Crowdfunding as a New Form of Commerce
It Takes A Village
What makes one restaurant a hit in your neighbourhood, and another a complete failure? Assuming the owners are equally competent in managing their business — the successful one has people continually buzzing in and out of. Put another way, it’s the business that’s able to generate demand within a community.
You might say then, a community collectively chooses what businesses will fail or succeed — or rather, products and services evolve out of a community. Successful firms are networks that most accurately represent, and deliver on the will of the community that it serves— a collective vehicle of sorts, aimed at the creation of products.
Everything from your iPhone to your Starbucks coffee, has been created and financed by the community it serves. Successful businesses are aware of this connection, and go out of their way to understand their customer’s needs before, during, and even after embarking on a new product. This process is referred to as customer development, a term popularized by Steve Blank.
Side note: If you’re interested in the origin of firm networks, and their role for us as individuals, check out this other post.
How Products Get Funded
There are many costs associated with organizing the resources and individual efforts needed to deliver a final product. To cover these costs, a firm needs to obtain some sort funding. There are generally three sources of funding for a new firm:
- Labour or work contributions: Time is money, as the saying goes. Usually when a firm has no other source of funding, it relies on the grunt work and time of it’s founders, especially in the earliest stages.
- Financing: Grunt work is usually not enough to sufficiently cover all the costs of delivering a product. There are materials and fees that need to be covered as well. Firms will typically seek monetary financing of some sort, whether through equity investments or debt.
- Revenue: This is often not categorized under funding as it’s usually seen as the end goal of a firm. However, considering that the creation of a collective product is really the goal of a company, revenue should be seen as a means to that end, and hence a form of funding.
The problem with revenue however, is that it’s received post production, leaving a gap between the conception of a product and the sale of it. There are some strategies to combat this, that don’t involve the other two forms of funding (labour or financing). For example, consider the millions of dollars Tesla obtained through pre-sales of their Model 3 alone, increasing their ability to produce and sell them a few years down the line.
Owners & Consumers, Managing Product Risk
If revenue, as a source of funding, has this catch-22, why not completely fund the product through the former two funding sources?
In any endeavour, there is a degree of uncertainty, or risk, involved in delivering on the vision of the venture. When a firm decides to organize itself to build a certain product, it’s taking on a certain amount of execution risk. As someone who just wants an iPhone, and not concern themselves with the risk Apple takes day-to-day, revenue presents itself as a risk-free way of funding a product, while still receiving the benefits of it.
Various forms of funding then, have various degrees of risks involved, and a certain degree of risk is necessary in every new endeavour. In order to incentivize individuals to take on risk, riskier forms of funding require a higher reward or payoff.
That’s exactly what equity in a project is designed for. The founders, who fund a company, primarily through labour, usually receive a higher degree of equity or ownership in the firm (hence the term “sweat” equity). The early financiers or investors in a company, also take on a high degree of risk, and are compensated as well through higher degrees of ownership.
Therefore, there is an inversely proportional relationship between a product’s timeline (from conception to final sale), and the degree of risk that funding the product entails.
To deal with this, we have various degrees of ownership over an endeavour. The founders, who usually take on the most risk, will typically receive the highest degree of ownership, and end consumers, or users, who take on almost no risk, get the least degree of ownership.
We mentioned other strategies to deal with the folly of revenue as a funding source. One of them was pre-sales, which remove a degree of execution risk, by both confirming demand, and delivering funding pre-production.
In some ways, pre-sales, combined with the internet, has opened a door to a whole new form of commerce completely. This new form of commerce is often referred to as crowdfunding. If you’re familiar with Kickstarter, you’re familiar with the power of crowdfunding. Firms are able to propose their vision for a new product or service, and a community can immediately confirm demand by offering contributions (i.e. funding), before receiving the product.
This has enabled a whole new generation of businesses that can deliver outstanding products, with a much lower degree of execution risk, making the market (and hence economy) more efficient as a whole. Firms who use crowdfunding don’t need to expend as much of their efforts towards finding financing, and cut their risk of failure by testing whether products will generate demand before production.
Funding a product before you receive it doesn’t come without a degree of risk however. Despite their best efforts, firms that crowd-fund, aren’t able to always deliver the final product. The contributors of these crowdfunding campaigns should certainly not be considered regular consumers then, but usually do not take on the same degree of risk founders or early investors do. In a way, these contributors can be put in a class of their own; backers.
Backers receive more upside than typical customers, usually in the form of perks or rewards. Not only do you receive theatre tickets to the play you funded, but your name appears on the show’s playbill and credits. Over the past few years, financial regulators have allowed this new class of “backers” to even receive a bit of equity as an upside to funding new products and services — a process referred to as equity crowdfunding.
So What’s With Tokens?
In even more recent years, especially since the start of 2017, a new phenomena of funding has begun to go mainstream. Analogous to equity crowdfunding, some web firm networks have begun issuing tokens or coins to large swaths of contributors, or backers as we’re going to call them, to help fund the production of a new product or service. This process is being referred to as an ICO, or Initial Coin Offering (in contrast to an “Initial Public Offering”, or IPO).
Unlike equity crowdfunding however, tokens actually have a utility towards using or consuming the final product of the issuing firm. Akin to a KickStarter campaign then, the backers of these tokens are backing a product they which to consume. And like a Kickstarter, backers expect a bit more of an upside than the regular class of consumers.
Instead of perks or rewards however, tokens are designed with the upside of the potential appreciation of value, similar to the function of equity (i.e. ownership). There are many other technological advances that tokens offer as a means of funding or financing (e.g. liquidity, transparency, low transaction costs), the gist of it however, is as follows:
As backers have appeared as a middle ground between consumers and owners, tokens have appeared as the corresponding middle ground between a consumable product and a stake of ownership (i.e. equity).
The Product-Security Duality
Like a photon that exhibits both particle and wave like properties, tokens observe properties of both a product and a security. Tokens have the power to truly empower backers, along with this new form of commerce — a way to ridiculously lower market risk for new products, and hence make our economy run ridiculously more efficiently.
Regulators must begin to embrace this product-security paradox, and be weary not to fall into the trap of regulating them as one, or the other. Tokens are truly a new species of their own.
May we learn to use them effectively.
Also, if you haven’t already read my central piece on “The Evolution of Organization and Consciousness” — I’d highly recommend it, as many future posts will build off it. Thank you, and feel free to share your thoughts below!