Crowdfunding Heroic Entrepreneurs

Ask Not 

The crowdfunding provisions in the JOBS Act have provided a rich source of material for commentators both for and against the concept. Providing bright eyed innovators with seed capital seems like a good idea, but pushing small investors into dubious schemes with little chance of success is less obviously smart.

In fact the crowdfunding regulations are still being created, so we don’t really know how much investors will be protected from themselves but we know one affected group who do need some help. Step forward the heroically biased entrepreneurs of America. Your country needs you, although you probably need your country more.

Risky Innovators 

The economist Joseph Schumpeter believed that entrepreneurs were the innovative lifeblood of a dynamic economy, perpetually tearing down old certainties and refashioning them in their own image (see: Time for Shiva and Schumpeter). It’s certainly true that innovators are the public face of change, even if the money men often pull the real strings.

The idea that entrepreneurs are bold, risk taking adventurers has more than a smidgen of truth to it, if truth be told. It certainly seems to be the case that they’re not like other people. In particular, they seem to be less risk averse than the norm, and far more confident. On risk aversion, Caliendo, Fossen and Kritikos established that people who choose self-employment, as opposed to those forced into it through loss of direct employment, are far more willing to take risks. 

Confident Innovators

As for overconfidence consider, for instance, Differences between entrepreneurs and managers in large organizations, in which Lowell Busentiz and Lay Barney established that their sample of entrepreneurs were both more overconfident, in terms of generally overestimating their probability of being right, and more prone to the representative heuristic, in respect of over-generalising from non-representative samples, than managers in large organizations (see: Behavioral Finance's Smoking Gun).  

The researchers went on to speculate that it was these biases that inclined people into entrepreneurship anyway, on the grounds that if they stopped and logically analysed their real chances they’d probably not even bother trying. This idea has been confirmed elsewhere, by research indicating that entrepreneurs do tend to be more self-confident and, slightly more worryingly, that there’s a correlation between confidence and business failure: the more confident the aspiring business person is about their abilities the more likely their business is to fail.

Perceptive Entrepreneurs

Quite what’s going in the minds of entrepreneurs that’s different from everyone else is open to question but, oddly, failure doesn’t seem to temper overconfidence in sequential entrepreneurs. One line of thinking suggests that they’re not particularly good at looking at situations from the outside. They’re less objective about decision making, more inclined to believe that their personal experiences generalise to the rest of the world and therefore less likely to consider that they may be wrong. As Pia Arenius and Maria Minnitti put it, in Perceptual Variables and Nascent Entrepreneurship:

“Across all countries and across genders, perceptual variables and, in particular, the perception that individuals have of their own entrepreneurial abilities are very important. Unfortunately, perceptual variables reflect subjective perceptions rather than objective conditions. As a result, they are likely to be biased. There exists some evidence that distortions in perceptions are common among individuals in general, and among entrepreneurs in particular.”

The researchers go on to speculate about how these types of very individualistic biases correlate with industrial policy – the idea that governments should encourage start-ups and entrepreneurship, with the underlying idea that there are deep, bubbling wells of innovation just waiting for the right financial support before springing into life:

“Perceptual factors such as opportunity recognition, knowing other entrepreneurs, and fear of failure, are all characteristics of the individual. They cannot be easily changed by exogenous interventions such as, for example, government policies.” 

Such as, for instance, giving entrepreneurs access to crowdfunding?

Sap Not

Crowdfunding is, roughly speaking, the raising of investment funds from a very large group of people, each of whom provides a small amount. The development of social networks is a powerful enabling mechanism for such mechanisms, offering entrepreneurs the ability to raise capital they’d otherwise struggle to reach, and the crowd the ability to invest early in promising start-ups.

Fairly obviously the founders of the ventures seeking crowdfunding are likely to include a large number of risk seeking, overconfident, perceptually biased entrepreneurs. What, though, of the psychology of the crowdfunders themselves? Presumably they’re desperately looking for the next big thing, and hoping to become mega-rich, the poor deluded saps?

Well, not exactly. In fact the motivation of crowdfunders doesn’t appear to be solely or even largely financial, it seems to be more about social reputation and other non-economic factors, as witnessed by the fact that many of the more successful crowdfunded initiatives are not-for-profits. In addition, the investors in many crowdfunded companies are also its customers, and are additionally motivated to engage with the company. 

It’s A Social Crowd 

As Elizabeth Gerber, Julie Hui and Pei-Yu Kuo find, in Why People Are Motivated to Post and Fund Projects on Crowdfunding Platforms the motivations of funders are many and varied, but not always entirely expected. So, sometimes supporting a venture confirms the individual’s own values, such as people who feel they’re supporting just causes, or who dislike the concept of big finance. Sometimes it’s about seeking rewards, but not in monetary terms – say getting first access to an interesting product or service. Others feel that it’s about engaging in a community in order to create something collaboratively, and strengthening their social ties with others.

Of course, the very popularity of crowdfunding, and the publicity given to it, will likely erode these value-laden motivations, and the development of crowdfunding platforms will increasingly put barriers between funders and entrepreneurs. The introduction of regulation of some kind is inevitable, to try and offer some protection to the legion of ill-informed investors who will doubtless try their hand at some early-stage investment.

Regulating Crowds

This regulation will also be interesting. Keeping it “light-touch” is essential, to keep crowdfunding economic for ventures, which suggests that disclosure of risks will be high on the agenda of mechanisms proposed. As Stephen Choi has noted about disclosure more generally:

“Investors of even seasoned or well-known seasoned issuers may, in fact, lack the ability to handle forward-looking information. While more disclosure into the market may help some investors, the increased information may simply cause others to fall further into the traps of overconfidence and overoptimism.” 

Which would at least align the investor with the entrepreneurs on the end of their funding. Still, while investors have motivations other than pure profit for their small donations to crowdfunded ventures then most obvious objections don’t really apply. But once profit becomes the main driver then crowdfunding becomes an accident waiting to happen.

Coalescing Crowds

Quite how regulators square the circle between a light-touch regime which doesn’t make crowdfunding impossibly expensive for innovators and one that offers some level of protection to investors without worsening their risks will be interesting to observe. The inherent bias in their founders’ psychology suggests that most crowdfunded ventures should fail; it’ll be fascinating to see what actually happens – strange things occur when social networks coalesce, and a socially motivated customer base can do wonders for a new business.

History suggests, of course, that when grass-root ideas are transformed into corporate business logic something important is lost. Applying the strict economic logic of big business to crowdfunding will change it, possibly terminally. An interesting dilemma for those itchy-fingered financiers currently wondering how best to exploit the latest popular meme.

Related articles:

• Time for Shiva and Schumpeter
• 3D Printing is Not Exogenous
• An Age of Miracles and Wonders
• Pulling Up The Intellectual Property Ladder
• Behavioral Anti-Trust: Microsoft to Apple
• Disruption by Digital Wallet: The Sailing Ship Effect Revisited
• From the Railroad to the Internet ... and Back Again
• Nowcasting with Google
• Moats, Unbundled