Crowd (un)funded - is Blockchain Ready to Take Over Traditional Crowdfunding?

Interestingly, in late 2021 Kickstarter announced their plans to move its crowdfunding platform to the blockchain (Matney, 2021) in what would be a decentralised version of their core-functionality. This raised several questions about their rationale to do so and subsequently the company faced heavy backlash (Hall, 2022). Seemingly, the consensus was ‘why change a winning system?’, however - is traditional crowdfunding in fact a winning system, and more importantly, is blockchain ready to take over traditional crowdfunding??

For most businesses it is difficult to get funding. Typically funding takes three forms: self-funding, bank funding, or venture capital. Self-funding is very limited, bank funding typically requires having either an existing business model with proof of strong cash flow or some security on the line, and venture capital (depending on the stage) like to see evidence of quick execution, a strong team and a potential to have a mass appeal. Then came along crowdfunding – the process of raising funds from a large group of people over the internet (Heminway and Hoffman, 2010). Crowdfunding works by a middle party essentially playing matchmaker: to link funders and fundraisers (De Rosa Righi et al, 2020) and in return the crowdfunding platform takes a commission. There has been many success stories. Peloton started with Kickstarter and raised US$307k, the Oculus VR headset also had a substantial raise of US$2.4m, however there has also been big schemes which burned through a lot of cash and failed to deliver (Davalos, 2021). Even worse for investors using crowdfunding, there is an alarmingly high risk of fraud due to limited security measures (Mayer, 2021). These frauds can be as simple as a project reaching certain milestones or even the project / cause itself being completely false.?

So, this is where blockchain can come in. Muneeza et al (2018) found that blockchain can help mitigate risks of crowdfunding platforms and result in them working more effectively whilst Zhao and Coffie (2018) studied the application of blockchain technologies in crowdfunding and identified that blockchain is the optimum solution to deal with issues related to security, investor abuse and illegal transactions.

Back when investment into blockchain was still relatively small, Fanning and Centers (2016) suggested that blockchain has the potential to disrupt the way that the financial system works on a global level and the potential to change the nature of investment. Fast forward to 2020, Deloitte did a study and found that 56% of respondents had considered using equity tokens in their business: equity tokens with regards to crowdfunding would simply be the company’s way of raising funds. In the simplest terms, blockchain can increase the trust and credibility of crowdfunding (De Rosa Righi et al, 2020). It can increase the credibility from the investors perspective, so they know that what they are investing in is legitimate, and it can also increase the credibility from the party raising the funds perspective. To put this into perspective, 78% of campaigns fall short of their goals (Wade, 2022) and 11% of listings on crowdfunding platforms had never received a penny of funding (Edmondson, 2021).

So, what is blockchain and how did it come about? Well, the first concept of blockchain was brought to light by Satoshi Nakamoto in 2008 and in January 2009 the concept was implemented as a key cog of bitcoin (Weiyi Cai, 2018). It was through the use of blockchain that bitcoin became the first digital currency without requiring a trusted authority. Research into digital currencies similar to bitcoin got more focused and the underlying technology of blockchain was separated from bitcoin and developed to apply the technology onto other existing technologies such as cryptography and network topology (Zhang, 2016). Quickly, blockchain became one of the most exciting technologies for future internet of things (Kosba et al, 2016).

Guar and Gaiha (2020) describe blockchain as a distributed, decentralised ledger. Essentially a digital system which records transactions among multiple parties verifiably, with little scope for tampering with. Walport (2016) simply defines blockchain as technology focused on the recording of a distributed ledger, whereas Guo and Liang (2016) consider blockchain to be a secure, decentralised data management technology which is both transparent and auditable. Somewhat differently to traditional methods of recording transactions, blockchain enables peer-to-peer transfer of digital assets without a need for an intermediary (Abozaid, 2014). So, to put that in the context of crowdfunding, it would essentially cut out the platform so that investors can send the money directly to the fundraisers.

