Choosing crowdfunding : factors influencing the choice of start-up financing

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Choosing Crowdfunding

Factors Influencing the Choice of Start-up Financing

Master Thesis

Fredric Gertsen | 0463515 First supervisor: Dr. G.T. Vinig Second supervisor: Dr. W. van der Aa 29-6-2014

University of Amsterdam, Amsterdam Business School Business Studies: Entrepreneurship & Innovation Track

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List of tables and figures

Tables

Table 1 Financing Rounds in the Start-up Cycle (Linde et al., 2000; Schwienbacher & Larralde, 2010) . 4

Table 2 Crowdfunding articles summarized ... 14

Table 3 Expected response rates ... 28

Table 4 Relationship between hypotheses, variables and survey items ... 29

Table 5 Descriptive statistics of the variables group A... 38

Table 6 Descriptive statistics of the variables group B ... 39

Table 7 Correlation matrix dependent and independent variables group A ... 41

Table 8 Correlation matrix dependent and independent variables group B ... 42

Table 9 Results of regression analysis group A ... 43

Table 10 Results of regression analysis group B ... 44

Table 11 Overview of hypotheses - results summary ... 47

Figures

Figure 1 Start-up financing cycle (Gromov, 1995) ... 3

Figure 2 Position of crowdfunding in entrepreneurial finance (Lasrado, 2013) ... 10

Figure 3 Capital structure decision-making process in small firms (Michaelas et al., 1998) ... 19

Figure 4 Conceptual model adjusted from Michaelas et al. (1998) to fit crowdfunding ... 20

Figure 5 How long has your company been active (in years)? (N=231) ... 35

Figure 6 What industry is your company in? (N=231) ... 36

Figure 7 Social media use of sample ... 36

Figure 8 Likelihood of choosing certain forms of crowdfunding ... 37

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Abstract

The recent financial crisis has limited the availability of start-up financing. In this thesis an increasingly popular alternative to the traditional forms of financing is examined: crowdfunding. Whereas much of the academic research so far has focused on the characteristics and needs of funders of crowdfunding campaigns, in this research the focus will be on the entrepreneur. What factors drive the entrepreneur to choose crowdfunding as a means of financing his company? These choice (selection) factors are drawn from academic literature on crowdfunding and fields such as entrepreneurial finance, capital structure decision-making and co-creation. To test if these factors influence the likelihood to choose crowdfunding, a survey is distributed among a group of entrepreneurs. The results of this survey will be used to run two regression models. One model contains all responses by entrepreneurs that have had experience with crowdfunding, and the other contains all responses by entrepreneurs that do not have any experience with crowdfunding. The entrepreneurs were contacted through the Crunchbase database and own interests in companies that are less than four years old and still active, and still in business, currently. The results of this research show that prior financing experience, both crowdfunding experience and experience with other forms of financing, have a positive influence on the likelihood that entrepreneurs use crowdfunding. The protection of intellectual property has a negative effect on the likelihood to use crowdfunding, as has crowdfunding time and costs (more time and higher costs decrease the likelihood to use crowdfunding). The ability of the crowd to add value to the product or service and the number of social media connections both positively affect the likelihood to use crowdfunding. The regression models only explain part of the variability in the dependent variable. To further improve these models several suggestions for further research are made.

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1. Introduction

Since the financial crisis in 2008 it has become more difficult for start-ups to receive financing for their business (Harrison, 2013; Silver, Berggren, & Fili, 2013). Both banks and venture capitalists have decreased the amount of financing available for start-ups. With this increasing difficulty the availability of crowdfunding can be expected to attract a large number of entrepreneurs. Crowdfunding is defined by Belleflamme, Lambert, & Schwienbacher (p.5, 2011) as follows:

“Crowdfunding involves an open call, essentially through the Internet, for the provision of financial resources either in form of donation or in exchange for some form of reward and/or voting rights in order to support initiatives for specific purposes.”

Which factors, however, determine the choice of financing for a start-up? Under which conditions will an entrepreneur choose to use a financing method such as crowdfunding? In entrepreneurial finance literature many articles have been written on an entrepreneur’s choice of new venture financing. Often the distinction has been made between choosing either venture capital financing (equity) or bank financing (debt) (de Bettignies & Brander, 2007; Winton & Yerramilli, 2008). Also the difference between venture capital financing and business angel financing has been described in literature (Fairchild, 2011). With the increasing popularity of crowdfunding as a new means of financing a business, the academic interest in the subject is also growing. However, based on my review of the current literature, no research has been conducted to determine the factors that influence the entrepreneur’s decision to either choose crowdfunding or not. In this study I shall develop a conceptual model examining the factors that influence the entrepreneurial team in their choice of financing. This model will be tested empirically by administering a survey among entrepreneurs that have had some experience with crowdfunding and those that have not had any experience using crowdfunding, either personally, or to fund their business. These two groups will be compared with each other in order to find out whether there are significant differences in the influence of the various factors. The following research question will be answered:

What factors influence the likelihood that an entrepreneur will choose crowdfunding as a means of financing and how do these factors differ if the entrepreneur has already had some experience with this type of financing?

Answering this question is expected to have a significant impact on the research body that currently exists both in entrepreneurial finance and crowdfunding. Crowdfunding currently receives much attention, both in the academic world and with the general public. An empirical study into the motivation of an entrepreneur to choose financing through crowdfunding can shed light on the choices the entrepreneur has to make in financing his venture.

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This study will show various managerial factors that influence the decision to use crowdfunding. The experience entrepreneurs have had with crowdfunding and other forms of financing have an effect on the likelihood to use crowdfunding. The number of social media connections an entrepreneur has and whether the crowd can add value to the entrepreneur’s product or service also have an influence on the choice to use crowdfunding. Interesting to note is that, against expectations, the amount required by the entrepreneur does not seem to have a significant influence on the likelihood to use this method of financing.

The structure of this thesis will be as follows: In the next chapter (2) the literature on entrepreneurial finance and crowdfunding will be used to identify the research gap that currently exists. In chapter 3 the conceptual model will be established and various hypotheses will be stated based on the available literature. In chapter 4 the research method and sample will be discussed. In chapter 5 the main findings from this research will be presented. In chapter 6, drawing from the literature discussed in chapter 3 and the results presented in chapter 5, the research question will be discussed. Finally in chapter 7 conclusions will be drawn. In this last chapter and throughout the discussion, some recommendations for further research will also be suggested.

