Crowdfunding vs. Bank Financing: Effects of Market Uncertainty and Word-of-Mouth Communication

Abstract

Bank financing is a traditional source of capital for small businesses, whereas crowdfunding has recently emerged as an alternative fund-raising solution to support innovative ideas and entrepreneurial ventures. Conceivably, crowdfunding could potentially replace some of the conventional roles of bank financing, but puzzles linger over when crowdfunding is a better funding choice. This paper investigates a firm's optimal funding choice when launching an innovative product to the market with both market uncertainty and word-of-mouth (WoM) communication. We characterize the firm's optimal pricing strategies under the two funding choices (i.e., bank financing and crowdfunding), compare their performances, and investigate the corresponding implications on social welfare. We find that the firm's optimal funding choice and pricing strategy depend critically on the market uncertainty, the WoM, and the initial investment requirement. More specifically, the firm would adopt intertemporal pricing under crowdfunding, where the exact format is determined by the WoM and market uncertainty; under bank financing, however, the firm should always charge a fixed price invariant to those parameters. Moreover, market uncertainty has a non-monotonic effect on the optimal funding choice: Bank financing is preferred only when the market uncertainty is within an intermediate range. The impact of initial investment requirement on the choice of funding scheme shares a qualitatively similar pattern. Finally, contrary to the conventional wisdom, we find that more active social interactions in crowdfunding, although beneficial to the firm, may hurt consumers and even reduce social welfare.

Keywords: Crowdfunding, all-or-nothing mechanism, bank financing, interface of operations and finance, funding choice, word-of-mouth, market uncertainty