Figure 1 – (Muneeza et al, 2018)

?Going a bit deeper, as previously mentioned, blockchain is a decentralised ledger. How it works is by recording each transaction in an efficient, transparent, and secure manner (Schatsky & Muraskin, 2015). Each transaction represents a new block: the term blockchain comes from a sequence of blocks which incorporates complete transaction records as a conventional public ledger would (Lee Kuo Chen, 2015). Each time someone makes a transaction, the respective person is assigned with their own unique identifiers (also known as digital signatures) in which they use to sign the block they add to the blockchain (Guar & Gaiha, 2020). Each subsequent step of the transactions are permanently recorded in a block and added to the prior transaction information, thus forming a blockchain (Weiyi Cai, 2018).

One of the key advantages of blockchain is that it provides a trustworthy audit trail which in essence is tamper proof (Guar & Gaiha, 2020). According to Deloitte (2020) another significant element of blockchain is that ownership records are recorded, including previous owner information and transaction records whilst Zyskind et al, (2015) considers blockchain to protect the security and privacy of user data. What that means in the context of crowdfunding is that since historical records all make up a certain blockchain, it builds up the legitimacy of the project. Since blockchain is decentralised, each transaction on the blockchain has to be validated by peers on the network (Monrat et al, 2019). Figure 2 shows a good representation of the validation.

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?Figure 2 – (Monrat et al, 2019)

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The architecture of blockchain is where a node initiates a particular transaction in the decentralised network by using a digital signature with a private key cryptography (Monrat et al, 2019). Peers in the network then validate these transactions and once the transaction is verified it is included in the block. The nodes do this automatically, therefore there is no human intervention in verifying transactions. Typically, a transaction need six confirmations in the network for it to be considered complete (Monrat et al, 2019). At the top right of Figure 2 you will see ‘miners’ who verify the transactions. Whilst it is the miners who validate the transactions, the nature of the miners have drawn some criticism towards blockchain in ‘selfish mining’ (Eyal and Sirer, 2014). When a transaction is sent, the miner nodes automatically try to solve the puzzle of each transaction and the miner who solves the puzzle first wins and in turn creates a new block…in reward they are given an incentive (Chuil & Koeppl, 2018). Selfish mining occurs when miners achieve a larger revenue than a fair share by essentially hiding blocks. In order to mine blocks, the miners use computational power (Kroll et al, 2012) – and it is not just a small amount of power.

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This moves on nicely to one of the biggest criticisms of blockchain – the high amount of computing resources and power it uses (Swan, 2015). Amazingly and to most, outrageously, in 2018 Bitcoin consumed around the same amount of energy as Ireland (De Vries, 2018) and by 2019, if Bitcoin was a country, it would rank 53rd on the most energy consuming country on the planet.

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Figure 3 – (Monrat et al, 2019)?

Energy consumption isn’t the only criticism towards blockchain. Whilst it is more secure than traditional crowdfunding, the risk of fraud does still exist (Deloitte, 2020). Similarly, as highlighted earlier, Guar & Gaiha, (2020) consider blockchain to be tamper proof. Well - this isn’t entirely true. Blockchain is in fact tamper resistant…not completely immutable (Yaga et al, 2018). There is what’s known as a 51% attack where essentially the attacker can simply create more blocks on a chain than the block creation of the rest of the network to falsify information, this however is very expensive and the chances of this happening are slim.

?So, what makes blockchain a good fit for crowdfunding and why are Kickstarter planning to switch their operations to the blockchain? Well, the first thing is smart contracts. Swan (2015) identifies smart contracts as a key piece of innovation which blockchain has enabled. Smart contracts are a digital transaction protocol that triggers a transaction based on the rules of a pre-agreed contract (Szabo, 1999). The use of smart contracts mean that people can keep track of all changes in the agreement and therefore enables regulators to identify fraudulent fundraising (Niforos et al, 2017). What that could mean for blockchain in crowdfunding is companies raising funds could update with certain milestones that have been hit, and it could also mean that investors money could disburse directly to the companies raising funds automatically based on pre-determined conditions.?

So before going into the question is blockchain ready to takeover crowdfunding, would like to briefly discuss whether blockchain is needed in crowdfunding. So, let’s first talk about the crowdfunding model itself.?