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2. Theoretical Background

In this chapter I shall describe the current state of literature on entrepreneurial finance. I shall start by examining the current forms of financing available to start-ups, by moving through the various start-up stages. Next, I shall further explore the current difficulties for start-ups in receiving financing. Finally, crowdfunding and crowdfinancing are introduced and the role these forms of financing can play in start-up financing is explored. After examining the current literature and establishing the existing research gap, a conceptual framework will be established in chapter 3.

2.1. Start-up financing

What sources of financing are available to a start-up are highly dependent on the stage the start-up is in. In this section the various stages in a start-up cycle will be discussed together with the available sources of financing for each stage. Within the various stages a distinction will be made between debt financing and equity financing. Debt financing involves borrowing funds from creditors with the stipulation of repaying the borrowed funds plus interest at a specified time in the future. For the creditors (those lending the funds to the business), the reward for providing debt financing is the interest on the amount lent to the borrower. Financing through equity means exchanging a portion of the ownership of the business for a financial investment in the business. The ownership stake resulting from an equity investment allows the investor to share in the company’s profits. Equity involves a permanent investment in a company and is not repaid by the company at a later date, other than when the company is liquidated. A good graphical representation of the various stages a start-up moves through, and the types of equity financing available can be seen in Figure 1.

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These various stages are also mentioned in a report by the Venture Support Systems Project, a joint effort between MIT1 and Harvard Business School (Linde, Prasad, & Morse, 2000). In this report a table is constructed showing the various stages of financing and the investors involved. However, both in Figure 1 as well as in the Venture Support Systems report debt financing is missing. In Table 1, below, the various stages are shown and both types of available financing, equity and debt financing, are included. The types of debt financing available are based on the start-up funding sources presented in an article by Schwienbacher & Larralde (2010).

Table 1 Financing Rounds in the Start-up Cycle (Linde et al., 2000; Schwienbacher & Larralde, 2010)

Financing Round Definition Typical Amounts Who Typically Contributes

Seed Prove a concept

/qualify for start-up capital

$25,000 - $500,000 Business Angels, Friends & Family,

Entrepreneur/entrepreneurial team, Bootstrap

Start-up Complete product

development and initial marketing

$500,000 - $3,000,000 Business Angels, Early-stage Venture Capitalists, Banks, Trade credit

First Initiate full-scale

manufacturing and sales

$1,500,000 - $5,000,000 Venture Capitalists, Customers/Suppliers

Second Working capital

for initial business expansion

$3,000,000 - $10,000,000 Venture Capitalists, Private Placement Firms

Third Expansion capital

to achieve break-even

$5,000,000 – $30,000,000 Venture Capitalists, Private Placement Firms

Bridge Financing to allow

company to go public in 6-12 months

$3,000,000 - $20,000,000 Mezzanine Financing Firms, Private Placement Firms, Investment Bankers

2.1.1. Seed stage

The seed stage is the very early stage in the development of a company in which its need for funds is manifested for the first time (Denis, 2004). The funding received in this stage allows a company to develop a product prototype and to generate enough interest from investors to raise funds in successive financing rounds (Basu, n.d.). In this stage various sources of financing are available. The most important equity sources include business angel finance and the entrepreneur or

entrepreneurial team. The most important debt source in this stage is bootstrapping. Friends and family can also be a very important source of financing in this stage, and can be based on equity or debt.

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5 Business Angels

Business angels can be defined as high net worth individuals who invest their personal capital in a small set of companies (Denis, 2004). These angels invest mostly in the seed stage of a company and the amount they invest is less than the amount invested by venture capitalists, normally in the range of $500,000 to $2 million. In his research on the business angel market Wong (2002) confirms that a company receives business angel finance earlier in its lifecycle, after 10,5 months, as opposed to venture capital financing, which normally takes place when a company is more than 1 year old. Looking at this early stage of company financing, it could be expected that, along with financing the business, angels also share a lot of knowledge and provide support for the entrepreneur. Wong (2002), however, notes that angels do not provide this kind of support. They do, however, support the entrepreneur in extending his network in order to receive more funding in the future. Denis (2004) concludes that business angels play a unique role in the venture financing cycle. They do not compete directly with venture capitalists, but provide a bridge until the company is in a position to be financed by a venture capitalist.

From their research on small business finance Berger & Udell (1998) conclude that business angel finance supplies only a small percentage, 3,59%, of total start-up financing. This low percentage is confirmed by Carter, Mason, & Tagg (2004) who found that angel finance only accounts for 0,7% of financing in Great Britain.

Entrepreneur/entrepreneurial team

Personal resources such as savings, early retirement funds or real estate equity loans (mortgages) can be used to finance a new venture. For young businesses, under 3 years old, entrepreneurs are most likely to use their own savings and retained profits, or rely on friends and family for financing (Carter et al., 2004). This dependence on internal financing is also shown in the research by Berger & Udell (1998). From this research it appears that the biggest equity category is funds provided by the principal owner. Two thirds of total equity is initially financed in this manner. Cassar (2004) also finds that personal funds are the most important source of start-up financing.

Bootstrap

In his article on bootstrap finance Bhide (1991) defines bootstrapping as ‘launching ventures with modest personal funds’. The difference with the previous type of financing, the entrepreneur or entrepreneurial team, is that bootstrap financing includes all types of financing, both equity and debt. Bootstrapping can, for example, include personal savings, credit card financing, second mortgages and retained earnings. Bhide (1991) describes several advantages of using this type of financing. First, most start-up companies do not yet qualify for other types of financing. The median amount of start-up capital in this research was $10.000. For business angels and venture capitalists

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this amount is much too low. Second, everybody can use bootstrapping. This makes it a very attractive opportunity for entrepreneurs who do not (yet) have access to other forms of financing. It also allows entrepreneurs to be independent of external investors. Finally, Bhide notes that the focus on cash generation lets the company detect any flaws in its business model quickly. Since every dollar earned in the company will be invested again right away, the entrepreneur has to make sure that this invested dollar creates value. There are some disadvantages to bootstrapping though. The focus on quick profits and cash generation could go to the expense of value-creation. Also, it is unlikely to raise high amounts of money using this method, which can therefore limit the high growth of a company (Winborg & Landström, 2001).

