Equity crowdfunding: a risky business for entrepreneurs and investors?

In 2019, equity crowdfunding (ECF) in Europe accounted for almost 6% of early-stage capital investment — around €780 million. The global crowdfunding market, which also includes rewards-based funding and donations, is projected to reach almost US$ 28 billion by 2027.

Yet while ECF may seem an attractive prospect for start-ups, new research suggests that those who choose this route are more likely to fail than those who receive investment from more traditional, established funding sources.

Analyses by Esade’s Daniel Blaseg and co-authors Douglas Cumming and Michael Koetter, which appeared in Entrepreneurship Theory and Practice, suggest that ventures of lower quality are more likely to use ECF to raise external finance — with important implications for investors.

Is ECF a viable alternative to traditional financing?

Online platforms offer new and young ventures a rapid path to a large number of potential investors. But, ask Blaseg, Cumming and Koetter, is this relatively new model a viable alternative to traditional financing?

“Or does it,” they query, “attract entrepreneurs who could not receive funding elsewhere for a very good reason — poor quality? Can a possibly uninformed crowd identify the low-quality from the high-quality entrepreneurs in the project pool of the economy more successfully than outside equity investors and banks?”

To find out, the team conducted a comprehensive sample of ECF campaigns in Germany, monitoring the four largest ECF platforms in the country between November 2011 and December 2015 — a total of 163 ventures, comprising 90% of the ECF market.

Online platforms offer new and young ventures a rapid path to a large number of potential investors

They then analyzed a sample of over 32.000 companies that did not use ECF but could have, defining a further 163 ventures that were selected for their counterfactual similarities.

“We assessed whether projects that use ECF are more likely or not to be successful for the investors,” they explain. “Specifically, we conducted an analysis based on manually collected insolvency data for each of these 326 ventures between 2011 and 2016.”

Germany was chosen for its large sample of detailed data, revealing whether entrepreneurs were associated with a distressed bank (one which has received state support), and information on whether outside equity investors were involved.

Connecting ECF with bank distress

The analysis revealed three main findings: ventures tied to distressed banks were 9% more likely to use ECF; the quality of the bank was an influencing factor on whether the entrepreneur sought ECF; and the entrepreneurs associated with a distressed bank who used ECF were more likely to fail.

“If connected banks are well-capitalized and liquid, associated entrepreneurs are less likely to tap the crowd for equity,” explain Blaseg and co-authors. “Those banks that have inefficiently managed costs and therefore require high loan-loss provisions are, in turn, more likely to drive entrepreneurs toward ECF.”

And, they add, entrepreneurs associated with these ‘risky’ banks who went on to seek ECF were up to 12% more likely to fail. “An unwise crowd is just as prone as a bad bank to finance the low-quality entrepreneurs in the pool of projects,” say the researchers.

ECF: A last resort

However, rather than suggesting that crowdfunders are bad at screening projects, the research implies that the overall quality of ventures is lower in ECF.

“Our evidence does not directly enable an assessment of whether or not ECF investors are worse at screening and due diligence,” explain Blaseg, Cumming and Koetter. “That type of wisdom of the crowd argument could only be tested with data unavailable to us.”

It is clear, though, that a dearth of early-stage capital in Europe, combined with poor bank profitability and tighter regulations, limit access to bank credit for new and young ventures and forces them to seek alternatives.

It seems that tighter funding constraints induce ventures to take to the crowd for funding

“It seems that tighter funding constraints induce ventures to take to the crowd for funding,” continue the authors. “Moreover, we find that ventures do not choose ECF randomly. Our evidence clearly points to a lower likelihood for ventures that are larger, more liquid, less unprofitable, and rated well to use ECF.

“Besides financial profiles and credit ratings, we also provide evidence that more tacit indicators, in particular management team traits, matter in the choice of ECF. Specifically, younger and less experienced management teams with female participation tend to use ECF more often.

“Together, these results suggest that ventures of lower-quality consider the less conventional method of ECF to raise external finance.”

Implications for investors

The overall results of the research reinforce the conclusion that low-quality entrepreneurs in Germany seek funding from the crowd, and the authors have a warning for would-be investors.

“Investors should be made fully aware of the risks associated with ECF through information disclosed on the platform webpages and through online material made available alongside crowdfunding regulations disclosed from securities authorities,” they say.

“Our findings imply that regulations that limit the amounts of investment per year from retail investors, as well as regulations that limit the amount of ECF capital that can be raised by entrepreneurs per year, can mitigate the potential losses associated with crowdfunding.”

All written content is licensed under a Creative Commons Attribution 4.0 International license.