Crowdfunding for Financing Wearable Technologies
Fehmi Tanrisever
Faculty of Business Administration, Bilkent
University, 06800 Ankara, Turkey,
tanrisever@bilkent.edu.tr
Karen-Ann Wismans - Voorbraak
Koninklijke Ahold N.V., 5600BG Eindhoven, The
Netherlands,
karen-ann.voorbraak@ahold.com
Abstract
We explore electronic crowdfunding platforms as
a means of receiving money and other resources by
an entrepreneur from many parties for financing
wearable technology project. The electronic platform
determines the cost of funding for the entrepreneur
and the return investors will receive per period. This
research aims to develop a framework to understand
and evaluate the quantitative and qualitative
implications of various crowdfunding platforms for
the entrepreneur and his investment decisions in
wearable technologies. We consider a debt financing
based platform and examine its operational
implications on the entrepreneur’s decisions. In
addition, we identify the incentive problems that
occur in these models.
1. Introduction
After the recent financial crises, banks have
developed a reluctance to provide financing to
entrepreneurs. The banks are even more reluctant to
finance wearable technology projects due to the high
market and technology risks associated with them. In
order to overcome this problem, entrepreneurs are
seeking alternative ways to obtain funding. As a
result, crowdfunding is becoming increasingly
popular as a means of new venture financing
especially for high risk wearable technologies.
For example recently, doppel (a performance-
enhancing wearable technology) managed to
successfully raise more than £ 110.000 from 820
backers through crowdfunding. Similarly, PUGZ
(world's smallest wireless earbuds charged through
phone) has already raised $300.000 through the
Kickstarter. As of September 2015, there are 33
wearables projects actively raising funds on
Kickstarter through crowdfunding. In general,
crowdfunding is viewed as a common financing
mechanism to finance high risk wearable technology
projects.
Crowdfunding is not new; it has been the
backbone of the American political system for a long
time [1, 2]. According to [3], raising funds by tapping
general public is the key element of crowdfunding.
The idea of crowdfunding is to obtain funding from a
large audience, where each individual provides a
small amount, instead of raising the money from a
very small group of sophisticated investors.
Entrepreneurs are not only motivated to use
crowdfunding for obtaining funding; they also use it
for acquiring information [4]. Hence, crowdfunding
can be employed as a way of promoting the
company, to support user-based improvement, or as a
way for the producer to be better informed about the
preferences of the consumer. In that sense, it is an
excellent tool for co-creation, in which both firms
and active customers create value through new forms
of interaction, service and learning mechanisms. The
meaning of value and the process of value creation
are rapidly shifting from a product- and firm-centric
view to personalized consumer experiences [5]. This
is in line with [3], who focus specifically on
crowdfunding and state that investors do not only
participate in crowdfunding projects because they
have extrinsic motivations (monetary reward), but
they also have intrinsic motivations (related to the
pleasure or fun of doing the particular task i.e.
investing). In this research, crowdfunding is defined
as follows:
“Crowdfunding is the process of one party
requesting and receiving money and other resources
from many parties for financing a project, in
exchange for a monetary or non-monetary return or
for a charitable reason.”
More specifically, [1] evaluates three typical
examples of crowdfunding to explain the concept:
peer-to-peer micro lending websites, funding art
(books, music, etc.) and funding starting companies.
The first example is peer-to-peer micro lending
websites like Kiva, where people can directly lend
money to small businesses in the Third World. Kiva
is a platform that uses the Internet to connect small
businesses in the Third World with philanthropically
2016 49th Hawaii International Conference on System Sciences
1530-1605/16 $31.00 © 2016 IEEE
DOI 10.1109/HICSS.2016.227
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minded lenders in the First World. Second, websites
like Sellaband and TenPages are set up to support
upcoming artists or writers by providing funding for
the production of an album or publication of a book.
Third, the crowd can fund a whole company or
project executed by an entrepreneur. Entrepreneurs
obtain money from the crowd to fund a concrete
project with financial needs, via websites like
Kickstarter.
This research will focus on the third type of
crowdfunding: funding new ventures. [3] consider
crowdfunding as an interesting alternative for
traditional financing methods like debt and equity
financing. This research will elaborate on this
observation. However, crowdfunding may be offered
in a debt or equity structure itself.
In crowdfunding, the entrepreneur makes an open
call for funding a new venture or other project on an
electronic platform. The entrepreneur offers the
investors a return on their investment, which may be
both a monetary return and/or a non-monetary return
(“in-kind”). He sets the return beforehand. The
monetary return depends on the revenues of the
venture and is constrained by a minimum of zero and
a particular maximum value. The in-kind reward
depends on the product or service that the
entrepreneur offers, like a free sample of the product.
In addition to the obligation of paying the investor a
return, the entrepreneur is compulsory to inform the
investor about his progression and financial
statements.