Friends & Family

When starting a new business, one can receive funds from friends or relatives who either receive an ownership interest in the business or provide a loan for the company. Especially in the very first stages of a new business, family and friends are a very important source of financing. In their report on small business financing in the UK, Carter, Mason, & Tagg (2004) concluded that ‘friends and family’ are in second place (20%) in the financing of a new business, right after ‘own savings’ (45%). This is confirmed in the research by Berger & Udell (1998) who also state friends and family are the second biggest equity category with 13%.

2.1.2. Start-up stage

When a company moves from the seed stage to the start-up stage it is completing product development and is likely to already be selling its product. In this stage a few more financing options become available. In addition to equity financing by business angels, venture capital also becomes an equity financing source. For debt financing, banks, leasing companies and trade credits become available.

Venture Capital

Venture capitalists supply funds in exchange for an ownership interest in the business in a later stage. Cassar (2004) confirms that venture capitalists play a greater role in the early growth phase of a company, and less so in the seed/start-up phase. Even though a business angel performs the same service, there are a few differences between these two types of investors. First, the amount invested is different. As can be seen in Table 1, the amount a venture capitalist does invest is much higher. Second, business angels also often invest because of a personal connection to the entrepreneur, or because of a high interest in the company itself. Venture capitalists are much more focused on the eventual return on their investment (Fairchild, 2011). Finally, since venture capitalists invest higher amounts, they also often demand more involvement in the company. The venture capitalist will

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supply knowledge since they are experienced in the guidance of start-up ventures. This is confirmed by Hellmann & Puri (2002) who state that venture capitalists provide support in building the internal organization of the company. Denis (2004) adds to this, that venture capitalists also provide monitoring and other support services to entrepreneurial firms. Furthermore, they can help entrepreneurs raise additional capital by implicitly certifying the quality of the start-up. Because of this certification by a venture capitalist entrepreneurs are often willing to accept an offer with a lower valuation if this means they will be affiliated with a more prominent venture capitalist (Denis, 2004).

Banks, leasing companies & trade credits

Banks and other commercial lenders are popular sources of business financing. However, as will be discussed in the next section, it has become much more difficult for start-up companies to find financing with these parties. The main reason is that the bank requires collateral on the debt. In many cases when looking for financing, the start-up is not yet profitable and lacks tangible assets to be pledged as collateral (Denis, 2004). Cassar (2004), however, finds that start-ups with the intent to grow appear to be more likely to use bank financing. The reason being that it is important for a company to establish a credit relationship as early as possible.

2.1.3. Further financing rounds

After the start-up stage the company is considering how to scale its business and to do so needs larger amounts of financing. In practice, these amounts are provided by either bank financing or venture capital financing. Both types of financing have been discussed before. When a company reaches this stage it has several options. It can strive to grow through its retained earnings and base its financing on debt. Alternatively, the company can strive for fast growth and try to initiate a public offering. When a company chooses to initiate a public offering it will be supported by many parties, including venture capitalists, private placement firms and investment banks. This stage in the company cycle is beyond the scope of this research and therefore will not be discussed any further. Literature supplies many articles that give an excellent overview of the sources of financing available at this stage (Cassar, 2004; Denis, 2004; Harris & Raviv, 1991; Titman & Wessels, 1988).

2.2. Current difficulties in obtaining financing for start-ups

As was briefly mentioned in the introduction, start-ups are having more and more trouble finding financing. Especially since the global financial crisis in 2008, all sorts of investors have become more reluctant to invest in start-up companies. Harrison (2013) states that since the global financial crisis in 2008 a financing gap has been created between the demand and supply for Small and Medium enterprise (SME) lending of between €32 and €66 billion in the United Kingdom. Silver, Berggren, &

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Fil (2013) recognize the same trend in Sweden. Their research shows that almost €10 billion has been moved away from small business loans to the private housing mortgage market. According to Silver et al. (2013) this shows that commercial banks do not understand the importance of small businesses for the economy.

This decline in bank financing is also confirmed by several research reports. A Dutch report (Verhoeven & Smit, 2011) indicates that banks have severely tightened their credit conditions in the period following the financial crisis in 2008. Banks also noticed a decreased demand in this period. Dutch SME’s and start-up companies confirm this decrease in demand and also confirm that the credit conditions were severely tightened in this period. The percentage of successful financing of companies applying for a bank loan decreased from 72% in 2008 to 33% in 2010, according to Verhoeven & Smit.

In a report by the OECD2 (2013) the severity of the financial crisis of 2008 and its impact on the availability of debt financing is further emphasized. The report states that GDP diminished with 3,6% in the OECD countries, and with 4,3% in the Euro area.

This report also confirms that overall demand for bank lending decreased over the period from 2008 to 2010, the reason being that companies sought to improve their balance sheets. Bank lending for SME’s and start-ups was also discouraged by a heightened risk aversion because of the debt crisis, and its possible impact on the banking sector. This impact was mostly visible in the tightened credit conditions, especially in comparison to larger firms. The costs of credit increased, the maturities shortened and the lending institutions demanded more collateral.

Not only bank financing was influenced by the financial crisis, the amount of equity financing available was also heavily reduced. According to Harrison (2013) business angel financing remains available, but the availability of venture capital and private equity has decreased further since the dot-com crash in 2000. Venture capital and private equity are increasingly being used as follow-on investments instead of investments into new companies. The decrease of venture capital invested in start-ups is also described by Silver et al. (2013). They state that after the dot-com crash in 2000 this amount decreased 80% to 90% over the past decade.

Bank financing, however, remains the most important source of external funding for start-ups and the financial crisis thus had a huge impact on the expansion of many start-ups. Venture capital and business angel financing only consist of a small percentage of total financing. Reported numbers range from 1% (Verhoeven & Smit, 2011) to 5% (OECD, 2013). The reliance on banks also shows in the results from Berger & Udell (1998). The largest sources of finance for start-ups and SME’s are the

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principal owner (which includes both owner equity and bootstrapping techniques), banks and trade credits. Together these forms of financing account for 70% of total funding.

