Signaling to the Crowd: Private Quality Information and Rewards-Based Crowdfunding

Abstract

Crowdfunding is a new and popular way of funding innovative products. Despite numerous advantages, there are challenges to this model, chief among them credibly signaling information about product quality to a pool of small, uninformed investors. We explore how an entrepreneur might accomplish this and overcome a key obstacle to crowdfunding. Specifically, we analyze a game theoretic model of signaling between an entrepreneur and campaign backers in which the entrepreneur designs a fixed funding rewards-based crowdfunding campaign for an inno- vative product. Product quality is known to the entrepreneur but unknown to some backers, and we analyze how the entrepreneur can signal quality to backers via the design of the crowd- funding campaign, including the price of the reward and the funding target. We find that the entrepreneur should signal high quality by setting a high target that is distorted above the full information optimal level. While a separating equilibrium always exists, a pooling equilibrium can only occur under very specific circumstances. We show that the high target affects the quality choice of entrepreneurs and may deter high quality, innovative projects. In addition, we discuss how the entrepreneur should modify the signaling strategy when a high target potentially deters backers from pledging due to the cost of participating in a failed campaign.

Keywords: rewards-based crowdfunding, fixed funding, asymmetric information, signaling

JEL Classification: D81, D82, M11, M13, M31