The second stakeholder is the group of investors.
In the Netherlands, the investor is by law allowed to
invest an amount between €10 and €5,000 per
venture, and in total not more than €40,000, allocated
over a maximum of 100 ventures.
Third, the platform plays a central role. The
platform facilitates the crowdfunding process by
bringing together entrepreneurs and investors and
assisting in the conclusion of an agreement between
investor and entrepreneur. The platform also assists
the entrepreneur in the fulfillment of his contractual
obligations and coordinates the cash flow from
investor to entrepreneur via a blocked bank account.
The crowdfunding process can been divided in
three phases: the pre-crowdfunding-period, the
crowdfunding-period, and the post-crowdfunding
period. In the pre-crowdfunding-period, the platform
screens entrepreneurs, they both sign a contract and
together they determine the variables that define the
financial structure.
Subsequently, the crowdfunding period starts.
During the crowdfunding phase, investors pay an
amount between €10 and €5,000 into a third party
account. Crowdfunding platforms typically work
with a minimum pledge: when the entrepreneur
attains a threshold amount, he obtains his money,
otherwise he does not. All payments are voided
unless a minimal amount is reached before some
deadline. If the total amount that is paid by investors
is smaller than the amount required by the
entrepreneur as determined beforehand, investors
receive their investment back, minus transaction
costs. On the other hand, if the entrepreneur has
collected the threshold amount, he receives the
amount minus a success fee. As a result, he sets up
his business and the post-crowdfunding period
begins. Within this phase, the entrepreneur yearly
pays a particular return to the investors, which is
based on yearly revenues and constrained by a pre-
defined maximum.
Along the crowdfunding process, three important
decision making points for the platform can be
identified. First, the platform needs to decide which
entrepreneurs to accept on the platform and which
not. However, this decision is affected to a large
extent by legal restrictions. The platform is not
allowed to select entrepreneurs, because they are
legally not allowed to provide investors with advice.
However, to prevent swindlers from getting access to
the platform, the platform has drawn up several
objective criteria, which should be met by the
entrepreneur. The entrepreneur should for instance be
able to open a business bank account.
Second, the platform limits the crowdfunding
period and determines the exact duration of this
period.
Third the platform specifies the financial structure,
i.e., the return investors will receive per time period.
This research aims to develop a quantitative
framework to understand and evaluate the
implications of various crowdfunding models for the
entrepreneur and investors. A detailed understanding
of crowdfunding is crucial for designing the
crowdfunding process in an optimal way. This
research will mainly focus on the financial structure
once the entrepreneur has collected his money, which
determines the financial return to the investor. An
optimal financial structure is essential in order to
keep all three stakeholders involved in the long term.
Insight in the various forms of financial models is of
main importance for a crowdfunding platform that
needs to choose for a particular financial model.
Besides, this knowledge will provide the entrepreneur
with understanding of the consequences of choosing
a particular crowdfunding platform.
2. Literature Review
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Crowdfunding finds its roots in crowdsourcing (1,
6, 7] the raise of crowdsourcing explains the
popularity of crowdfunding. Crowdsourcing is the
general phenomenon in which firms outsource tasks
that are traditionally performed by their employees to
people who use their own time to complete these
tasks. Hence, people use crowdsourcing to obtain
ideas, feedback and solutions from the “crowd”. The
crowd is usually but not necessarily reached through
the Internet or social media. Jeff Howe in June 2006
first mentioned the word “crowdsourcing” in Wired
Magazine. He defines crowdsourcing as follows.
“Crowdsourcing is the act of a company or
institution taking a job traditionally performed by a
designated agent (usually an employee) and
outsourcing it to an undefined, generally large group
of people in the form of an open call.”
[1] states that crowdsourcing, and thus also
crowdfunding, has emerged for four reasons. (1) As a
result of the specialization of jobs, private individuals
are interested in contributing to economic production
in their spare time to do something different for a
change or because they are willing to share their
knowledge. (2) Dividing an overwhelming task into
small enough chunks makes completing it not only
feasible, but fun. See for example the open source
software trend in the software industry (3) Increasing
accessibility of information. (4) Emergence of online
communities in which the online population is
organized. The Internet allows for communication
between amateurs and professionals. Where once
professionals were in power, now a self-organizing
community of amateurs takes on a large extent of the
labor.
These four reasons seem to apply to
crowdfunding as well. Concerning the second reason,
the small chunks can be compared to the small
amounts that investors provide individually. In
addition, [3] state that the risk taken by investors
might be smaller than in traditional venture financing
methods, because a member of the crowd may
become a consumer once the product has been
brought to the market. Besides the investors have an
incentive to spread the information about the product
if they participate in the profit of the venture; they
benefit when their network buys the product. As a
result, crowdfunding may be used for e-marketing as
well.