As was also mentioned in the previous section, the problem with bank financing is that the bank will require collateral on the debt. In many cases when looking for financing, the start-up is not yet profitable and lacks tangible assets to be pledged as collateral (Denis, 2004). This is confirmed by Ushilova & Schmiemann (2011) who found that the main reasons for failing to secure loan financing were a poor credit rating, a lack of own capital and insufficient assets to be pledged as collateral. As an alternative to bank financing, companies apply for venture capital financing, but only a very small percentage of requests for venture capital financing is approved (Cosh, Cumming, & Hughes, 2009). 2.2.1. Financing gap

As can be seen in the previous sections there are only a few possibilities for the entrepreneur to raise capital in the very first stage of the business. Equity financing is available through some external sources such as business angels, but the percentage of companies that raise money through these angels is low and the amounts business angels invest are usually higher than most entrepreneurs need in the seed stage. As bank financing often requires assets to be pledged as collateral, this is not a viable option for many companies. Therefore, in most cases, the entrepreneur has to rely on his own funds, his family and friends, and on bootstrapping techniques to bridge the gap to bigger investments. However, with crowdfunding rising in popularity this can add a new means of financing to the entrepreneur’s toolbox, especially in the seed stage of the business. In the next section the various forms of crowdfunding and how an entrepreneur can use these forms will be discussed. The research that has been conducted in this new and fast expanding research area will also be explored.

2.3. Opportunities of Crowdfunding

In this section I shall shortly discuss the history of crowdfunding. Next, the different types of crowdfunding that exist will be examined and some of the research that has been conducted on crowdfunding to date will be discussed. From this discussion a current research gap will appear. In the next chapter I shall build a conceptual model in order to close this gap.

2.3.1 History of crowdfunding

Crowdfunding has its roots in crowdsourcing, a concept first introduced by Jeff Howe in Wired Magazine (2006). Howe defines crowdsourcing as follows:

The act of a company or institution taking a function once performed by employees and outsourcing it to an undefined (and generally large) network of people in the form of an open call.

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The development of Web 2.0 has played a large role in crowdsourcing. Geographic location is no longer a limitation and by sending out an open call the diversity of participants greatly increases. Whereas crowdsourcing can be used by companies to receive feedback, solve problems and generate ideas, crowdfunding is focused on collecting financing for the company. With crowdfunding increasing in popularity, it becomes a viable alternative to the financing methods mentioned before in this chapter. What forms can best be supplemented or replaced by crowdfunding will be discussed below. A graphical representation of the role crowdfunding can take in entrepreneurial finance is shown in Figure 2.

Figure 2 Position of crowdfunding in entrepreneurial finance (Lasrado, 2013)

2.3.2. Forms of crowdfunding

So far, five different business models can be identified within crowdfunding. Harrison (2013) mentions four of these crowdfunding models: (1) Donation model, (2) Reward/Pre-purchase model, (3) Lending model, (4) Equity model. A fifth model comes from Thurston (2010): (5) Revenue-based model. How these forms of financing can replace or supplement existing financing methods as mentioned in the first sections of this chapter will be examined.

2.3.2.1. Donation model

Within the donation model the project backer does not receive any tangibles in return. This form of crowdfunding is most often used for charities or other philanthropic goals. The motivation of the backer is intrinsic and social (Collins & Pierrakis, 2012).

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This form of crowdfunding is not suitable to act as a replacement for any of the financing methods discussed earlier. It can, however, be used as a supplement in order to raise money for a specific cause and by increasing the visibility of a certain project.

2.3.2.2. Reward/Pre-purchase model

The reward/pre-purchase model is currently the most popular model in crowdfunding. Over 80% of all projects are structured in this way (Massolution, 2012). Kickstarter3 and Indiegogo4 are currently the most used platforms for this type of crowdfunding. Within this model the project creator asks backers to pledge a certain amount in exchange for some sort of reward. In crowdfunding campaigns that focus on a product the reward very often is this yet to be produced product (pre-purchase). If the project is not focusing on a certain product the reward can also be something related to the project, for example, a t-shirt or even a personal thank you note from the project creators.

This form of crowdfunding can be used by an entrepreneur both as a replacement and as a supplement, before reaching out to business angels. A main reason for an entrepreneur to use crowdfunding is to show a product/market fit (Belleflamme et al., 2014; Gerber, Hui, & Kuo, 2012). If the entrepreneur can show larger investors, such as business angels, that the product or service is able to raise a smaller amount from many different investors, this can be a signal to larger investors that there is a market for the product or service.

2.3.2.3. Lending model

The lending model is comparable to a bank loan. Whereas the previous two forms of crowdfunding mainly focus on projects with a clear start and end, the lending model and the models following in the next two sections are used when the transition from crowdfunding to crowdfinancing is made. Crowdfinancing is a subset of crowdfunding; here the crowd is used to finance an ongoing business. Within the lending model an entrepreneur tries to raise financing for a certain project. The investors will receive an interest payment on this principal amount. As with a bank loan, the loan will have a set interest rate and set time to maturity. At this time, the amount will be repaid to the investor in full. If, however, the entrepreneur does not succeed in continuing his business, the loan will still be outstanding. In many cases the entrepreneur can be personally held accountable for this loan5. Since a considerable number of starting companies does not succeed eventually, this form of financing is quite risky for both the entrepreneur seeking financing and the investor.

This form of crowdfinancing can be an alternative to a bank loan. As was discussed previously, banks have become more reluctant in providing loans and require assets to be pledged as collateral. In

3_{www.kickstarter.com} 4

www.indiegogo.com 5

See for example http://www.oneplanetcrowd.nl/page/risicos (Entrepreneur will be held personally accountable for 50% of the total loan amount)

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many cases, a start-up cannot provide these assets, so a loan with the crowd can provide an opportunity.

2.3.2.4. Equity model

The equity model is also a form of crowdfinancing. Within this model the entrepreneur sells part of his company to a large crowd of investors. Very often this form of financing is structured in such a way that the investors do not have a controlling interest in the company, as would be the case if the entrepreneur sold part of his company to a venture capitalist. When there is a large number of investors within this model it would be very inefficient for each investor to also have a vote in the direction the company is going. By limiting the shareholder voting rights, the start-up can move quickly and doesn’t have to check each decision with all the investors, which could severely limit progress.

Equity crowdfunding has been growing very quickly over the past years and it is expected that it will grow even faster in the coming years due to a change in US legislation. Currently, equity crowdfunding is not allowed in the US, but with the acceptance of the JOBS act, smaller individual investors will be allowed to purchase equity (Heminway & Hoffman, 2010).

