Crowdfunding with Enhanced Reputation Monitoring Mechanism (Fame)

Omid Torabi, Abbas Mirakhor

• Publisher: De Gruyter Oldenbourg
• Year: 2020
• ISBN:
  9783110580167
• Edition: 1
• Topic: Commerce
• Subtopic: Finance

Crowdfunding is increasingly becoming a method of mobilizing project finance ventures, particularly in a sharing economy. Moreover, the element of risk sharing which is found in equity crowdfunding makes up the essence of Islamic finance. However, as with any type of risk-sharing contract, Islamic crowdfunding faces the problem of lack of trust and information asymmetry. The author employs a game theory approach to Islamic crowdfunding as a means to tackle the issue of information asymmetry through a "reputation mechanism" which is touted as one of the latest means of solving information asymmetry in web-based social networks. The primary objective of the reputation mechanism is to enable more efficient transactions in communities where cooperation is compromised by post-contractual opportunism or information asymmetry.

The game theory approach in this study involves two different games: "without Fame" and "with Fame", and it is proposed that a "with Fame" crowdfunding game produces better results. The reputational mechanism in this research was also designed specifically to eliminate any potential moral hazards and minimize information asymmetry. In this study, "Fame" refers to the credibility of every individual within the crowdfunding system. Fame is a form of systematic, measurable and computable (implicit and explicit) reputation, which allows other members of the crowdfunding social network to better learn about the individual and their credibility.

1 Introduction

1.1 What is Crowdfunding?

Crowdfunding is a rapidly growing method of mobilizing financing for projects of varying scale. It can be defined as an investment carried out by a group of individuals (“crowd”) rather than financial institutions. Crowdfunding is a result of direct communication between entrepreneurs and investors on an internet platform, without the involvement of any intermediaries such as banks. In other words, entrepreneurs “tap the crowd” by raising funds directly from the crowd (Schwienbacher and Larralde 2010). In crowdfunding, a large number of individuals each provide a small amount of funding, instead of the traditional method of a very small group of experienced investors providing large amounts of funds (Voorbraak 2011). The term could encompass different types of fundraising such as donations or selling shares of a company (Ahlers et al. 2012). Another interesting feature of crowdfunding which is inherited from crowdsourcing is that the individuals involved in crowdfunding gain the opportunity to play the role of entrepreneur as well. They are also empowered to be involved in the development of new products and invest in projects of their choice (Ordanini et al. 2011).

There are two types of crowd-based investing according to Schwienbacher and Larralde (2010), namely passive investment and active investment. Passive investment offers only returns to investors – with no possibility of becoming actively involved in the business processes, such as through voting rights, while active investment offers investors the opportunity to become actively involved in the business, which is closer to the concept of crowdsourcing.

Crowdfunding investments can be structured as debt or equity financing (Lehner 2013). In recent times, equity-based crowdfunding – in which crowd members become actual shareholders of a company – has become a prominent financing alternative in the start-up scene. It allows shareholders to be more involved with the growth and direction of the business via the provision of specific rights such as the ability to vote, and a proportionate share of the risk and rewards. Since 2009, the volume of funds raised via equity crowdfunding has doubled every year and is expected to increase sharply in the future (Ahlers et al. 2012). The staggering rise in funds raised via this particular method has prompted more start-ups to consider equity crowdfunding as an alternative option in their fundraising repertoire. As an example, an Australian technology start-up sold approximately 10% of its equity on the Australian Small Scale Offerings Board (ASSOB), one of the world’s most popular equity crowdfunding platforms for AU$630,000 (approximately US$645,000) to 23 investors in 2009 (Ahlers et al. 2012). As of 2014, ASSOB has provided more than AU$150 million in equity investments to small and medium-sized enterprises (SMEs).

