The Promise of Reward Crowdfunding

Abstract: We study reward crowdfunding, the fastest growing segment of the crowdfunding market, where, instead of a debt or equity contract, fund providers are promised some good or service in the future in exchange for their contribution to the funding of the investment project under a contract that does not penalise the creator’s failure to deliver. The existing economic and legal literature is puzzled by the platforms use of this seemingly inefficient contract where a standard pre-sale contract would appear to work better. Counter intuitively, we prove that the no-penalty contract is the optimal contract between creators of unknown talent and early adopters of their products. We show that far from being an inefficiency, the no-penalty contract is a contractual innovation specially designed for talent discovery. Traditional pre-sale contracts penalise the creators in case of non delivery, which reduces the risk of strategic non-delivery and facilitates funding. However, we show that penalties distort the signal on the creator’s ability that the market can infer from a successful crowdfunding campaign in a way that reduces the potential for talent discovery and therefore are sub-optimal in this context. Interestingly, neither intangibles nor demand uncertainty -which are considered key aspects of reward crowdfunding- are driving this result. Nevertheless, their presence facilitates funding under the no-penalty contract. Our analysis has important policy implications on how backers should be protected. Standard measures of consumer or investor protection may be counterproductive.