In the existing crowdfunding model, a pool of people contribute a chosen amount of money to a project or cause. The model then works by charging a commission and the premise of the crowdfunding platform is to match the needs and expectation of funders and fundraisers (De Rosa Righi et al, 2020). Currently there are three parties actively involved in crowdfunding; funders, fundraisers and crowdfunding platforms. There is, however, another party – the bank. The banks act as another intermediary who hold the funds before disbursing to the fundraisers (De Rosa Righi et al, 2020). Whilst the existing crowdfunding model has an essence of being decentralised in comparison to raising funds from venture capital for example, most of the campaigns are actually centralised and controlled by a central authority controlling the platform that matches funders and fundraisers (Wade, 2019). See now the issue with this is that either consciously or subconsciously, preferential treatment is awarded to the listings that the respective crowdfunding platform deems worthy. With the inclusion of blockchain onto this, it means not only do every company looking for funds gets an equal chance: but it also drastically increases the scope of people who have the potential to invest. As I mentioned earlier, approximately 78% of campaigns end up falling short of their funds. Another damning number is that that only 1.2% of campaigns go to developing countries. If you think about it, what are the chances of someone lets say in America to search for a crowdfunding platform to invest in a local startup in a developing country? Again, blockchain crowdfunding has the potential to eliminate all boundaries of investment.?

Whilst the elimination of boundaries means the scope for investment is greater, what blockchain also does is provides investors genuine information of the number of funders, the history of the currency, the contracts, the milestones and the fundraisers (De Rosa Righi et al, 2020) - making it super transparent. Shrier et al, (2016) also consider this a key factor which makes blockchain important for crowdfunding in that truth can be measured through the storage of historical information. In turn, it means that the chances of businesses hyperinflating any milestones are thin. If they were to do that by changing the hash of a block – they would have to change the hash of every existing relevant block prior to the transaction which would be incredibly difficult considering the amount of work that would need to be done (Monrat et al, 2019).

In addition, Zhu and Zhou, (2016) also notably highlight the liquidity issues that people in crowdfunding typically has. The nature of crowdfunding means that depending on the type of agreement, it is difficult to get funds back outside the realms of what’s contracted of if a buy-out occurs. Blockchain crowdfunding could enable the crypto-equity issued to be very liquid. Like a standard stock, the price of equity fluctuates depending on the performance of the business. As crowdfunding is focused on startups however, the nature of stock price is very difficult to publicly traded stock and the price is reflected by the price a buyer is willing to pay. In crypto-equity, if the company is doing well and the equity sees an appreciation of the currency, the respective currency holder can sell at the appreciated value. And as we already know, the new buyer will have all the information about the company and the history of the token.

?A thing to keep in mind that if a company was to sell digital tokens on the blockchain, it doesn’t mean that they have to switch their whole operations to log data on the blockchain. Instead, it will interface with their legacy systems (such as an ERP system for example) not supersede the legacy systems. The startup would generate blocks of transactions from its own system and then add them to the blockchain. This, according to Guar & Gaiha, (2020) makes it easy to integrate flows of transactions across numerous parties.

So, is blockchain ready to takeover traditional crowdfunding? Well, lets recap the benefits. In essence, it has the potential to make crowdfunding more reliable, trusted, decentralised, cost-efficient and convenient (De Rosa Righi et al, 2020). My first question would be convenient for who? Yes, it will increase the scope for investment from the company’s perspective and the range of investments from the investee’s perspective, but to those not privy to blockchain, I cannot see them switching at least within the next few years. From a startup’s perspective, in their already hectic schedule do they really want to not only learn how to use blockchain but update it regularly with their business activities. Deloitte (2020) say that issuing digital tokens provides liquidity for companies – well, so does crowdfunding. The key difference would be the absence of commission from the marketplaces (for reference Kickstarter takes 5% as a standard fee plus a further 3-5% processing fee) (Kickstarter, 2022). There is also the critical issue of energy consumption. With the world looking to go ‘greener’, it seems highly unlikely that ‘green’ startups will support fundraising through blockchain, at least at this level of energy consumption. Another thing to keep in mind is that due to the fact blockchain eliminates middle parties due to the decentralised nature, it kind of takes the power away from the banks which is something the governments are likely to want to avoid (Monrat et al, 2019). My feeling is that whilst there are obvious benefits to incorporating blockchain into crowdfunding, I cannot see a widespread application soon. But who knows, with the advancement of blockchain – I funnily enough wouldn’t be surprised if I was wrong.

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