The Principles of Crowdfunding

Understanding the key principles that lie behind crowdfunding is important. This series of posts introduces some of the key ones beginning with The Long Tail and Atomisation

In recent weeks we have made a number of comments about how the principles and underpinning foundations of crowdfunding are often poorly understood. These have largely been in the context of how this unsophisticated understanding of the sector can lead to poor regulation which actually increases risk rather than decreases it, or how people inadvertently expose themselves to risk by participating in crowdfunding in an ill informed way, or alternatively where people sometimes  set unreasonable or misinformed expectation of what crowdfunding entails.

We have also seen comments made that crowdfunding is being held back through misunderstanding. A final motivation for bemoaning the lack of understanding of what we believe makes crowdfunding so distinctive are the increasing number of online finance platforms presenting themselves as “crowdfunding” platforms but which would be unlikely to pass a test of true crowdfunding authenticity!

It seems to me then that I should set out some of the key things that make crowdfunding different and distinctive from traditional investment models, and how these are underpinned by a foundation of interlinked, mutually supportive set of characteristics and philosophical principles that must be defended for the effective safe and sustainable operation of crowdfunding.

To that end we will publish a linked set of blogs under the heading The Principles of Crowdfunding, not unlike our ongoing series on the Components of a good crowdfunding campaign beginning with this post which deals with two key elements at the heart of crowdfunding, the principle of The Long Tail and what we refer to as Atomisation.

The Long Tail

The Long Tail is a concept popularised by Chris Anderson in his book of the same name. The tail in question is the tapering tail of a statistical distribution plotted on a graph. The distribution plot in the graph shown below can be divided using a typical and widely used 80/20 rule giving two distinct sections. Section B – to the right of the divide is referred to as The Long Tail.

The Long Tail – Chris Anderson

The premise is that much of our traditional business thinking is founded in the idea that we focus our instinctive thinking for a range of activity in section A, the 20 of the 80/20. This is where conventional business thinking would typically identify the greatest opportunity for creating value or profit. To illustrate this with an example we can use the popular analogy of a book seller. If we plot a graph that lists all the books available on a horizontal axis against the anticipated sales for each one on the vertical axis, we end up with a plot with the big sellers forming section A on the left of the plot and declining line to the right as we enter the realm of the many many books published that will sell ever decreasing number – this is the Long Tail. Traditionally a book shop will tend to stock a limited number of titles from A or 20 sector in the belief that they will sell well and so this is where the majority of their revenue will come from. It makes perfect economic and logistical sense to do this, maximising the returns on finite shelf space, and reducing delivery and transaction costs by storing only this type of live valuable asset. The Long Tail theory however shows that under that diminishing Long Tail of the graph which would include the myriad of book titles that might only sell very occasionally, there are actually a comparable number of transactions as with the popular titles. When we aggregate all these small individual transactions together then we have a significant total, just as significant as the popular. So if we are able to tap into that mass of tiny incremental transactions we have a valuable resource. And this is exactly what large online book sellers have unlocked by stocking a massive inventory of books, many of which will sell only very rarely but, when brought together, become an economically sustainable total.

This is key to the idea of crowdfunding. It is the idea that instead of relying on funding from a small number of large funders we can reasonably find what we need by gathering together a crowd full of small contributions.

This may not seem revolutionary to you now but just 20 years ago it was. What changed was the arrival of the internet, the web and ecommerce. This has enabled reach and exposure that would once have been impossible and it is the Long Tail which exemplifies the disruptive models which have transformed the notion of the possible though online empowerment.

The distribution of this Long Tail is much more marked in some forms of crowdfunding than others and is perhaps least noticeable in the equity based crowdfunding models. This is in part because typical regulatory frameworks (generally put in place by poorly informed regulators) push against the idea of low barriers to entry and still artificially gate participants from getting involved. That said the Long Tail is the model all crowdfunds should look to tap into. The reason for this is that a wider exposure to greater skills, insight, expertise and diversity of contributors will yield greater benefits for a project as well as a large chunk of funds. If you doubt this then ask yourself what is best, a crowd of experts and advocates to draw on or just a handful?

Atomisation

The second of our key principles is what we refer to as atomisation.It captures the idea that most investments made in crowdfunding should be  small ones. This idea is closely allied to the concept of the Long Tail, something we will refer back to in a future post.

Atomisation manifests itself in a serial investor theoretically developing a wide portfolio of small investments which spreads and balances the exposure to risk. The failure of any one investment will not therefore have catastrophic results on the overarching portfolio. This idea has been advanced from the early days of crowdfunding as part of its inherent resilience and risk mitigation approaches. It has not been accepted without question, the more cynical believing this was an extremely unlikely behaviour trait where the profit motive would out. Interestingly evidence would suggest, drawn for some of the leading P2P platforms, that this is in fact the way portfolios are naturally evolving without the need to regulate or mandate it. Overarching loans on these platforms are being formed by atomised parts and the average investor is indeed segmenting their investments into much smaller parts than might happen in other investment circumstances.

By doing this not only is the underlying strength of the Long Tail principle being demonstrated as both viable and sustainable, but it provides a framework for the widest levels of participation that underlie so many of the other crowdfunding principles. The crowd must be able to take part, and to do so it is necessary to both permit and encourage the smallest of contributions as both possible, valid and welcome.

Of course for this to work well we need the other thing that can come with online transactions and another fundamental principle of crowdfunding – low incremental transaction costs. Our next principle covered in the next blog in this series.