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

Abstract

Problem definition: We consider an entrepreneur designing a fixed funding rewards-based crowdfunding campaign for an innovative product. Product quality is known to the entrepreneur but unknown to some backers. We study how the entrepreneur can signal quality to backers via the design of the crowdfunding campaign, including the price of the reward and the funding target. Academic/practical relevance: Crowdfunding is a new and popular way of funding innovative products. Despite numerous advantages, there are challenges to this model, one of the most significant being 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. Methodology: We employ a game theoretic model of signaling between an entrepreneur and campaign backers. Results: 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 unique, high-quality projects. In addition, we discuss how the entrepreneur should modify the signaling strategy when a high target potentially deters backers from pledging because of the cost of participating in a failed campaign. Managerial implications: We show how entrepreneurs can effectively design their crowdfunding campaign to signal high quality, thus providing guidance to creators listing products on crowdfunding websites. We also show information asymmetry and signaling affect product quality decisions by creators, which in turn is of interest to platform designers seeking to solicit high-quality products for their platforms.