China, India, Japan, and Vietnam — crowdfunding efforts have been met with a tepid response.

The reasons are both institutional and societal, Kshetri suggests. Government regulations (or a lack thereof), financial lending practices, the cultural norms surrounding trusting someone else with your own money, and the role of the Internet in people’s lives all play a part in determining whether crowdfunding will flourish or founder in a given economy. After all, giving money to a foreigner halfway around the world is simply not done in some places. As an investment director at a major firm in Russia put it: “People want to be part of something constructive and have the money to do it. But the level of mutual mistrust here is higher, so crowdfunding will take longer to gain a foothold in Russia.”

Giving money to a foreigner halfway around the world is simply not done in some places.

And because of its grassroots, bottom-up model, crowdfunding has failed to take off in countries where online platforms are rigorously monitored from the top down by authorities or regulators. For example, although government officials in China are keen to promote entrepreneurship, they are equally determined to retain control of the Internet.

Entrepreneurs and investors in Asian economies do have one advantage over their counterparts in Western societies, Kshetri writes: Their extensive social networks, which are fundamental to doing business in the East and derive from a long history of backing smaller business and family firms, should make it relatively easy to incorporate a digital form of moneylending and overcome concerns over fraud. On the other hand, outsiders could find it even harder to crack these markets, at least until regulators relax restrictions and lend some viability and legitimacy to crowdfunding platforms.

Generally speaking, crowdfunding works in regions characterized by high social capital — places where people tend to trust strangers and have a propensity to donate to various causes or projects.

There are, of course, many forms of crowdfunding, which are affected differently by institutional and cultural factors. Some platforms are purely donation-based; others offer some amount of equity to those who contribute. Although many countries don’t allow firms to sell equity stakes online, the U.S. passed the JOBS Act in 2012, which included provisions for small businesses to offer equity to a large number of investors. The legislation also legalized the mass marketing of crowdfunding projects to accredited investors and instructed the SEC to draft rules specifically governing crowdfunding.

Several European countries have followed suit, and last year Japan passed regulations in line with the JOBS Act. And as Kshetri notes, even regulators in strict regimes may not be very concerned by entrepreneurs raising equity online from foreign investors who operate in countries with more advanced laws and protocols regarding crowdfunding.

Reward-based crowdfunding is another popular approach. In this model, contributors are offered nonfinancial incentives — such as autographed merchandise, special editions of products, or early access to new offerings — in exchange for their backing. This market raked in more than $1.4 billion worldwide in 2012, or more than half of the total crowdfunding investment for that year.

Kshetri credits the helpful efforts of trade associations — such as the National Crowdfunding Association in the U.S., formed in advance of the JOBS Act — with driving legislative and policy changes, especially regarding equity- and reward-based models (though these groups probably won’t have the same luck at changing deeply held cultural beliefs or financial practices).

And then there’s technology. Given the global reach of crowdfunding, its growth and usefulness to entrepreneurs depends on the compatibility of payment schemes. For example, the crowdfunding portal Ideame struggled to become the dominant player across Latin America because countries within the region use a variety of currencies and employ different systems to process Internet transactions. As a result, it’s more difficult for people to make cross-border investments, and collaboration between governments is needed to make the industry grow.

As crowdfunding projects become more sophisticated, Kshetri writes, their creators and promoters could improve their prospects by tailoring pitches to match the cultural expectations of potential contributors. For example, U.S.-based crowdfunding projects are typically product oriented, meaning investors expect to have a tangible asset as a result of their backing. Funders in South America, on the other hand, are more likely to support causes or products that benefit society as a whole.

Regardless, demand far exceeds supply in the worldwide finance industry. For example, the World Bank reports that about 2 billion adults in don’t have bank accounts. Could crowdfunding help fill this enormous gap and stimulate new activities among entrepreneurs who lack the access, experience, or cultural support to take advantage of traditional methods? Or will it simply be an alternative for those who already have other options?

Source:Success of Crowd-Based Online Technology in Fundraising: An Institutional Perspective,” by Nir Kshetri (University of North Carolina at Greensboro), Journal of International Management, June 2015, vol. 21, no. 2

Matt Palmquist

Matt Palmquist is a freelance business journalist based in Oakland, Calif.

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