Other authors also endorse the importance of
online communities. [8] show that social ties provide
an important mechanism through which information
asymmetry is overcome in venture finance in general.
[9] identifies crowdfunding as an approach used to
stream joined good will efforts of people; the option
that community members have to invite each other
for giving funding is an important trigger to donate.
[10] model the importance of peer effects on the
contributions in crowdfunding. They claim that the
number of investors that has already invested is an
indication of the probability of success for potential
investors.
In conclusion, crowdfunding seems to be a subset
of the more general concept of crowdsourcing.
However, practically, crowdfunding is more difficult
to implement because of various legal, technical and
social complexities [6, 3]. Important legal limitations
occur, if it involves the offering of equity to the
crowd, because making a widespread solicitation for
equity offering is limited to publicly listed equity. As
a result of legal limitations, the crowdfunding
participation is often structured in the form of making
the participating crowd a member instead of a
shareholder. Second, problems may be caused by
information asymmetry, a topic that will be evaluated
later on. Investors are not specialists and thus have
access to less information about the industry, past
performance of the entrepreneur and many other
pieces of relevant information. Idea stealing may
further be of concern, since the entrepreneur needs to
disclose appropriate information to a wider audience
than under traditional forms of fundraising. On the
contrary, other information problems that exist in
traditional venture finance are solved for
crowdfunding.
Not much research has been executed on
modeling crowdfunding in particular. However,
attempts of modeling crowdsourcing and
crowdfunding are discussed subsequently. Several
models have been developed to illustrate
crowdsourcing, both with risky return [10,11,12,13]
and guaranteed return [14]. When comparing these
models to crowdfunding, the risky return models
seem to be more applicable, because the investors
may not always get repaid their money. [10] and [11]
have modeled crowdsourcing as an auction, but this
does not seem to be a useful instrument because the
return provided to investors by crowdfunding is
unknown in advance. The return does not only
depend on the investor’s own efforts but also on
revenues; the efforts of the entrepreneur.
[10] and [11] have used game theoretic tools for
modeling crowdsourcing. Furthermore, [6] has used
those tools for modeling crowdfunding as well. He
has developed a model in which interdependent
agents operate in a dynamic, discrete setting.
Potential investors decide whether to invest in
passive investment, active investment, donation or
whether they should wait for the next period.
Moreover, he approaches the topic from investor’s
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perspective and focuses on the process of money
collection: earlier defined the crowdfunding period.
In addition, [4] identify a number of issues related
to crowdfunding that are worth studying from an
industrial organization perspective. Besides, they
propose some preliminary efforts towards modeling
crowdfunding. In their model, they associate
crowdfunding with pre-ordering and price
discrimination and they identify crowdfunding as an
entrepreneur’s attempt to inform consumers of their
product’s value. The trade-off that is explored is the
following: with respect to external funding,
crowdfunding has the disadvantage of delaying profit
by one period and the advantage of offering an
improved product to some consumers. In contrast,
one would expect that investors invest mainly for
receiving financial return and for the fun of being
involved, and not especially for improving the final
product.
In conclusion, there is a gap in literature in terms
of a modeling framework to provide precise
assessment of the post-crowdfunding period in
particular.
3. Methodology
In this chapter, the methodology and terminology
are introduced. Several assumptions that are
applicable to the framework are described and
justified below.
Assumption 1: The venture is completely financed by
crowdfunding.
The venture is completely financed by debt-based
crowdfunding: no other variants are possible.
Besides, the entrepreneur does not have other sources
of funding.
Assumption 2: The fixed startup costs are zero.
For simplicity, fixed startup costs are normalized
to zero. However, the results trivially extend to the
case with fixed startup costs lager than zero.
Assumption 3: No taxes.
As stated earlier, in the debt case the entrepreneur
may have tax benefits on interest paid. Other authors,
like [15], do consider tax benefits of debt on
production decisions. However, tax is not a main
issue in this research, and including them will make it
unnecessarily complicated.
Assumption 4: The only variable that the
entrepreneur can affect is the production quantity.
At the beginning of each period, the entrepreneur
determines which quantity to produce, while
taking into account forecasted demand as market size
and the production costs per unit . This is the only
decision that the entrepreneur makes in the models.
Although in practice the entrepreneur can engage in a
variety of activities, which generate profit and costs,
like choices about markets, organization and
innovation [15], those choices will not be taken into
account.
Assumption 5: The price of the product is assumed to
be defined by a linear inverse demand function of the
entrepreneur’s product [17].
The price of the product is defined by a linear
inverse demand function:
in which represents the market size [17]. To
incorporate the implications of stochastic demand in
the model, a demand shock is introduced in each
period , which likewise also affects the price. The
demand shock has a normally distributed probability
density function , with mean and variance ,
and cumulative distribution function . The
demand shocks occur by the end of each time period.
