The market for ideas can be seen as a principal-agent relationship with asymmetric information (for instance see Laffont and Martimort (2002) for more detail). In this context the entrepreneur-agent has significantly more information about the project than the investor-principal. We are in a situation of adverse selection in which all projects will be promoted as high quality regardless of their actual value.
The traditional way of approaching this problem during the last twenty years has been the business plan. Delmar and Shane (2003) corroborated empirically that business plans are a good instrument to reduce asymmetric information. They used an extensive sample of Swedish entrepreneurs with and without business plan. But their value with investors is still limited because business plans are usually based on sales predictions and not current ones. In informal conversations with investors I have come to understand that this adverse selection problem can be better managed if the entrepreneur is able to start selling on her own. Although this is not always easy two new methods facilitates this process to entrepreneurs: Pop-ups and Crowdfunding.
A first formula to start selling is to make a Pop-up. This consists in creating a commercial spot for a limited period of time, normally from 1 to 3 months. This usually requires an initial investment by the entrepreneur. The Pop-up works very well when selling food. This is the case of "the Loaf in a Box" in San Sebastian (Spain). The Loaf in a Box was a pop-up bakery during the summer 2012 and after the success in 2014 they are going to set up a permanent bakery. "The cookie" is other example of pop-up selling US cookies with ice cream during summer 2013 also in San Sebastian.
But it is clear that the creative content is different. If a filmmaker, or a designer want to experiment with new formats out of the usual in the industry, it is more difficult for them to develop a project without having funding. Reward Crowdfunding covers this gap. For example in this link from Financial Times we have the successful example of the platform Kickstarter. Empirical studies with evidence on the case of Kickstarter have been already released. Kuppuswamy and Bayus (2013) show that additional support from clients-investors is negatively related to its past funding support. Successful projects can suffer from the assumption that others will provide the necessary funding. The same study also identifies the deadline effect. Funding support increases when the project funding cycle approaches its closing date.
But, Crowdfunding also serves as a source for equity (see link from Expansion). Recent research in Italy conducted by Giudici, Guerini and Rossi-Lamastra (2013) using information from more than 400 projects identifies that this source of funding is substitute of other sources, like business angels. In fact, according to their results there is an adverse selection problem between entrepreneurs and crowdfunders. In territories with good funding alternatives, Crowdfunding could be seen as a last resort, and in the eyes of crowdfunders this could be seen as a bad indicator.
This argument is probably taken huge assumptions. In conversation with Miguel Angel Trujillo, country manager of Fundedbyme (one of the fastest growring Crowdfunding platform in Europe) in Spain, this view is flawed. With the current economic situation full of funding constraints, the entrepreneurs search for all sorts of funding sources at the same time. There is not incompatibility between sources.
In this view reward and equity Crowdfunding could suffer from some asymmetry of information, but as long the investment is done in smaller portions, this “risk” could be shared among more investors. Moreover, having achieved large sums from Crowdfunding is a good signal for larger investors like business angels. This is the indication that the firm will be able to sell the product as this has attracted small investors or clients before the product or service have been produced.
Here, we have new methods to address the adverse selection between entrepreneurs and investors. Methods that go a step forward to a mere business plan based on sales predictions. When the product-service can be offered in the market a pop-up is a proper method of trial-and-error, demonstrating (or not) the value of the commercial proposal. When this is not possible the entrepreneurs can still use Crowdfunding platforms, in which they can sell their ideas at a conception stage. This collection of information will facilitate the market for larger investments as long as adverse selection is hugely reduced.