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SEP. 16, 2022

Where Did My Money Go?

How can a company finance its operations? The answer to this question used to be trivial: a company can issue shares, which entitle shareholders to assets and profits of the company, or it can issue debt, which the company will have to reimburse in the future, together with the interests, otherwise bondholders can claim the company’s assets. Both financing means involve a claim on the assets of the company and some strict rules the company has to comply with.
Nowadays, these traditional financing means are accompanied by other, innovative ones, sometimes involving nothing more than a vague promise and little consequences if the promise is not maintained.

Crowdfunding is one such example. Crowdfunding involves a project creator, who asks for funds to complete a project, and a multitude of backers who pledge money for that project. If the amount pledged reaches a pre-determined threshold, the money is transferred from the backers to the creator, and the backers receive a reward promised in the funding campaign (usually the product funded). Crowdfunding was initially introduced to fund projects with artistic content or projects aimed at improving the quality of life. Now, it is also used by profit-oriented companies to finance new projects. In 2021, Kickstarter, the largest crowdfunding company, collected around USD 800m in total for the project on its platform. Backing a project on a crowdfunding platform constitutes no equity or debt capital subscription (per their terms of use). The backer is not fully entitled to the reward promised even if the project is successfully funded, i.e., the backer is not purchasing the reward. Given these conditions, the creator has only its reputation at stake. Looking at crowdfunding through the lenses of traditional finance, we can see that it has a delinquency rate (the percentage of project rewards not delivered on time) of 75%, it has a default probability (the ratio of fully funded projects that failed) of 9%, the same as a B-rated bond, and a recovery rate (the percentage of reimbursed pledges of failed projects) of 13%. Lawsuits are technically possible, but given the low amount given by the backers, they are just not worth it. Recently, a project initiated by an established board game company received funds for more than USD 1m but failed to deliver the promised game miniatures. To avoid the project failure, they resorted to a funding campaign on a charity website. Fortunately, this despicable plan failed.

Some companies consider crowdfunding a way to raise capital, but it is by no means an investment. At most, it could be a terrible investment opportunity if we look at the default rate and at the amount of protection the backer receives.

Should you back a crowdfunding project? Sure, but remember, this is by no means an investment.

We thank you for the continued support.

The FAM team