A major hindrance to the actualization of a business idea is the lack of capital. A new business venture is usually not attractive to traditional financiers such as banks and venture capitalists. Tapping into online communities of strangers is becoming a new source of capital for investors. This is referred to as crowdfunding. Crowdfunding is an informal form of business financing in which entrepreneurs appeal directly to the public for financial capital to turn innovative ideas into a revenue-generating business (Lehner et al., 2015). An entrepreneur makes an open invitation to the public for the provision of capital either in exchange for a reward or as a donation (Dehling, 2013). In most cases, the entrepreneur appeals through social media or online crowdfunding platforms such as Kickstarter or Indiegogo (Lehner et al., 2015). In recent years, the crowdfunding phenomenon has gained popularity and the amount of money invested has risen exponentially. This method of funding has proved effective for individuals and small businesses. According to Agrawal et al., 2014, the financial capital due to crowdfunding is more appealing to small entrepreneurs as it lacks stringent attached conditions that usually accompany capital from banks or venture capitalists.
Crowdfunding enables risky ventures such as technology or creative ventures which traditional financiers usually avoid to raise capital. An example is the Pebble smartwatch which was unable to raise capital from venture capitalists but went to raise more than $10 million on Kickstarter through crowdfunding (Lehner et al., 2015). Projects with high costs but no guaranteed financial returns such as art projects can only secure funding through crowdfunding. People always seem to make irrational decisions when making financial decisions (Schmitz, 2013). Instead of properly weighing the benefits and cost before making decisions, people usually chose the products that have immediate appeal rather than products that have long-term benefits to them. This is caused by lack of self-control and emotional factors. A branch of economics called behavioral economics analyzes what influences people to make these decisions. In behavior economics, the psychology behind irrational economic decisions is analyzed.
Purpose of the Study
Behavior economics affect decisions made by investors in crowdfunding. These ventures are usually risky, and most of them do not offer financial returns to the investor. It is against rational behavior to invest in crowdfunding. Despite this, many people invest in crowdfunding. This study aims at analyzing the influence of behavioral economics on the successfulness of crowdfunding projects. It analyzes what factors attract investors into a project and how entrepreneurs can make their projects successful on crowdfunding platforms such as Kickstarter. It analyzes the investors on Kickstarter in an effort to understand what factors they consider before investing in a venture. Kickstarter was chosen because of its readily available data.
Hypothesis
The hypothesis of this research paper is: Irrational behavior leads to the success of a crowdfunding venture.
Research Questions
The following research questions were used
What factors influence crowdfunding investor behavior?
How could these identified factors be utilized by project owners to improve project success?
Literature Review
Behavioral economics is the study of the effects of social, cognitive, psychological and emotional factors on peoples economic decisions. Generally, it is the study of how human behavior affects economic decisions. It gives the insight between on how psychology affects economics. Behavior economics enables us to comprehend how people fail to acts in their best interests (Dehling, 2013). It also gives us valuable insight on how people are systematically biased when making decisions especially monetary decisions. A key concept analyzed in behavioral economics is the risk factor. Risk factor describes a persons willingness to participate in a financial event with an uncertain outcome.
The aim of behavioral economics is the integration of how psychologists understand human behavior into economics. It explains how people do not make choices that are in the best interest such as taking drugs and eating junk food. This is caused by peoples limited cognitive abilities and difficulties in exercising self-control (Dehling, 2013). The tendency of people to choose things that have immediate appeal over their long-term interests is examined in behavioral economics. It also suggests how environments can be restructured to enable people to make better decisions.
Behavior economics contrast rational model in traditional economics. In this model, a person weighs cost and benefits carefully before making his choice. A rational person is expected to understand his preference vividly and never deviate from that choice. He has the perfect control that restrains him from impulses that hinder his ability to achieve his long-term goals (Lehner et al., 2015). Traditional economics utilize this model to predict human behavior. Unlike traditional economics, behavioral economics focus on irrational decision-making by an investor. Irrational decisions may be caused by emotional factors. For example, an investor may invest in a company because he has a positive feeling about the company. This may prevent him from considering the financial aspects of the company.
Crowdfunding is defined as the practice of utilizing small amounts of capital from a large group of people to finance a venture or a project (Jalonen, 2014). Crowdfunding uses large networks of people to through crowdfunding websites or social media to connect entrepreneurs and investors. There are three main parties in crowdfunding; the entrepreneur who has the business proposal, the investors to whom the business proposal is presented, and the moderating entity that brings the investors and the entrepreneurs together (Agrawal et al., 2014). In the contemporary world, the moderating entity is either social media or a crowdfunding website. Crowdfunding provides an alternative pool of investors and thus entrepreneurs cannot access capital from traditional investors such as venture capitalists can use it to raise capital.
