The Promise of Reward Crowdfunding

Reward crowdfunding is fundamentally different from both debt and equity crowdfunding because the provider of funds does not buy a financial security. But it is also different from charity since, in exchange for the money given, the provider of funds is promised some good or service in the future. Depending on the money provided, the promise can range from a promotional T-shirt to a full unit of the good or service that is being funded. Although this may seem similar to a standard pre-sale contract, there is also an important difference. In reward crowdfunding the promise to deliver does not include any compensation whatsoever if the promise is not kept.

At first sight this contractual arrangement seems to make funding very difficult. The lack of reputation of the creators means that trust cannot substitute for formal penalties and backers should expect the creator to behave in an opportunistic manner and not deliver the good. Nevertheless, when we look at the numbers, we find that the RC market is thriving and a vast majority of creators deliver on their promises. This poses a puzzle for understanding (and regulating) the reward crowdfunding market.

In this paper we offer a solution to this puzzle by arguing that the RC market should be understood and regulated as a market for talent discovery rather than a market for funding. We show that the “no-penalty” contract used in RC is in fact the optimal contract between a creator of unknown talent, who wants to be discovered by the wider market as highly talented, and early adopters of the product.

We think of RC as a first stage where a creator is discovered to be talented if early adopters support his campaign. There is a second stage of production where, if the creator was successful in the RC campaign, he can capitalize on the discovery of his talent by selling to late adopters and benefitting from goodwill generated in the delivery to the early adopters. Introducing penalties for non-delivery in the crowdfunding stage makes funding easier because penalties induce a higher probability of delivery. But, the higher delivery rate for creators makes the information on the creator’s talent that the funding provides to the market a weaker signal on talent. This, in turn, reduces the chance of "being discovered" and accessing second stage benefits.

Our analysis contributes to understanding RC by showing that the “no- penalty” contract is a contractual innovation suitable for talent discovery. This conclusion has important policy implications because it calls for the RC contract to be exempted from the application of consumer protection rules that impose warranties upon the seller for product failur