This form of crowdfinancing can also be used in the seed stage of a company. For the investor this form increases the potential upside. By owning part of the company the potential return of the investor, when the company gets a valuation by venture capital financing in a later round, is much bigger than with the other forms of crowdfunding. This form of crowdfunding can also act as a signal to a business angel or a venture capitalist in the same way as the reward/pre-purchase model and the revenue-based model below.

2.3.2.5. Revenue-based model

Within the revenue-based model the investor receives a return on a principal amount based on the revenues the company realizes. These returns are paid out during a set period of time or until a maximum return (cap) has been reached. The returns that are paid out are dependent on the revenues the company realizes. If the revenues are low, the amount paid out will be low as well. If the company would fail, there would be no remaining debt and therefore the entrepreneur does not have to repay the amount raised. If, on the other hand, the company is very successful and the revenues are high, then the amount paid out will be higher as well, and the company will be able to reach the set cap more quickly (Thurston, 2010). SEEDS6, a Dutch crowdfunding platform, uses this model together with a rewards/pre-purchase based model. In this form the investor gets a reward shortly after he has invested and can get a financial return over a longer period of time, if the

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company does well. This combination of a rewards based model with other forms of crowdfinancing also occurs with the lending and equity models. Dutch examples include Symbid7, Oneplanetcrowd8 and Crowdaboutnow9.

This form of crowdfunding can be used in the same manner as the equity and reward/pre-purchase models. When the company is able to raise the required amount this is a signal to other, bigger, investors that there is a demand for the product or service. This form of crowdfunding has the added advantage for the entrepreneur in that he does not give up any control of the company and will not be held personally accountable if the company would go bankrupt.

2.3.3. Research on crowdfunding

As crowdfunding is increasing in popularity the academic interest in the topic also increases. In the past few years many scholars have investigated various aspects within the crowdfunding field. In this section a summary will be given of the different research areas by discussing various academic articles. As can be seen from the articles mentioned in Table 2 much of the crowdfunding research has been conducted within the economics and management fields. Consumer behavior is studied by making use of economic modeling (Belleflamme et al., 2014). Management scholars investigate the underlying dynamics of crowdfunding success (Mollick, 2014) and find that crowdfunding diminishes the geographical distances that exist between entrepreneurs and investors (Agrawal, Catalini, & Goldfarb, 2011). Kickstarter, one of the biggest crowdfunding platforms, makes most of its funding data publicly available. Many scholars have used this data set in order to extract models that can predict the success of a crowdfunding campaign within the first few hours, based on the frequency and times of funding (Etter, Grossglauser, & Thiran, 2013; Greenberg, Pardo, Hariharan, & Gerber, 2013) or on the contents of the project page (Mitra & Gilbert, 2014). While examining these aforementioned articles it becomes clear that not much focus has been given to the factors determining the choice of entrepreneurs to use crowdfunding. This research gap will be discussed in the next section.

7 www.symbid.nl 8 www.oneplanetcrowd.nl 9 www.crowdaboutnow.nl

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Table 2 Crowdfunding articles summarized

Author(s) Crowdfunding Research Area

Study Design Citations Main Findings

Belleflamme et al. (2011) Pre-order pricing mechanisms (Crowdfunding vs. traditional finance)

Economic modeling 128 Community-based experience is important. Crowdfunding is most profitable for lower levels of finance. Crowdfunders pay more than customers who wait for the product to reach the market.

Schwienbacher & Larrald (2010)

Crowdfunding as an alternative for existing financing methods

Case study 72 Amount to be raised should be reasonably low. Project should be innovative to attract investors. Creators should be willing to extend their skill set and be open to suggestions by the crowd.

Mollick (2014) Underlying dynamics of crowdfunding success

Data analysis of 48,526 Kickstarter projects

8110 Crowdfunding success factors: Strong personal network and large online social network. High quality project.

Etter et al. (2013) Predicting crowdfunding success

Combined Kickstarter data analysis with social media analysis (Twitter)

5 Predictors that can predict project success with 89% accuracy in the first 15% of the campaign run time. Achieved by combining the time series of money pledged with related tweets.

Greenberg et al. (2013)

Predicting crowdfunding success

Data analysis on attributes from Kickstarter project pages

9 Created model that can predict with 68% accuracy if a campaign will be successful, based on the various attributes.

Agrawal et al. (2011) Geographic implications in crowdfunding

Data analysis on Sellaband investor/entrepreneur location pairs.

9311 Average distance between project backers and creators is 4500 km. This rejects the notion that funding would mainly come from funders located close to the creators.

Mitra (2014) Predicting crowdfunding

success

Data analysis of Kickstarter project pages

4 The use of certain phrases on the project page can contribute to the chances of success of a project.

Ordanini, Miceli, Pizzetti, &

Parasuraman (2011)

Funder and platform motivations

Three case studies 80 Each of the three cases showed different results for the motivations of both the project backers and the

platform owners.

10_{Combined two different listings on Google Scholar (scholar.google.com)} 11

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Gerber et al. (2012) Motivations to use crowdfunding

11 Semi-structured interviews with both project creators and project backers

28 In addition to receiving funding, project creators use crowdfunding to receive feedback from project backers. Next to products and rewards, funders are motivated by social interactions within the

crowdfunding community

Hui, Gerber, & Greenberg (2012)

Demands of crowdfunding

46 Semi-structured interviews with project creators and ran own project

8 Uncovered six stages in the crowdfunding process (more on these stages later in this study). Requires more work and effort than expected.

Belleflamme, Lambert, & Schwienbacher (2013)

Individual crowdfunding practices (not using a crowdfunding platform)

Hand collected data of 44 projects and 19 completed questionnaires

8 Individual efforts allow the entrepreneur to better customize the project. Non-profit projects are more successful than for-profit projects.

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16 2.3.4. Research gap

In Table 2 some of the most referenced articles on crowdfunding are discussed and this overview shows that many different areas have been researched within crowdfunding. What is interesting though, is that not much research has been conducted on the factors influencing the choice of entrepreneurs to use crowdfunding. Most research has focused on the characteristics of funders/backers of crowdfunding projects. When the focus was on the entrepreneurs (Gerber et al., 2012; Schwienbacher & Larralde, 2010), the method of study was qualitative, either through interviews or a case study. Through my literature research it becomes apparent that a research gap currently exists. This gap can be closed by conducting a quantitative study among entrepreneurs in order to determine the factors that influence these entrepreneurs in their choice to use crowdfunding as a form of financing for their business. In the next chapter a conceptual model will be established using both literature from the crowdfunding field and other related fields. Within this model various factors that can influence an entrepreneur in his choice to use crowdfunding will be determined. Once the model is established it will be empirically tested by means of a survey issued to entrepreneurs, as discussed further in chapter 4 and 5.