Crowdfunding enables the entrepreneur to solicit capital from thousands of investors. Anyone with an idea can present it to thousands of potential investors. The crowdfunding concept is strongly influenced by social media, and it uses social media to promote its fundraising projects (Lehner et al., 2015). The use of social media enables the entrepreneur to reach millions of potential investors thus widening his capital base. The projects range from music and arts, software development, developing a new item and creating games. Crowdfunding projects are reward-based. An investor may get a gift or even participate in the product launch.
There are two types of crowdfunding; reward crowdfunding and equity crowdfunding. Reward-based crowdfunding is a form of crowdfunding where the entrepreneur requests small amounts of capital from a large number of investors by promising them rewards that increase the prestige of their donation such as pre-sale of the item to be produced (Jalonen, 2014). Donation-based enables the entrepreneur to retain control of the company while in equity crowdfunding, the investor receives shares in a company in exchange for their pledge. Such investors provide capital in the form of equity.
There two major differences between traditional financing and crowdfunding. First, in crowdfunding, a huge number of investors provide small contributions for a venture over fixed time duration, and second, potential backers can also see the level of support from other investors before committing their investment (Jalonen, 2014). This means that other investor's decisions will be considered by an investor before investing in a venture.
The types of financial reward expected in crowdfunding vary with different crowdfunding communities. Some investors hope to use their financial contribution to acquire equity in new companies while others use crowdfunding as a form of peer-to-peer lending when the expected return is their principle alongside some interest (The European Union, 2015). Crowdfunding is beneficial to both entrepreneurs and the investors. This is because fundraising is done quickly and efficiently and the funds are not accompanied with many obligations except the expectations of delivering what the entrepreneur has promised.
There are more than 500 online platforms for crowdfunding. Kickstarter is one of the most popular. Kickstarter is an online crowdfunding platform based in Brooklyn, New York. The company aims to bring creative projects to life by providing them with an avenue to raise capital. The company backs creative projects in music, film, journalism, comics, food, and technology. Investors in Kickstarter are promised gifts or experiences in exchange for their pledges. A wide variety of products and projects are financed via crowdfunding every year. The motivations of crowdfunding investors vary from those of the traditional investors (Dresner, 2014). While the motivations of traditional investors are usually financial return, for crowdfunding investors, the motivations are usually diverse. Most crowdfunding businesses offer the product they are building as a reward to its financiers instead of equity.
Crowdfunding and Behavior Economics
It is not a rational decision for an investor to finance a venture in crowdfunding. These ventures are very risky, and most of them do not offer a financial return to the investor. Startups have a failure rate of 90% (Patel, 2015). Apart from gambling, no other investment is as risky as crowdfunding startups, at least according to Jalonen (2014). In order to take equity in a startup, one needs to invest a lot of money since the entrepreneur prefers to be accountable to a small group of people. Thus, the entrepreneurs stipulate high minimum contributions from the investor, and this increases the risk factor to the investor.
The investment in a startup is not liquid (Baker & Filbeck, 2013). It is difficult to sell one's shares, and in most situations, the investor is held up with the company until the company succeeds or goes bankrupt. Investors also make investment decisions on startups without adequate assistance from investment experts. Since crowdfunding is a relatively new, there are few experts in this field. Start-ups that request capital have many different aspects that are vital to their success (Jalonen, 2014). Competence of the founding team, the uniqueness of their innovation, competition and environmental factors which may affect the probability of success of the venture are usually unknown to the investor.
Most crowdfunding investors lack adequate business knowledge. They do not fully comprehend the risks associated with businesses and lack in-depth knowledge of product concept, business models, and competition. These investors also use wrong criteria to choose the business to fund. They choose investments that seem idiosyncratic rather than practical. The probability of an investor to crowdfund a venture is determined by the number of other investors who have pledged to fund the venture. According to a study, individual investors are likely to invest in high-profile stocks which have a large number of backers (Vulcan et al., 2015). Exaggerated promises by investors also lure investors to crowdfund the venture. Emotional appeals by investors also attract individual investors.
The herd mentality is common in crowdfunding. Many investors are seeking investment from crowdfunding platforms because they have seen...
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