Assumption 6: The only risk that the entrepreneur
faces is demand risk.
Although the entrepreneur may also experience
technical uncertainty or market uncertainty [18], only
demand risk is taken into account because the models
focus on operational decisions. The other
uncertainties are less important for the scope of this
research.
We consider a two-period model and by the end
of each period, the entrepreneur realizes revenues
from sales. The revenues made after each period are
described by:
As a result, subtracting the production costs from
revenues results in the profit in period , given by
:
This profit, however, does not take into account
the costs of obtaining funding yet. The final profit for
the entrepreneur is affected by those costs. The costs
of funding differ per model, and after subtracting
those costs, the entrepreneur makes profit . We
aim to formulate a model that can be used to find the
optimal production quantity that maximizes
expected profit for the entrepreneur. The two period
model is solved by backwards induction. Hence, the
second period optimal production quantity is
determined first by solving a simple optimization
problem. Using this information, one can determine
what amount to produce in the first period.
Assumption 7: The entrepreneur does not have any
competitors.
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In addition, it is assumed that the entrepreneur
holds a monopoly position in both periods. This
seems reasonable, as the entrepreneur identifies and
initially exploits an opportunity [18]. As a result, the
optimal quantity to produce in the second period is
called the monopoly quantity. However, the model
can be extended with the occurrence of competition.
We build on a model developed by [19]. We start
from their two period model with stochastic demand,
and aim to formulate a model that can be used to find
the optimal production quantity that maximizes
expected profit for the entrepreneur in the debt case.
The entrepreneur needs to make debt payments; he
pays off the debt with a constant positive interest rate
. He should generate a pre-specified level of profit
from its operations during the first period to be able
to repay his debt and to ensure survival into the
second period. Therefore a probabilistic survival
constraint is introduced. In the second period, the
entrepreneur obtains an additional loan to continue
production. In their model, [19] showed that
entrepreneurs can respond to bankruptcy risk by
creating an operational hedge with its production
decisions. For instance, he may produce less than the
monopoly quantity in the first period to avoid
bankruptcy (underproduction).
The models are maturity based: the entrepreneur
pays to investors after a certain time period, and after
both periods he has no obligations anymore, no
matter how much has been paid. However, also
income-based models are possible, in which the
entrepreneur pays back to investors up to a particular
amount. Nevertheless, those alternatives are not
considered in this research.
Our results provide model-based guidelines for
the financial repayment structure of a crowdfunding
platform. The effect of the following variables is
studied: market size, interest rate, percentage
profit/revenues paid, / threshold after which
entrepreneur starts paying.
3.1. Mathematical Model
As stated earlier, we build on a model developed
by [19]. We start from their two period model with
stochastic demand, and we aim to formulate a model
that can be used to find the optimal production
quantity that maximizes profit for the
entrepreneur in the debt case.
If the entrepreneur chooses for a bank loan, it is
assumed that he gets as much money from the bank
as he needs. In the first period, , the
entrepreneur starts running his business. By the end
of the first period, the entrepreneur makes debt
payments. If the entrepreneur made sufficient
revenues to pay back debt plus an interest rate, he
proceeds to the second period, .
At the beginning of each period, the entrepreneur
determines what quantity he will produce,
according to his forecasted demand and the
production costs per unit . Subsequently, the
entrepreneur receives the amount required for
production from the bank. The price of the product is
defined by a linear inverse demand function:
in which represents the
market size (Varian, 2010). To incorporate the
implications of stochastic demand in the model, a
demand shock is introduced in each period . The
random variable is described by a normally
distributed probability density function , with
mean and variance , and cumulative distribution
function . The demand shocks occur by the end
of each time period. The revenues made after each
period are described by
As a result, profit in period , given by , can be
calculated:
Assumption 4.1: Debt is issued at a constant interest
rate and upon fully paying its previous debt the
entrepreneur can borrow again in the second period
to cover its production cost.
Then, the entrepreneur makes debt payments; he
pays off the debt with positive interest rate . Hence,
the costs of a bank loan for the entrepreneur are given
by in time period .
As a result, profit in period , given by , can be
calculated:
Assumption 4.2: The entrepreneur goes bankrupt
and gets liquidated unless he pays debt and interest
at the end of each period.
The entrepreneur must generate a pre-specified
level of profit from its operations during the first
period to ensure survival into the second period.
Therefore a probabilistic survival constraint is
introduced: the entrepreneur only survives the first
period if . If the entrepreneur defaults, he
goes bankrupt and gets liquidated [16].
According to [19], entrepreneurs can respond to
the bankruptcy risk, which is caused by demand
uncertainty and the probabilistic survival constraint,
by creating an operational hedge with its production
decisions. Here, operational hedging is defined as
employing operational activities to mitigate risk
exposure and reduce disadvantageous risk.
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