Crowdfunding, an offshoot of crowdsourcing, is being touted as an alternative to traditional sources of financing for small businesses. Despite all its promise, crowdfunding is not without potential problems. To the extent feasible, these possible issues must be anticipated well in advance so that crowdfunding can fulfill its goal of democratizing access to capital.
This paper explores how asymmetrical information in the crowd-funding market can lead to a lemons problem, where high quality start-ups are driven out of the market by low quality projects. Understanding how the lemons problem can arise is critical in determining what reforms are needed to ensure that small entrepreneurs will continue to have the ability to raise money from the crowd.
Part I describes the crowdfunding process and focuses on the equity crowdfunding model. By way of example, we study two popular equity crowdfunding platforms: Grow VC and CrowdCube. Part II describes how the lemons problem is creeping up in crowdsourcing, and explains how a similar lemons problem can occur in crowdfunding. To help prevent information asymmetry, Part III proposes the use of reputation systems, friendship networks, and discussion boards to signal or give clues on the quality of a start-up. Part IV concludes.
Gmeleen Faye Tomboc, The Lemons Problem In Crowdfunding, 30 J. Marshall J. Info. Tech. & Privacy L. 253 (2013)