Economics & Finance

When following the crowd weakens crowdfunding

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A recent study shows that herd-like behaviour could undermine a crowdfunding project, but establishing an all-or-nothing threshold can counteract this effect

Startups often face the challenge of securing funding to scale up their operations. How are they going to get their first bucket of gold? In the modern era, crowdfunding has emerged as an alternative to traditional financing like bank loans or angel investments for its edge to raise funds from a large pool of individuals, while showcasing innovative ideas to a broad audience.

Today, crowdfunding is now a mainstream capital source for entrepreneurs. According to a recent report by Fortune Business Insights, the global crowdfunding market is expected to reach US$3.62 billion by 2030, growing at a compound annual rate of 14.5 per cent.

Comparable with a real-life crowd, economic interactions in crowdfunding platforms normally see investors following others by relying on simple observations to make decisions without pondering their own critical thinking. This phenomenon is called an “information cascade”, which can lead individuals to restrain their true preferences, leading to herd-like behaviour and distorting the perception of project quality. As a result, funded projects attract more backers while unfunded projects struggle to gain traction.

Information cascades can occur in various settings, including financial markets, social media, and consumer behaviour, where individuals are influenced by the actions of others. In crowdfunding, this can result in flawed information gathering as individuals may not contribute their knowledge to the collective process and amplify errors in decision-making, which results in suboptimal outcomes.

The implementation of all-or-nothing thresholds in crowdfunding can improve project feasibility, efficiency and information aggregation.

Professor Xiao Yizhou

To address this issue, a recent study suggests that implementing an all-or-nothing threshold, where the proposer receives all contributions only if the campaign reaches pre-specified funding, can help. This model is an alternative to keep-it-all and partial funding models, where the campaign creator is allowed to retain all or a portion of the funds raised, irrespective of the goal achieved.

“The implementation of all-or-nothing thresholds in crowdfunding can improve project feasibility, efficiency and information aggregation,” says Xiao Yizhou, Associate Professor of the Department of Finance of The Chinese University of Hong Kong (CUHK) Business School.

The real decision-maker

Professor Xiao notes that many projects in the real world can be only implemented after reaching a certain funding goal or threshold. With an all-or-nothing threshold, the project would not take off if the crowdfunding does not reach its goal, and the funds are returned to the supporters, leading to a more efficient allocation of resources.

Professor Xiao, along with Professor Cong Lin from Cornell University, in their study titled Information Cascades and Threshold Implementation: Theory and an Application to Crowdfunding, explain that a crowdfunding campaign begins with a certain number of potential investors whose decisions inspire others. Before making any decisions, investors receive and collect informative signals while observing the actions of preceding investors.

The gatekeepers, who have observed a longer history of preceding supporters can make a more informed decision to influence subsequent supporters.

“Through game theory and economic modelling, our analyses showed that all-or-nothing threshold implementation drastically alters informational environments and economic outcomes,” says Professor Xiao.

As the campaign progresses, reaching the funding threshold becomes dependent on the decision of a supporter whose contribution will bring the total funds to the threshold. These supporters are referred to as “the gatekeepers” by the researchers. Considering this circumstance, people are more eager to contribute with all-or-nothing thresholds as it would lead to “uni-directional cascades”. This occurs when early supporters delegate their key decisions to the gatekeepers, who have observed a longer history of preceding supporters and can make a more informed decision to influence subsequent supporters.

While information cascades refer to the phenomenon of individuals relying their decisions more on observed actions than on their own information, uni-directional cascades specifically describe a sequential pattern of decision-making where individuals are influenced by the actions of those who have made decisions before them.

“Individuals with positive signals will always support because they essentially delegate decisions to the gatekeeper. The gatekeeper is the last one to reach the threshold and the real decision-maker,” says Professor Xiao. “This delegation hedges against mistakenly supporting a bad project because the subsequent gatekeeper makes the contribution decision with better information by observing a longer sequence of previous actions.”

Although people may make emotional decisions in real life, Professor Xiao highlights rational investors tend to send accurate signals they receive to the gatekeeper. Investors or supporters in crowdfunding campaigns can signal each other through their contributions, endorsements, information sharing, engagement with project creators, early support, and the like, which significantly impact the perceptions of potential supporters in the ecosystem.

Positive implications of thresholds

crowdfunding is now a mainstream capital source for entrepreneurs.

The presence of all-or-nothing thresholds in crowdfunding has several positive implications. Firstly, it enhances project feasibility by supporting good projects with high production costs. Without a threshold, the first investor may reject even with a positive signal due to high production costs. However, with a threshold, investors are incentivised to support such projects. Secondly, these thresholds improve project implementation efficiency by ensuring that projects are pursued only when there is strong confidence in their positive quality, which prevents premature or suboptimal implementation.

Furthermore, all-or-nothing thresholds enhance information aggregation, particularly in the context of a large crowd. When investors realise that they are not the sole decision-makers, they become more inclined to support a project. At the same time, they also recognise the responsibility to convey the right signal to the gatekeeper. Therefore, individuals at the back of the sequence possess more knowledge than those at the front, resulting in improved information aggregation.

On the other hand, a higher threshold, albeit less likely to be reached, can achieve a higher contribution price by allowing more individuals to participate in the crowdfunding process. “In general, a larger crowd mitigates the concern about implementation failure and generally permits a higher optimal price,” Professor Xiao says.

Providing insurance to investors

The findings of this research shed light on how crowdfunding projects can be made more successful, particularly by emphasising the crucial design of all-or-nothing thresholds. By implementing all-or-nothing thresholds, the information aggregation, proposal feasibility, and project selection of crowdfunding projects will be improved.


How to Create a Successful Crowdfunding Campaign

Additionally, as the number of investors approaches infinity, project implementation and information aggregation achieve socially efficient levels, even if there are some challenges in getting and sharing information. “Enough investors in the market can kill the information cascades,” Professor Xiao says.

In general, the implementation of thresholds in crowdfunding campaigns offers a promising solution to address the challenges associated with information cascades.

As crowdfunding continues to gain prominence as a capital source, Professor Xiao says that companies can adopt marketing strategies that provide insurance to investors, reassuring them that costs will only be incurred if there is sufficient collective support, “People won’t worry too much if they know they are not the only one to jump in.”