Jeongmin “Mina” Lee, Christine A. Parlour,
Based on: Review of Financial Studies 35 (2022) 1105–1140 DOI: 10.1093/rfs/hhab058
Crowdfunding is a way to raise money for investment from many small investors, most of whom hope to buy the new products that will be produced. The technologically innovative initial coin offerings (ICOs) are also a type of crowdfunding, with the twist that the digital assets they issue (“tokens”) are easy to trade.
Does crowdfunding improve outcomes when there is already an established industry of traditional financial intermediaries like banks or venture capitalists? Does crowdfunding lead to the same or different types of investments as those funded by traditional intermediaries?
Financial intermediaries value projects based on the cash flows they generate. Most commonly, a financial intermediary compares the investment cost to the stream of profits that an entrepreneur gets from selling the products to consumers. Thus, projects whose cash flows do not justify required investments cannot obtain funding. This process is usually viewed as efficient, consistent with the well-known NPV (net present value) rule.
In contrast to financial intermediaries, consumers also benefit from consuming the product, and the benefit is typically greater than the market price (otherwise they wouldn’t buy it). That is, unless the entrepreneur is a perfectly discrimating monopolist, consumers enjoy a “consumer surplus.” This wedge between the consumption benefit and the dollar price means that there is a range of projects whose total value, including the consumer surplus, exceeds the required investment, even when their cash flows do not. From consumers’ perspectives, these are efficient projects.
Consumers would prefer that these types of projects are funded, but they cannot convince financial intermediaries to fund them. This is because, once the investments are sunk and the output is available on the open market, consumers have no incentive to pay more than the prevailing market price, so the projects still do not generate sufficient cash flows.
Crowdfunding effectively allows consumers to commit to giving up some of their future benefit so that the projects can be undertaken. By funding them directly, they ensure that the projects they value highly get launched and produce output, and, in exchange for funding, they receive claims to future outputs. Here, of course, consumers cannot renege because the money is already spent.
Imagine a penniless entrepreneur, a financial intermediary, and consumers. The entrepreneur has a project, which requires a fixed amount of initial investment. Either the intermediary or consumers can fund the project. If funded, the project produces a stream of output over a long horizon. The output is then sold to consumers in the product market. Only consumers enjoy the output. The entrepreneur and the financial intermediary do not.
There are two key ingredients. First, the entrepreneur has limited market power. This implies that the price of output he can charge in the product market is strictly less than the value consumers enjoy. Second, individual consumers can randomly stop enjoying the output, which means that they have a short time horizon.
The gap between the price of output and consumer value prevents financial intermediaries from funding all projects that are efficient from consumers’ perspectives. Thus, even absent other frictions, financial intermediary funding suffers from inefficient underinvestment. Crowdfunding can improve productive efficiency by filling this gap. The scope, however, is limited due to consumers’ short time horizon, heavily discounting the value of output produced in the future.
This leads to the benefit of opening a resale market for the consumers’ claims, as in the case of ICOs. Consumers who no longer enjoy the output can sell their claims to output to other consumers in the future. With future consumers, however, the same commitment problem as in financial intermediary funding arises. They buy the claims in the resale market after the investment is sunk and are only willing to pay up to the market price for the product. So, the resale market helps but inefficient underinvestment remains.
Figure 1: The rectangle represents the set of all projects that generate more consumption value than investment costs. The triangle at the bottom represents the set of projects that can obtain funding from financial intermediaries. When the entrepreneur’s market power in the product market is weak, financial intermediaries choose to forego many efficient projects. Crowdfunding and the resale market, as in ICOs, improve productive efficiency by funding some of the efficient projects that would not have launched otherwise.
Naturally, consumers could face a free-rider problem: what if everyone simply waits for others to step in? If some consumers can retain their consumer surplus by not funding the project and just buying the product at the market price, would any consumers still want to participate in funding and give up their future surplus? The problem, however, can be overcome in various ways. First, the entrepreneur can offer discounts to initial funders, which is often done in practice. Discounts allow initial funders to retain a minimum surplus so that funding is no worse than waiting. Even with discounts, crowdfunding can improve productive efficiency relative to financial intermediary funding. Second, when the capacity of the project is limited and there is rationing, the entrepreneur can give preferential access in the product market to funders, so they have a greater chance of obtaining the product. Preferential access may be transferred to those who purchase claims from initial funders. Tokens issued in ICOs can be useful for identifying initial funders and the purchasers of their claims.
One interesting issue is speculation, which often accompanies any active markets. With restricted short sales, speculators in the resale market can raise the price of the consumers’ claims. Anticipating a higher price with the speculative premium in the resale market, consumers may be willing to contribute more at the initial funding stage. While speculation is often viewed as harmful, it has nuanced implications in our setting. Speculation can help address inefficient underinvestments, although it can also cause inefficient overinvestment beyond certain levels.
Due to the consumption benefit enjoyed by consumers, cash flows and other observable characteristics of crowdfunded projects may appear to be different from financial intermediary–funded projects. This, however, does not imply that they are socially inefficient, but rather that a full analysis of any crowdfunded projects should include an estimate of the consumption benefit. This potential consumption benefit may be taken into account when evaluating the implications of broadening the access of individual investments under the 2012 U.S. JOBS Act.
Sylvan C. Coleman Chair Professor of Finance
Haas School of Business, University of California, Berkeley
