Crowdfunding: Geography, Social Networks, and the Timing of Investment Decisions

• Author: Ajay Agrawal,Avi Goldfarb,Christian Catalini
• Published date: 01 June 2015
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/jems.12093

Crowdfunding: Geography, Social Networks,

and the Timing of Investment Decisions

AJAY AGRAWAL

Rotman School of Management

University of Toronto

105 St. George St. Toronto, ON M5S 3E6, Canada

CHRISTIAN CATALINI

MIT Sloan School of Management

Massachusetts Institute of Technology

100 Main Street, 02142 Cambridge MA, United States

AVI GOLDFARB

Rotman School of Management

University of Toronto

105 St. George St. Toronto, ON M5S 3E6, Canada

agoldfarb@rotman.utoronto.ca

We examine a crowdfunding platform that connects artists with funders. Although the Internet

reduces many distance-related frictions, local and distant funders exhibit different funding pat-

terns. Local funders appear less responsive to information about the cumulative funds raised by

an artist. However, this distance effect appears to proxy for a social effect: it is largely explained

by funders who likely have an offline social relationship with the artist (“friends and family”).

Yet, this social effect does not persist past the first investment, suggesting that it may be driven

by an activity like search but not monitoring. Thus, although the platform seems to diminish

many distance-sensitive costs, it does not eliminate all of them. These findings provide a deeper

understanding of the abilities and limitations of online markets to facilitate transactions and

convey information between buyers and sellers with varying degrees of social connectedness.

1. Introduction

Crowdfunding provides a method for artists and entrepreneurs to finance their projects,

potentially facilitating gains from trade that would not otherwise occur. It works by

enabling small funding increments (often as low as $5 in nonequity settings) through

social networking platforms that allow funders to communicate with each other as

We thank Pierre Azoulay, Jennifer Brown, Ron Burt, Iain Cockburn, Gary Dushnitsky, Richard Florida, Jeff

Furman, YaelHochberg, Ig Horstmann, Nicola Lacetera, Karim Lakhani, Matt Marx, Ed Roberts, Tim Simcoe,

Scott Stern, Will Strange, Catherine Tucker, Pai-Ling Yin, two anonymous referees,the coeditor, and seminar

participants at MIT, the Roundtable on Engineering and Entrepreneurship Research at Georgia Tech, the

Law and Economics of Digital Markets conference at Northwestern University,Boston University, the Martin

Prosperity Institute, the MIT Open Innovation Conference, NYU, the NBER Summer Institute, Wharton, ZEW,

and the University of Torontofor comments. We thank Liz Lyons, who provided excellent researchassistance.

Wealso thank Johan Vosmeijer and Dagmar Heijmans, cofounders of Sellaband, for their industry insights and

overall cooperation with this study.This research was funded by the Martin Prosperity Institute, the Centre for

Innovation and Entrepreneurship at the Rotman School of Management, the NET Institute (www.netinst.org),

and the Social Sciences and Humanities Research Council of Canada. Errors remain our own.

The copyright line for this article was changed on July 21, 2015 after original online publication.

This is an open access article under the terms of the Creative Commons Attribution License, which permits

use, distribution and reproduction in any medium, provided the original work is properly cited.

C2015 The Authors. Journal of Public Economic Theory Published by Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 2, Summer 2015, 253–274

254 Journal of Economics & Management Strategy

well as with funding recipients. Although small in terms of overall economic activity,

crowdfunding is expanding in the variety of sectors to which it is applied as well as in the

value of overall transactions (Lawton and Marom, 2010). Furthermore, thereis increasing

interest in the potential role it could play in early-stage finance. For example, in April

2012, President Obama signed into law the Jumpstart Our Business Startups (JOBS) Act

with the goal of reducing regulatory restrictions on raising capital for young and small

businesses. While at the time of this writing the implementation of key elements of the

Act, such as legalizing equity investments by nonaccredited investors, still await the

required rules to be set by the Securities and Exchange Commission, many platforms

are already growing exponentially, such as AngelList (which currently only allows for

equity investments by accredited investors) and Kickstarter (which focuses on rewards

for funders and does not allow equity investments).

We examine data fromthe first significant crowdfunding platform, Sellaband. The

platform was dedicated to new musical artists not yet signed to a record label, and

enabled artists to raise capital to finance the recording and production of an album.

The company, headquartered in the Netherlands at the time of our study, allowed for

equity-like crowdfunding (through revenue sharing) for approximately 3 years before

being acquired by a German firm, at which time it was subjected to stricter securities

rules. Weexamine data on every investment transaction on that platform during its first

3 years of operations.1

This new and rapidly evolving form of financing offers insight into a range of inter-

esting questions regarding the early-stage finance of projects and ventures. In Agrawal

et al. (2014), we lay out the key economic features of these platforms, including the

actors (entrepreneurs, funders, platforms) and the incentives and disincentives facing

each in terms of the attractiveness of raising capital through crowdfunding relative to

traditional sources of funding. In this paper, we focus on two specific questions relating

to information and reputation: How do local and distant investment patterns differ?

What might explain those differences?

A long literature suggests that (offline) investments in early-stage ventures tend

to be local due to the importance of reputation and trust, which are especially im-

portant in the absence of regulatory disclosures and oversight, and also because of

distance-sensitive costs associated with early-stage investments, such as identifying op-

portunities, conducting due diligence, and monitoring progress (Tribus, 1970; Florida

and Kenney, 1988; Lerner, 1995; Sohl, 1999; Sorenson and Stuart, 2001; Seasholes and

Zhu, 2005; Nieuwerburgh and Veldkamp, 2009). In the case of offline funding, reputa-

tion and trust are often built through interpersonal interactions which most commonly

occur between colocated individuals.

However, a striking feature of crowdfunding is the great distance between artists

(and other types of entrepreneurs) and many of the people who fund them. In this paper,

we document some of the key challenges of distant investments and explore the mecha-

nisms through which they have been overcome in the context of crowdfunding. We also

speculate on the consequences of these mechanisms for market outcomes. Thus, one

of our objectives is to better understand how crowdfunding platforms might generate

challenges and opportunities for geographically isolated funders and artists or other

entrepreneurs.

1. Although this platform was based on revenue sharing with funders, individuals may have invested for

philanthropic or other reasons besides pecuniary returns. This need not affect the interpretation of our main

results. Weaddress this point in Section 2.1.