Reward crowdfunding (RC) is fundamentally different from both debt and equity crowdfunding, because the provider of funds does not buy a financial security. However, it is also different from charity since, in exchange for the money given, the provider of funds is promised some good or service in the future. Depending on the money provided, the promise can range from a promotional T-shirt to a full unit of the good or service that is being funded. Although this may seem similar to a standard pre-sale contract, there is an important difference: in reward crowdfunding, the promise to deliver does not include any compensation whatsoever if it is not kept.

At first sight, this contractual arrangement seems to make funding very difficult. The lack of reputation of the creators means that trust cannot substitute formal penalties, and backers should expect the creator to behave in an opportunistic manner and not deliver the good. Nevertheless, when we look at the numbers, we find that the RC market is thriving and a vast majority of creators deliver on their promises. This poses a puzzle for understanding (and regulating) the RC market.

In our paper, we offer a solution to this puzzle by arguing that the RC market should be understood and regulated as a market for talent discovery, rather than as a market for funding. We show that the ‘no-penalty’ contract used in RC is in fact the optimal contract between a creator of unknown talent, who wants to be discovered by the wider market as highly talented, and early adopters of the product.

We think of RC as a first stage, where a creator is discovered to be talented if early adopters support his campaign. In a second stage of production, if the RC campaign proved successful, the creator may capitalize on the discovery of his talent by selling to late adopters and benefitting from goodwill generated in the delivery to the early adopters. Introducing penalties for non-delivery in the crowdfunding stage makes funding easier, because penalties induce a higher probability of delivery. However, the higher delivery rate for creators makes the information on the creator’s talent that the funding provides to the market a weaker indicator of talent. This, in turn, reduces the chance of ‘being discovered’ and accessing second stage benefits.

Our analysis contributes to understanding RC by showing that the ‘no-penalty’ contract is a contractual innovation suitable for talent discovery. This conclusion has important policy implications because it calls for the exemption of the RC contract from the application of consumer protection rules, which impose warranties upon the seller for product failure.

In particular, within the EU, according to Directive 1999/44/EC, sellers of consumer goods are required to guarantee the conformity of the goods with a contract. Consumers can ask for the goods to be repaired, replaced, and reduced in price, or for the contract to be rescinded if the goods are not delivered in conformity with the contract. The remedies the Directive contemplates would protect unsatisfied backers, since the legal warranty created by the Directive can neither be waived nor restricted.

So far, the lack of litigation has allowed the RC market to develop in a legal vacuum, and the platforms have been able to maintain the ‘no-penalty’ contract. Nevertheless, if backers ask for judicial protection, we can expect the consumer protection framework to be enforced, which would put the no-penalty contract in jeopardy. Mandatory penalties for non-delivery (or any type of product failure broadly conceived) would interfere with the talent discovery function of the RC market. The application of the Directive would turn this market into a standard pre-sale market, where it is not possible to signal ability and scale up projects.

María Gutiérrez-Urtiaga is Associate Professor in the Department of Business and Finance of the Universidad Carlos III, Madrid and a research associate at the European Corporate Governance Institute.

Maribel Sáez Lacave is a Professor in the Faculty of Law, Universidad Autonoma de Madrid