Non-risk sharing investments, according to Schwienbacher and Larralde (2010), on the other hand, afford lower levels of risk due to collateral and seniority of their claims over equity. This has made some contracts such as Ijarah or lease financing, a popular choice in Islamic banking (Osmani and Abdullah 2010), while the risk-sharing model of Musharakah lags behind as the least-utilized contract in the world. Despite its greater potential for profitability, the limited use of Musharakah can be attributed to a perceived problem of information asymmetry between investors and entrepreneurs, since the two parties do not have access to the same level of information (Myers and Majluf 1984). It is assumed that the entrepreneur will have more reliable information on the true quality of the project compared to its potential investors (Ahlers et al. 2012). This problem arises even before the investor decides to embark on a partnership with the entrepreneur and tends to carry on after an agreement is made. As a solution to overcome this problem, investors use signaling and screening methods to assess business performance and draw up contracts to monitor the activities of the firm (Smith and Smith 2004). There are various methods in which businesses can be screened – either via information on their financial statements or the quality of their team. They can also be assessed through their business environment, i.e., the market in which they operate (Berger and Udell 1998). Credit enhancement instruments such as collateral, guarantees and guardians are also commonly used.

Another more innovative technique involves the use of reputation as a mechanism to reduce the problem of asymmetric information. The internet permits this powerful social dynamism to be specifically measured and controlled through proper engineering of the information systems that mediate online communities. Such automated “feedback mediators” specify who can participate, what type of information is solicited from participants, how it is aggregated and what type of information is made available to them about other community members. Through the proper design of these mediators, mechanism designers can exercise precise control over a number of parameters that are either very difficult or impossible to influence in brick-and-mortar settings (Dellarocas 2015).

Equity-based crowdfunding is empowered by social media communication. For example, with user-generated content as a noteworthy guide for investors, Lehner (2013) suggests interesting possibilities to overcome at least part of the information asymmetry problem. Since it is safe to assume that capital is allocated in a democratic way on a social platform, entrepreneurs are more motivated to be transparent about their plans and activities in order to successfully convince investors to participate (Voorbraak 2011). All in all, the networking theory has already proven to be highly accurate in modeling the flow of resources, opportunities and information in various situations (Dobrow et al. 2011).

The main sources of information in a crowdfunding business model are derived from the internet, social media and blogging. The process of an investor choosing a suitable business to invest in is called matchmaking, which is an individual’s decision to participate in an investment, based upon its perceived legitimacy (Lehner 2013). For this to happen, crowdfunding websites provide some metrics such as total pledge amount of the project, funding ratio, number of investors contributing to the project, and the entrepreneur’s number of social media followers. These metrics influence the potential investor’s decision about the project’s support. For instance, if they observe significant social support for the project at an early stage, they will more likely be motivated to invest in the project. In contrast, if the project does not receive active support in its early stages, it is less likely for investors to support it to the end of the fundraising period (Moisseyev 2013). To affirm this claim, data shows that 82% of unsuccessful projects received less than 20% of target funding in the early stages (Kickstarter Stats 2013). Blogs which also fall under the category of social media (Moisseyev 2013) also help to reduce information asymmetry of a crowdfunding project by making information on the project available on a widely accessible network.

However, the availability of such a ubiquitous platform requires investors to analyze and screen the information that is available in a precise manner, especially via signaling indices, in order to effectively reduce information asymmetry. Ahlers et al. (2012) conducted empirical research on start-up signals that are more likely to entice smaller potential investors into taking part in an equity crowdfunding project by introducing and examining various types of signaling. They are comprised of Basic Information (such as offering information and a detailed company overview), Capital Market Roadmap (financial statements), External Certification (third-party endorsements), Board Experience (measured by the quantity and quality of entrepreneurial talent, including the management team’s education level and qualifications), Risk Level (determined by the forecasts of EBITDA, EBIT, and net earnings, the number of intended financing rounds and the ratio of equity offered), and finally information on the Speed of the Investment. Their results provided strong evidence of the crucial role of signaling, especially with respect to potential risk factors, share of equity offered, and board size and structure. In addition, they found that start-ups with more board members, higher levels of education, and better networks are more likely to have a higher number of investors (Ahlers et al. 2012).

With regard to observing the psychology and motivations of individual crowdfunding investors, Hardy (2013) designed a model to examine the effect of consumer income and the role of producer strategy defined by a provision of incentives to the crowd. Nevertheless, it seems that the behavior of crowdfunders is not yet well understood in these formulation efforts (see Burtch et al. 2012). Their research considers the information on prior contribution behavior, including the amount and timing of other individuals’ contributions as a key factor that can influen...