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3. Conceptual Model

As has been discussed in the previous chapter, a research gap exists in the entrepreneurial finance literature. Much of the research that has been conducted in crowdfunding has focused on the characteristics of the funders. When the research did focus on the entrepreneurs the method of study was always qualitative and mostly focused on how crowdfunding could be an alternative to other forms of financing. With crowdfunding and crowdfinancing emerging as new start-up financing forms, however, the question arises what factors influence an entrepreneur in his decision to choose crowdfunding as a means of financing. In this chapter a conceptual model will be established in order to answer this question. Based on literature from different fields six factors have been determined which are assumed to have an influence on this decision. The influence of these factors will be tested empirically in the next chapters. Many papers have been written on the financial factors that drive an entrepreneur to choose a certain form of financing, such as cost of capital, taxation consequences and the collateral value of assets. These factors are, however, only a small part of the decision-making process, especially in small entrepreneurial firms. Managerial preferences should also be taken into account when researching the entrepreneurial finance field. Therefore in this research the focus will lie on the managerial factors, and/or preferences, that influence the entrepreneur. The importance to focus more on these factors was stressed by Matthews, Vasudevan, Barton, & Apana (1994) who noted that the capital structure literature has focused on the finance paradigm, but that the managerial perspective, which considers nonfinancial and behavioral factors, deserves more attention. Myers (1984) confirms that this new focus is necessary since the finance paradigm ignores these managerial preferences. Michaelas, Chittenden, & Poutziouris (1998) find that these non-financial factors, such as entrepreneur experience and goals, may even be more important in influencing the capital structure of a firm than financial factors. They state that the capital structure decisions in small firms are strongly influenced by the preferences, unique experiences and characteristics of the entrepreneur.

In order to structure the conceptual model for this study, the model used by Michaelas et al. (1998) is adapted to fit the issue of crowdfunding. Michaelas et al. established a model that showed the determinants of the capital structure in small firms. They concluded that this capital structure will be a function of the characteristics of the firm, of the firm’s managers and of the marketplace. The model established by Michaelas et al. is shown in Figure 3.

This model is adapted to better fit the case of crowdfunding by including the various factors that were drawn from the researched literature. The conceptual model used in this study is shown in Figure 4. The six factors that will be discussed in this chapter are as follows; (1) Entrepreneur’s prior experience with financing forms, (2) Financing amount required by the entrepreneur, (3) Resources

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contributed by the entrepreneur, (4) Amount of time, money and effort associated with financing, (5) The fit with and added value of the crowd and (6) Social media connections. In the final section of this chapter other (demographic) factors that could influence the likelihood to use crowdfunding will shortly be discussed. In chapter 4 this model will be operationalized and tested.

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Owner’s/Manager’s Characteristics

Experience Amount required Pre-existing resources Financing cost &

time

Fit with & added value of crowd

Perceptions, Beliefs and Attitudes Towards Entrepreneurial Finance (including Crowdfunding)

Other External Factors: State of the Economy Financial Condition of Marketplace

Availability of Funds Industry Characteristics

Government Policy

Other Internal Factors Firm Characteristics: Age, Size, Risk, Growth, Profitability, Asset Composition,

Trade Debtors, Stock, Nature of Operations, Ownership, Social Media Use

Decision on form of Entrepreneurial Finance

Resulting form of Entrepreneurial Finance

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3.1. Prior financing experience

The first factor influencing the managerial, or in this case, entrepreneurial preference for a certain form of financing is the prior experience the entrepreneur has had with financing. As the goal of this research is to determine which factors influence the entrepreneur’s decision to choose crowdfunding, a distinction is made between prior experience with crowdfunding or crowdfinancing and prior experience with other forms of financing as discussed in more detail in section 2.1. The prior experience with financing as an influential factor in the financing choice in the future has also been discussed in literature. In their article on capital structure decision-making in family businesses Romano, Tanewski, & Smyrnios (2001) refer to several variables that influence the capital structure decisions. Among these factors is the entrepreneur’s prior experience with various forms of capital structures. In the model by Michaelas et al. (1998) it is also noted as an influencing factor. They state that, for example, prior experience with debt influences the choice to use debt in the future. If a firm had a very unsatisfying experience with debt, this firm is less likely to use this form of financing in the future. Firms with a satisfying experience, on the other hand, may very well use this form of financing again in the future. Matthews et al. (1994) confirm the importance of experience in the likelihood to use a form of financing. They state that a negative experience will create a negative attitude towards the used financing form and will reduce the likelihood that the form of financing will be used again in the future. From this factor the following hypotheses are drawn:

Hypothesis 1a: Previous positive experience with crowdfunding or crowdfinancing positively

influences the likelihood to use crowdfunding

Hypothesis 1b: Previous positive experience with other forms of financing negatively

influences the likelihood to use crowdfunding

3.2 Amount required by entrepreneur

As was discussed in chapter 2, the amounts required by an entrepreneur can differ a great deal. This amount required depends on the stage the business is in. The required amount will increase as the business grows from stage to stage. Bhide (1991) mentions in his article on bootstrap finance that every type of financier has a different, pre-defined amount they are willing to invest. This distinction between types of financiers is also confirmed in Table 1. Even though crowdfunding is not mentioned as a separate form of financing in neither the article by Bhide nor in Table 1, crowdfunding does have a pre-defined range of amounts in which most projects fit. A report by Massolution (2013) shows that the median amount for an equity based crowdfunding campaign is approx. $190,000, for a lending based campaign approx. $4,700 and for a reward based campaign approx. $2,300. The spread in these median amounts is large, but looking at the total number of campaigns, this gives the same range; for equity projects 79% is for an amount under $250,000 and for reward and donation

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based projects 90% is under $10,000 (Massolution, 2012). Entrepreneurs looking to raise amounts over $250,000 are expected to do so using other forms of financing. Therefore, for this factor the following hypothesis is set:

Hypothesis 2: If the amount required increases, the likelihood to use crowdfunding decreases.

