Crowdfunding, essentially a type of microfinance, has experienced an unprecedented growth over the last few years, becoming an important driver of economic and financial development. Recently, the World Bank has estimated that crowdfunding could reach U.S. $90 billion by 2020, surpassing venture capital and angel capital as a means of financing. While much of this growth has been spurred by lending-based crowdfunding, an interesting phenomenon has been the strong emergence of reward crowdfunding, in which project creators (i.e., entrepreneurs) promise future in-kind rewards in exchange for backer contributions. In reward crowdfunding platforms, project backers represent “hybrid” stakeholders, in between investors and consumers.
The hybrid nature of project backers renders their contractual claims difficult to regulate and enforce in case of contract breach by creators. Reward crowdfunding does not involve the offering of securities and therefore does not fall under the U.S. securities laws or the jurisdiction of the Securities and Exchange Commission (SEC). As such, SEC rules specifically designed for equity crowdfunding do not apply. Reward crowdfunding platforms also disclaim any liability, stating that they act as mere intermediaries. As it is often the case for evolving technologies, the emergence of reward crowdfunding led to a regulatory limbo, in which backers were initially left without much recourse.
A regulatory void is particularly troublesome given the adverse selection and moral hazard problems that characterise these markets. Information asymmetries between creators and backers regarding creator ability and project quality (adverse selection), coupled with backers’ inability to induce creator effort and ensure that pledged funds are not diverted for personal consumption (moral hazard), are in fact inherent to crowdfunding. Project creators may rely on disclosure to signal their ability and project quality. However, the lack of clear regulation and oversight in the early years of reward crowdfunding, the absence of a trustworthy and independent third-party (e.g., an auditor) that certifies the information disclosed by the creator, and the one-time nature of most of these transactions (many creators access these markets only once) may render disclosure not credible. In these markets, in fact, creators can easily engage in “cheap talk.” For example, when they provide voluntary disclosures about the project and themselves with the aim of enticing backers into pledging funds, they can “oversell” the project or, in extreme circumstances, communicate false information in bad faith.
In our recent paper, we examine two main questions. First, does (voluntary) disclosure facilitate contracting in reward crowdfunding, or is it mainly perceived as cheap talk? Second, to what extent does an increase in regulatory oversight enhance the perceived credibility of disclosure?
In our empirical analyses, we first examine the association between disclosure and project funding to gauge the extent of disclosure credibility on the platform. We find that disclosure (measured as either the length of the project’s campaign pitch or the length of the project’s risks and challenges section) exhibits a positive and robust association with pledged amounts and the probability of a project being funded, which suggests that backers take disclosures by creators into account when deciding to make a pledge.
We also examine alternative measures of project success, such as the number of (new and returning) backers and the level of backer engagement measured as the number of comments on a project’s website. The evidence from these tests is also consistent with disclosure playing a stronger role in facilitating contracting between backers and creators in states with stricter consumer protection regulation following the rule change.
Further, we conduct cross-sectional analyses to explore heterogeneity in treatment effects and find that the increase in the perceived credibility of disclosure varies with the magnitude of rewards, as well as across states with court busyness and with degree of confidence in courts. Specifically, the effect of the rule change on the project success-disclosure relation is stronger when litigation risk is likely to be higher, such as when project rewards are larger, when courts have a lower caseload and when confidence in courts is higher.
- This blog post is based on the authors’ paper “Does Consumer Protection Enhance Disclosure Credibility in Reward Crowdfunding?”
- The post gives the views of its authors, not the position of LSE Business Review or the London School of Economics.
- Featured image by methodshop.com, under a CC-BY-SA-2.0 licence
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Stefano Cascino is an assistant professor of accounting at LSE. He received in PhD in accounting from the University of Naples Federico II. His primary research interests include international disclosure regulation, corporate governance and credit markets. His research appears in leading journals and has generated the interests of practitioners and standard setters. He is a member of the editorial board of Accounting and Business Research. He has received funding and research grants from the Institute of Chartered Accountants of Scotland (ICAS) and the European Financial Reporting Advisory Group (EFRAG). For his dedication to teaching, he received in 2012 the LSE Teaching Excellence Award, and the LSE Education Excellence Award in 2016, 2017, and 2018.
Maria Correia is an associate professor of accounting at LSE. She received her PhD in accounting from Stanford University. Before joining the LSE she was an assistant professor of accounting at the London Business School. Her research interests are in the area of default prediction and credit markets, and enforcement and securities litigation. She is the recipient of the Best Paper Award at the 2011 Review of Accounting Studies Conference and her papers are published in leading journals. She is a member of the editorial board of Review of Accounting Studies and European Accounting Review, and an associate editor of Accounting and Business Research.
Ane Tamayo is a professor of accounting at LSE. She received her PhD in finance from Rochester University. Before joining the LSE she was an assistant professor of accounting at the London Business School. Her research interests include the impact of accounting information on capital markets, the role of financial intermediaries, and corporate social responsibility. Her research appears in leading journals. She is an editor of Journal of Business Finance & Accounting, and an associate editor of European Accounting Review. She is the recipient of a European Corporate Governance Institute (ECGI) prize for research into social capital, trust and firm performance during the financial crisis.