E-commerce and crowdfunding: why are they the same in China?

Photo Julien Legrand / Yenching Scholar & Mines ParisTech Engineer / April 18th, 2016

As long as laws and regulations are not changed to promote further diversity in crowdfunding, the industry will very likely focus on products that have already proven their feasibility. This is unlike in the West, where platforms such as Kickstarter or Indiegogo can promote projects even before their first proof of concept. Entrepreneurs in China can therefore see in crowdfunding an alternative to venture capital in scaling up, or use it as a way to test their markets.

Raising funds for one’s start-up in China is a serious challenge. Firstly, commercial banks are reluctant to lend money to small and medium enterprises; currently, less than 10% of bank loans are directed towards them. Secondly, institutional investors, such as InnoFund, the Chinese equivalent of the French Banque Publique d’Investissement (BPI), decline to fund high-risk ventures. They prefer government-backed companies. Thirdly, even though venture capitalists are quickly multiplying in China, the total value of venture capital deals has skyrocketed by 80% year-on-year since 2007. They are still focused on businesses about to scale up. Fortunately, a new hope is developing: fundraising from crowds. Interestingly, Chinese crowdfunding platforms have adopted a very different approach to crowdfunding compared to standard business models in the West. China is witnessing the absorption of crowdfunding activities by its e-commerce platforms, since both the legal and social environments impose constraints unknown in the West. This article analyses those constraints and explains why China’s crowdfunding is being increasingly driven by its leading e-commerce companies.

Crowdfunding is a young industry in China, as it only appeared in 2011 with the creation of the platform Demohour (点名时间). Since then, the industry has undergone an average year-on-year growth of about 155% in total funds raised, reaching US$70 million in 2014. The same year, there were 110 active platforms, 50 of which had been created within the previous 12 months. The market is therefore highly competitive, led by JingDong (京东) with a 31.6% market share, followed by Zhongchou (众筹) at 11%, and Taobao (淘宝) crowdfunding (part of Alibaba – 阿里巴巴) at 9%. Demohour, the first Chinese crowdfunding platform, has fallen to 4th place, being responsible for only 7.2% of the total funds raised by all the crowdfunding platforms.

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If competition is this rough, it is because the potential is real: China counts 650 million netizens, accessing the Internet mostly via smartphones (86% of Internet usage), on which many have electronic money. Alipay alone has 350 million users, and there’s still WeChat Wallet, Baidu Wallet, etc. Household savings are huge – about US$4.6 trillion – and Chinese are increasingly looking for new investment channels at a time of financial uncertainty. Consequently, the World Bank estimated that the Chinese crowdfunding market should reach a total value of about US$50 billion by 2025. With such forecasts, it’s no wonder companies have rushed to the opportunity. Alibaba, following its 2014 IPO, decided to enter the industry with Yu’ebao (余额宝), a reward-based crowdfunding platform focused on movies, and Zhaocaibao (招财宝), a peer-to-peer loan platform. A few months after Alibaba, Jingdong launched its own kickstarter-like platform, Coufenzi (凑份子)—a reward-based crowdfunding platform with a large portfolio of projects. Less than a year later, it also launched an equity-based crowdfunding platform. In the same period, Baidu founded Baifa Youxi (百发有戏) to compete directly with Alibaba’s Yu’ebao on movie-making. Tencent surprisingly remains out of the competition.

These developments, however, occur in a legal grey area. Laws regulating crowdfunding are still to be written. While the Chinese government sees fintech start-ups as a way to force traditional banks to improve their services and products, it also acknowledges the problems they generate. Just in 2013, there were 3,700 cases of illegal fundraising, costing a total of about RMB 6.4 billion. The government has consequently grown increasingly suspicious of loan and equity-based crowdfunding platforms, seeing in them potential Ponzi schemes. Public consultations to update security laws are being held, but they will most likely result in forcing potential investors to possess a specific accreditation, limiting the scale-up effect that gives power to crowdfunding. Reward-based crowdfunding, on the contrary, has not raised similar concerns, and regulators are still rather flexible on this type of activity. As a consequence, crowdfunding platforms have almost all adopted the latter model.

Adding to the legal uncertainty, trust is still rather low among the crowds, the platforms and the start-ups. Many platforms have turned out to be scams in the past few years; both crowds and entrepreneurs are therefore thinking twice before interacting with them. Secondly, start-ups’ failures are still numerous and both crowds and platforms may therefore be reluctant to accompany them in their venture. Last but not least, entrepreneurs may be reluctant to trust crowds with the development of their products—a problem that is especially acute in the case of equity-based crowdfunding.

The Chinese way
Those multiple problems have found a solution in the development of a China-specific type of crowdfunding that has no equivalent in the West: sale-oriented crowdfunding. It is a specific kind of reward-based crowdfunding where the reward is the project’s final product itself. This enables the platforms to avoid too much regulatory scrutiny, as we have seen before. Crowdfunders therefore basically buy the product before it has actually been produced, sharing the production costs and risks. This explains why the two major Chinese e-commerce players (Alibaba and Jingdong) have decided to enter the market, while no e-commerce company has crowdfunding activities in the West. Both had already solved the trust problem through the development of third-party e-payment solutions for e-commerce purposes (e.g. Alipay) and can nowadays boast a sufficient brand recognition to attract both investors and entrepreneurs. Proving that this strategy makes particular sense in China, Demohour, the first crowdfunding actor in the country, has actually pivoted its business model to align with this pre-sale paradigm.

If this type of crowdfunding has proven suitable for the Chinese market specifics, it also has its drawbacks. Because crowdfunders are the final consumers, there is an obligation for results shared by both the start-up and the platform proposing the project. This type of crowdfunding therefore focuses on products that have already reached an advanced stage of development—products that, most of the time, just need funds to launch a large-scale production. As a consequence, as long as laws and regulations are not changed to promote further diversity in crowdfunding, the industry will very likely focus on products that have already proven their feasibility. This is unlike in the West, where platforms such as Kickstarter or Indiegogo can promote projects even before their first proof of concept. Entrepreneurs in China can therefore see in crowdfunding an alternative to venture capital in scaling up, or use it as a way to test their markets.

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