3.3 Pre-existing resources

Another factor that can influence the entrepreneur in the choice of financing method is the existence of resources already owned by the company. In this section two types of company resources will be discussed; assets that can be pledged as collateral and intellectual property rights. As was discussed in chapter 2, if a company lacks assets that can be pledged as collateral it is more difficult to obtain bank financing (Denis, 2004). Cassar (2004) confirms this by stating that firms that lack tangible assets are more often financed through less formal means. Due to this difficulty in obtaining funds, especially in the early stages of the company when very few tangible assets exist, crowdfunding may provide an opportunity for an entrepreneur to receive the funds he needs.

Schwienbacher & Larralde (2010) introduce another asset that can play an important role in the choice to use crowdfunding, intellectual property. The importance of intellectual property is confirmed by Rivera (2000) who states that, especially in today’s technology intensive industries, companies’ biggest assets are their intangibles. For example, patents can defend proprietary market advantage, translate into category leading products or even serve as a foundation for a new industry. For entrepreneurs contemplating the use of crowdfunding, however, this protection of intellectual property could play an even more important role. When an entrepreneur posts a project on a crowdfunding platform he will have to disclose part of the ideas to the crowd, even before the product is produced. This could lead to his ideas being misappropriated if the intellectual property is not protected (Hui et al., 2012). An entrepreneur, therefore, is more likely to choose crowdfunding if his intellectual property is protected. However, Haeussler, Harhoff, & Müller (2009) find that when a company has its intellectual property protected, it is more likely that a firm will be financed through venture capital. They state that the process of patenting serves as a signalling function to the venture capitalists. The influence of filing a patent on venture capital financing is substantial; filing at least one patent application decreases the time to the first venture capital investment by 76% (Häussler et al., 2009). Since no evidence could be found in literature to support the notion that the protection of intellectual property would have a positive influence on the likelihood to use crowdfunding, the hypothesis will be based on the article by Haeussler et al. (2009) by stating that, because a company is more likely to receive venture capital financing when the intellectual property rights are protected, this will have a negative influence on the likelihood to use crowdfunding.

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Hypothesis 3a: A lack of tangible assets has a positive influence on the likelihood to use

crowdfunding

Hypothesis 3b: Protected intellectual property has a negative influence on the likelihood to

use crowdfunding

3.4 Crowdfunding time and costs

The time and cost associated with crowdfunding can also influence the likelihood of an entrepreneur to choose crowdfunding. According to Hui et al. (2012) the perception exists that crowdfunding is a quick and easy way to raise funding. They find, however, that in practice this is not the case. Crowdfunding requires more time and involvement from the entrepreneur and requires a specific set of skills to manage all aspects of the crowdfunding campaign. Schwienbacher & Larralde (2010) confirm this by stating that the entrepreneur should be willing to extend his skill set, or to incorporate the opinion of other people. The reason for this is that crowdfunders are interested in projects in which they can participate and in which they can have influence. Entrepreneurs also have to be very comfortable with the use of Web 2.0. Almost all project communication makes use of the internet, either through e-mail, through the crowdfunding platform or through social media. An entrepreneur is not obliged to use the internet, but not doing so can lead to higher costs and more time (Schwienbacher & Larralde, 2010). This intensive use of the internet is supported by Hui et al. (2012) who state that it is common practice for an entrepreneur to send his personal connections at least one e-mail every week reminding them to support his project.

Next to time saving, another factor that could influence the likelihood to use crowdfunding is the cost associated with this form of financing. Kleemann, Voß, & Rieder (2008) state that the main reason for companies to use the crowd is to reduce costs (such as personnel costs, investment banking fees and underwriting costs). Even though Kleemann et al. wrote their article in light of crowdsourcing, this aspect translates to crowdfunding as well. Cassar (2004) confirms the importance of costs in the choice of financing. He states that the choice of financing is affected by the transaction costs. For a small firm it can be expensive to resolve an informational asymmetry, leading to smaller firms to pay a higher interest rate on their loans or being offered less capital. From the discussion in this section the following hypotheses are drawn:

Hypothesis 4a: If the time to run a crowdfunding project increases, than the likelihood to use

crowdfunding decreases

Hypothesis 4b: If the costs to run a crowdfunding project are lower compared to bank

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3.5 Fit with and added value of the crowd

From the funders point of view it is very important to have some affinity with the project in which they will invest in (Gerber et al., 2012). This fit with the project is improved when the funder is also able to add value to the product. From the entrepreneur’s point of view the fit with the crowd, and the value the crowd can add, can also be an influencing factor on the likelihood of the entrepreneur to use crowdfunding. In this section both the fit with the crowd and the ability of the crowd to add value to the project will be discussed. Two sub factors that make up the fit with the crowd are (1) the positive influence a company establishes and (2) the ability of the company to connect with the crowd. From literature on socially responsible investments (Anand & Cowton, 1993; Lewis & Mackenzie, 2000; Renneboog, Ter Horst, & Zhang, 2008) it appears that certain investors are drawn to a company more by the fact that the company complies with high standards of corporate social responsibility (CSR) rather than that they are drawn to a company because of its high financial rewards. As crowdfunders are more involved with the projects they invest in, it can be assumed that they are also interested in how the company performs in the CSR area. Assuming that the entrepreneur is also aware of this, the likelihood that an entrepreneur will use crowdfunding is higher if his company also strives to make a positive influence on the world and comply with a high CSR standard.

