How a Simple Change Can Protect Crowdfunding Backers from Fraud

Budding entrepreneurs with a business idea inevitably face the problem of finding financing. With the advent of crowdfunding platforms such as Kickstarter or Indiegogo — where the entrepreneur appeals to the masses to support the business venture — raising funds to get projects off the ground is getting easier.

But crowdfunding also opens the door to a host of unwanted behaviors. Some entrepreneurs may inflate a product’s potential, or decide to keep backers’ funds despite being unable to deliver the product. Backers of the projects are left in the lurch, typically with little recourse to a refund. And lawsuits are rare.

New research shows that a few simple changes to a crowdfunding platform’s design could substantially strengthen protections for the backer, and make everyone better off. Currently, crowdfunding platforms’ terms of service make it clear they are not responsible for safeguarding the money of those who choose to back the project.

As such, “campaign backers are exposed to significant entrepreneurial misconduct risk,” according to the research paper, “Rethinking Crowdfunding Platform Design: Mechanisms to Deter Misconduct and Improve Efficiency,” written by Simone Marinesi and Gerry Tsoukalas, both Wharton professors of operations, information and decisions, along with Elena Belavina, a professor at Cornell University.

The paper’s authors believe that designing a better crowdfunding platform will help mitigate those risks — and yet academic research has largely ignored this area of study despite its practical benefits, according to Tsoukalas.

“This is the first paper to propose practical crowdfunding mechanisms that deter entrepreneurs from misappropriating backers’ money and making exaggerated performance claims during the [fundraising] campaign,” added Marinesi.

Pitfalls of Crowdfunding

The way crowdfunding is supposed to work is fairly straightforward. On all major crowdfunding platforms, entrepreneurs can launch a campaign webpage for free. They describe their business idea, how much they’d like to raise, and typically offer a discounted price of the product being developed to backers.

All pledges temporarily go to the platform. After a month or so, if the funding goal is met, entrepreneurs collect the money and pay a commission to the platform, usually 5%. Months later, backers get the product. If the funding goal is not met, the backers get a refund and the entrepreneur ends up empty handed.

One problem is that backers largely have to take entrepreneurs at their word that the product can do everything they claim. “Backers do not get a chance to see or try the product, but have to rely instead on what the entrepreneur chooses to report in the campaign page,” the authors wrote. “And since this information is not verified by the platform, there is ample room for misrepresentation of product features and performance.”

The researchers call this issue “performance opacity.” Such misconduct damages not just backers but also honest entrepreneurs by fostering mistrust towards crowdfunding campaigns in general.

Another problem backers face is that entrepreneurs can run away with the money as soon as the campaign ends, or when the project hits a roadblock that prevents the product from being completed. After all, pledging on crowdfunding campaigns is not like buying a product on Amazon or eBay: Things can always go wrong, and recourse is quite limited. According to the paper, in 87% of these cases, backers did not receive the product, nor a refund. The researchers call this problem “funds misappropriation.”

Ten Percent Fail Rate

Still, the record of success is quite good. On Kickstarter, for example, only 10% of successfully funded campaigns suffer from these problems.

Well-known campaigns that failed include the one by Zano, which claimed to be developing an affordable, palm-sized drone for aerial photography. In 2014, it set a goal to raise 125,000 pounds ($160,000) on Kickstarter, but was so popular backers poured in $3.5 million. Zano promised drone features such as thermal imaging cameras, wireless charging, an obstacle avoidance sonar and even facial recognition down the line.

Backers who gave as little as 139 pounds ($177) could get one of these feature-filled drones — in six months. But the problem is “there were drones costing 10 times as much that couldn’t match Zano’s specs,” reported an investigative article commissioned by Kickstarter to dig into the firm’s demise. The backers who got their drones said even these were “barely operational.” Debt-laden Zano went bust in 2015 with no refunds for most backers.

Kickstarter CEO Yancey Strickler said in the article that backers seemingly believed that his platform would “require creators to mail us their single prototype, that we spend a week play-testing it and [then would] mail it back to them.” However, “practically speaking, those are hard things to enforce,” he said. “The system is reliant on backers to make a decision.” Kickstarter does have some rules, such as banning pre-orders, but its credo is “the crowd decides which projects get funded and which do not.”

But Marinesi said preventing misbehavior is in the platform’s best interest in the long run. “In crowdfunding, backers are asked to trust with their money entrepreneurs and products they have never seen,” he noted. “Trust is paramount in crowdfunding, and we all know that once it’s lost, it is very difficult to get it back. This is why we should put in place systems that protect backers while enough trust in the platforms still exists.”

Platforms are listening. Since the study was released, sites such as Indiegogo have moved in the direction the authors have recommended, Tsoukalas said. It’s still a work in progress, though. “We were very mindful of the fact that any new designs we suggested would have to be relatively straightforward and could not stray too far away from the status quo in order to have potential impact in practice,” he said. “Platforms are understandably reluctant to try and improve something that isn’t perfect but still works ‘well enough,’ for fear of breaking it.”

Strengthening the Platform Design

Marinesi, Tsoukalas and Belavina discovered that a few simple and potentially inexpensive changes to the platform design can make a big difference in curbing fraudulent or unrealistic projects. After testing 10 designs, two stood out. “Despite the fairly large number of designs considered in our study, our search for the best crowdfunding design yields a surprisingly neat result — that platforms need to consider just two designs,” they wrote.

Both of these designs defer some part of the payments until certain conditions are met. They are the following:

Maximum-Aftermarket (MA). The campaign stops collecting money when the original fundraising goal is reached. Any backers that want to get in afterwards will have to buy the product once it hits the market. Why would entrepreneurs agree to this design since it seems to limit sales? If the product is genuinely marketable, then restricting sales on a crowdfunding platform means relatively few units would be priced at a discount. So when the product finally hits the public at the full retail price, the entrepreneur stands to make more profits.

Platform Escrow with Post-campaign Mandatory Verification (PE-V). Any funds that exceed the campaign’s original goal will be put in escrow until the product is developed successfully. If the product fails to deliver, the money in escrow will be used to refund backers. The platform also must take steps to verify that the product works as promised. To minimize the cost of verification, survey the backers to see what they think of the product. Commission traditional testing, which is costlier, only if backers complain the product didn’t deliver.

Both of these designs are useful under different circumstances and for different reasons, according to Tsoukalas. But after talking with industry executives, he said, “it seems like behavioral considerations as well as communication challenges [which are not included in study] could sway the needle more towards PE-V in practice. To this point, we have seen some momentum towards escrow adoption in the industry since our work was released.”

Optimal platform design is long overdue. “The current system is leaving money on the table for all stakeholders, and importantly, this is also affecting successfully funded campaigns,” Tsoukalas added. “Our research suggests those campaigns could have done even better, in theory, if the platforms were using the slightly more complicated designs we are suggesting.”

Once optimized, the platform’s benefits to all participants in the network are clear. “To attract as many entrepreneurs as possible, the platform needs to attract as many backers as possible, and vice versa. In short, it needs to deliver the highest possible value to entrepreneurs and backers,” Marinesi said. “Our analysis takes into account the incentives and costs of entrepreneurs and backers … to find the design that delivers the highest value to all stakeholders, including platforms.”