In the Handbook of Entrepreneurial Finance (Oxford University Press), Armin Schwienbacher and Benjamin Larralde discuss crowdfunding as an alternative way of financing projects, with a focus on small, entrepreneurial ventures. They conclude with recommendations for entrepreneurs seeking to make use of crowdfunding and with suggestions for researchers about yet unexplored avenues of research.

An inherent problem that entrepreneurs face at the very beginning of their entrepreneurial initiative is to attract outside capital, given the lack of collateral and sufficient cash flows and the presence of significant information asymmetry with investors (Cosh et al., 2009). While different investors exist for larger amounts of capital such as VC funds and banks, entrepreneurial initiatives that require much smaller amounts to start with need to rely on friends and family or own savings. They then also make extensive use of bootstrapping techniques to mitigate their financial constraints (Bhidé, 1992; Winborg and Landstrom, 2001; Ebben and Johnson, 2006), by boosting their short-term profits.

More recently, some entrepreneurs have started to rely on the Internet to directly seek financial help from the general public (the “crowd”) instead of approaching financial investors such as business angels, banks or venture capital funds (Kleemann et al., 2008; Lambert and Schwienbacher, 2010). This technique, called “crowdfunding”, has made possible to seek capital for project-specific investments as well as for starting up new ventures. A prominent example is Trampoline Systems, a UK-based software company that intends to raise £ 1 million through crowdfunding. A first tranche was successfully raised at the end of 2009, with the remaining to be completed in 2010 through three follow-up tranches. To our knowledge this is the largest amount ever raised by a single venture through crowdfunding. It shows that crowdfunding may potentially be a mean to raise funds not only for small projects but also for high-growth startups that are typically financed by business angels and even venture capital funds. Whether it will become a meaningful alternative to angel finance and venture capital still needs to be seen. However, Trampoline Systems has shown that it is possible. While this is certainly an exception in terms of amounts targeted, crowdfunding has been used already by many other startup companies to raise smaller amounts of money for their initial stage.

Based on [our] study and analysis, it would seem fairly relevant to give these few pieces of advice to potential crowdfunders:

• Know how to efficiently communicate with Web 2.0, or at least know people that do: the more communication around the project you get, the better;

• Use your network as extensively as possible: communication from people that have faith in your project is way more effective than formal communication;

• Use information asymmetry at your advantage: make the project look fancy but have barriers make it look ugly to non-serious investors;

• Know what skills your company could benefit from, and look for these skills in your potential investors;

• Motivate your shareholders to be active participants in your company, by creating the adequate platform and showing them how valuable their help is;

• Know the laws you are working under. Make sure using crowdfunding will not make you an outlaw.

In this article, we discussed when it makes sense for small entrepreneurial ventures to use crowdfunding rather than another source of finance. Some main characteristics of ventures emerged:

• They need to raise a reasonably low amount of capital that would accommodate a relatively small number of investors. First because some legal forms have limitations in respect to that, and second because managing too big groups can prove to be difficult, even with new technologies. There are however a few cases that have shown how to circumvent many of these problems.

• They have an interesting project to offer to prospects, in particular something innovative. Indeed, since crowdfunders are not only rent-seekers, they also need to be interested in the project, often ready to become an active investor in decision making.

• They need to be willing to extend their skill set, or at least welcome other people’s opinions. The reason for this is that, once again, crowdfunders seek projects where they can participate and be useful. This could be an advantage to anybody.

• They need to know how to work the controls of Web 2.0, because the whole process goes through the interactive Internet, from communicating the project to managing shareholders. All of this could be done without the web, but at a considerably higher cost in time, money and efficiency.

Consequently, and mainly because of the first characteristic, crowdfunding is just adapted to small ventures. Bigger ones would be hindered with the cap in associates. Some companies have however circumvented this problem, like Trampoline Systems. Others adopt different organizational structures such as cooperatives or are based on membership. Moreover, not all small ventures can access it, only innovative ones that plan to grow big. Finally, big ventures might not be able to satisfy shareholders in their need for participation, so that excludes them too.

This paper has studied the emergence of a new kind of business funding, the crowdfunding. It has been argued that funding was particularly difficult to obtain for small businesses in respect of their size and lack of available historical data creating information asymmetry for potential investors. Hence, traditional financing methods like bank loans, business angels or VCs are out of reach for these small companies. Moreover, bootstrapping does not allow businesses to grow fast due to its focus on cash generation, often at the expense of maximizing value creation. As a result, crowdfunding can become a viable fundraising method obtainable for small entrepreneurial companies or project-based initiatives.

Our analysis of crowdfunding practices provides avenues for future research. One urgent question is the relation with intellectual property rights. Entrepreneurs making use of crowdfunding will need to disclose some of their ideas to the crowd well in advance, creating risks of idea stealing due to the fact that potentially valuable information is put into the public domain. Does this deter financially constrained entrepreneurs from tapping the crowd?

Another interesting question concerns the informational content for entrepreneurs for obtaining the crowd committing capital. To which extent does this affect the precision about potential demand that the entrepreneurs may receive for his product? Moreover, which remuneration scheme for the crowd generates the most information about potential demand? As pointed in above, each remuneration scheme may generate different forms of information and may vary in terms of degree of credibility of the signal. While investors signal interest in the product if the investor is promised a free copy of the product only, letting investors participate the voting process of certain product characteristics may yield feedback on the market sentiment in general. Indeed, in the latter case, investors do not need to be consumers. This raises questions about the optimal remuneration and participation scheme to offer to the crowd to optimize informational content of the crowdfunding process.

The full essay can be read here.

Armin Schwienbacher is professor of finance at the Université Lille Nord de France, SKEMA Business School (France), and research fellow at the University of Amsterdam Business School (the Netherlands). He obtained his PhD in finance at the University of Namur (Belgium). His dissertation focused on exit strategies of venture capitalists. In 2001-2002, he was a visiting scholar at the Haas School of Business, UC Berkeley (USA). He teaches courses in corporate finance and entrepreneurial finance at the master, MBA and executive levels. He has presented his research on venture capital and various other topics in corporate finance at numerous universities, financial institutions and international conferences, and his work has been published in various international academic journals, including Journal of Financial Intermediation, Economic Journal, Journal of Banking and Finance, Entrepreneurship Theory and Practice, Journal of Business Venturing and Financial Management.

Benjamin Larralde is a Master student specialized in Entrepreneurship. He graduated in Business Studies from the University of Amsterdam (The Netherlands) in 2009, where he studied the topic of crowdfunding for startups for his master thesis. He is currently following another year-long Master degree at the University of Luxembourg (Luxembourg) in order to acquire deeper knowledge in all areas of Entrepreneurship. In the meantime, he is also launching a French platform allowing all creatives to leverage the power of the crowd in order to promote and fund their projects.