The ability of the company to connect with the crowd and its potential customers is also important. From literature on co-creation (Payne, Storbacka, & Frow, 2007; Prahalad & Ramaswamy, 2004) it becomes apparent that in order to utilize the crowd to partake in co-creation, it is necessary for the company to easily connect to the crowd. A lack of this ability could limit the number of opportunities the company gets through the use of co-creation. This concept can also be transposed to the use of crowdfunding. If a company is unable to reach out to its desired crowd, it will become very difficult for the company to receive the necessary funding, and also to profit from the input and feedback from the crowd. The ability of the crowd to provide this input and feedback can play an important role in the value the crowd can add to the project. Even though crowdfunders might not possess the specific knowledge of an industry that business angels or venture capitalists have, the sheer number of potential investors in a crowdfunding campaign could make up for this lack of knowledge. Schwienbacher & Larralde (2010) add to this that a crowd can be more efficient than a few equity investors alone. The ability to add value to a project is also confirmed by Ordanini et al. (2011) who state that crowdfunding models include crowdsourcing elements. Members from the community share ideas to solve problems. But the crowd not only contributes its knowledge to solve problems, it also plays a promotional role in supporting the project (Ordanini et al., 2011). If the entrepreneur can see that the crowd can add value to both his product or service and the project as a whole, this could

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increase the likelihood he will use crowdfunding as a source of financing. From the above section the following hypotheses can be drawn:

Hypothesis 5a: A fit with the crowd positively influences the likelihood to use crowdfunding Hypothesis 5b: The added value of the crowd positively influences the likelihood to use

crowdfunding

3.6. Social media connections

Having a large network has been mentioned as a success factor for running a crowdfunding campaign in various articles (Etter et al., 2013; Greenberg et al., 2013; Mitra & Gilbert, 2014). In these articles the online social media network is mentioned as an important part of the entrepreneur’s network. Both the size of the social media network and the level of social media activity are shown to have a positive influence on the success of a crowdfunding campaign. To investigate whether the number of social media connections also has an influence on the likelihood to choose crowdfunding, the following hypothesis is drawn:

Hypothesis 6: A larger number of social media connections increases the likelihood to use

crowdfunding

3.7. Other influencing factors

Evidently, the abovementioned factors do not include all factors that are of influence to the entrepreneur in his choice to use crowdfunding. As was discussed in chapter 2 not much research has been conducted on the motivations of entrepreneurs to use crowdfunding, and therefore many factors had to be deduced from other streams of academic literature. When additional factors arise these will be discussed in later sections of this research and suggestions will be given on how to incorporate these factors in future research. In order to determine whether demographic factors also influence the likelihood to use crowdfunding a variety of questions are asked about the characteristics of firm and its entrepreneur. In the next chapter I shall elaborate further on the method used to conduct this study.

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4. Research design

4.1. Sample

For this study a sample was taken from the total population of start-ups as listed in CrunchBase12. As a thorough understanding of the networking advantages of Web 2.0 is important in the success of a crowdfunding campaign (Belleflamme et al., 2014), in this research the focus has been on acquiring a sample of entrepreneurs that is mainly active in the technology sector. Entrepreneurs active in this sector are well aware of these advantages and are expected to be in a better position to reach the crowd through, for example, the use of social media. The sampling technique used is best described as convenience sampling (Saunders & Lewis, 2012). The New Venture13 group used for the pilot study was easily approachable through my internship at SEEDS. The Crunchbase database was more difficult to access. The method used will be discussed later in this chapter.

4.1.1. Pilot study

A questionnaire was created for this study. In order to test the reliability and validity of this questionnaire, a pilot study was conducted among a group of entrepreneurs present at a financing event organized by New Venture. This group consisted of 30 entrepreneurs, and a response rate between 25% and 35% was expected, as I could ask the respondents in person to participate. From this pilot group 9 completely filled out questionnaires were returned, resulting in a response rate of 30%. Since only 9 responses were received, no statistically significant results can be presented. However, the feedback of these nine respondents did allow me to improve various survey items. 4.1.2. Main study

In order to create the sample for the main study a group was approached through the Crunchbase database. Crunchbase is a database linked to Techcrunch14, which is a website focused on technology companies. In this database information on all the participating companies is registered. The Crunchbase database contains for example; the founding date of the company, the number of financing rounds, and the amounts raised in these rounds, the type of financing received, and whether the company is still active or not. The total database contains data points of approximately 40,000 companies, however, it includes companies founded many years ago and companies that either failed or grew beyond the start-up phase. In order to include only start-up companies in the sample, a selection was made based on the following criteria: (1) Founding date in or after 2011, (2) Company still operating (as of the date of the survey). This left a selection of about 11,000

12_{www.crunchbase.com, CrunchBase is the world’s most comprehensive dataset of startup activity and it’s} accessible to everyone.

13

www.newventure.nl, New Venture is a Dutch accelerator program linking start-ups with mentors. It also organizes seminars to inform the start-ups about various subjects related to entrepreneurship.

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companies. Using an e-mail crawler, the e-mail addresses of these companies were accumulated. This resulted in a database containing 8,990 e-mail addresses to which the survey was sent. The expected response rate for this group was low since this group was approached ‘cold’. Based on the survey length, lack of pre notification and lack of material incentives (Deutskens, de Ruyter, Wetzels, & Oosterveld, 2004; Fan & Yan, 2010), the response rate which could be expected for this sample was estimated to be between 2% and 4%. An overview of the different groups and the expected responses are summarized in the table below.

Table 3 Expected response rates

New Venture Group Crunchbase Group

Total sample size 30 8990

Low response 8 (25%) 180 (2%)

High response 11 (35%) 360 (4%)

The invitation e-mail to participate in the survey (See Appendix A) was sent in several batches on different days and at different times in order to determine what day and time would result in the best response rate. A reminder was also sent, one or two weeks after the first e-mail. By sending this reminder e-mail, the response rate was increased from 1,86% to 2,6%, an increase of some 40%. 455 surveys were started, however, only 231 were usable. If a survey was not filled out completely but the completion percentage was over 90%, imputation applying the Hotdeck Macro was used (T. Myers, 2011). The completion percentage was quite low, 50,7%, which is most likely due to the length of the survey. From the results it shows that many respondents started the survey and stopped about halfway. The resulting response rate for a ‘usable’ survey is 2,6%, which is within the range of expectation.

From the total sample 85% was male and 15% female. The average age of the entrepreneurs was 38 years and the average age of their business was 2,4 years. For analysis purposes the sample was split in two. One group contains all respondents that did not have any experience with crowdfunding, whether personal or for their business. The second group contains all respondents that have some experience with crowdfunding, either personal, for their business, or both. In assembling these groups it was essential that all respondents also answered the question leading to the dependent variable, indicating their likelihood to use crowdfunding for their business in the future. This resulted in 109 respondents in the first group and 74 respondents in the second group. For both these groups a regression analysis will be run in chapter 5 and the results from these analyses will be discussed in chapter 6. More information on the demographics of the sample will also be discussed in chapter 5.

Choosing crowdfunding : factors influencing the choice of start-up financing