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Should securities regulation promote equity crowdfunding?

Should securities regulation promote equity crowdfunding? Small Bus Econ (2017) 49:579–593 DOI 10.1007/s11187-017-9839-9 Lars Hornuf & Armin Schwienbacher Accepted: 8 July 2016 /Published online: 4 April 2017 The Author(s) 2017. This article is published with open access at Springerlink.com . . . . Abstract In this paper, we show that too strong investor JEL classifications G20 G18 G38 K22 L26 protection may harm small firms and entrepreneurial ini- tiatives, which contrasts with the traditional Blaw and finance^ view that stronger investor protection is better. 1 Introduction This situation is particularly relevant in equity crowdfunding, which refers to a recent financial innova- tion originating on the Internet that targets small and BWe need to have some experience with [equity crowdfunding] before we take away the safety net innovative firms. In many jurisdictions, securities regula- … This is a new and dramatically different proce- tion offers exemptions to prospectus and registration re- dure with a high potential for fraud.^ quirements. We provide an into-depth discussion of recent John Coffee Jr. (Columbia University) regulatory reforms in different countries and discuss how they may impact equity crowdfunding. Building on a Securities regulation is a driving policy tool for en- theoretical framework, we show that optimal regulation suring strong investor protection and, thus, stock market depends on the availability of an alternative early-stage development (La Porta et al. 1997, 1998; La Porta et al. financing such as venture capital and angel finance. Fi- 2006). Traditionally, stronger securities regulations nally, we offer exploratory evidence from Germany on the emerged in response to the financial crises, accounting impact of securities regulation on small business finance. scandals, corporate governance problems, and financial innovations. For example, the United States (US) Con- . . gress adopted the Securities Act of 1933 and the Ex- Keywords Equity crowdfunding Crowdinvesting change Act of 1934 in response to the stock market . . Small business finance Securities regulation Investor crash of 1929 and the resulting Great Depression. These protection regulations were intended to mitigate the information asymmetries between securities issuers and investors, L. Hornuf (*) complementing former state-level legislation in place at Max Planck Institute for Innovation and Competition, 80539 Munich, Germany the time. Similar actions were taken in other developed e-mail: lars.hornuf@ip.mpg.de countries, most recently as a response to the financial crisis of 2008. L. Hornuf Securities regulation primarily concerns firms, which Department of Economics and Institute for Labour Law and Industrial Relations in the European Union, University of Trier, seek to place large security issues to the general public. Behringstraße 21, 54296 Trier, Germany Fervent debate about reforming securities regulation has arisen from the emergence of equity crowdfunding (also A. Schwienbacher (*) referred to as investment-based crowdfunding, Department of Finance and Accounting, Université Côte d’Azur - SKEMA Business School, Avenue Willy Brandt, 59777 Euralille, France e-mail: armin.schwienbacher@skema.edu Source: Wall Street Journal, 1 May 2014. 580 Hornuf and Schwienbacher securities crowdfunding, or crowdinvesting), which de- crowdfunding market is emerging and affected by the scribes a financial innovation in securities issuance that regulation in place (Section 5). Consistent with our gives small entrepreneurs access to the general public predictions, our empirical analysis indicates that firms (Ahlers et al. 2015; Hornuf and Schwienbacher 2016; raise inefficiently low amounts of money when the Vismara 2016a,Vismara 2016b). While transaction exemptions are restrictive. The German case best evi- costs made it unlikely in the past that small amounts dences these funding constraints. Finally, we discuss would be offered to the general public, the Internet now how the existing rules have performed so far and con- provides opportunities to do so. Equity crowdfunding clude (Section 6). has therefore become a viable alternative form of exter- nal finance for entrepreneurial firms in countries that permit the solicitation of the general public without the issuance of a costly prospectus. In this paper, we inves- 2 Recent reforms promoting equity crowdfunding tigate the impact of securities regulation on equity crowdfunding and whether securities regulation should In Europe, equity crowdfunding has challenged securi- promote equity crowdfunding in order to offer alterna- ties regulation because it makes use of the exemptions, tive source of finance to entrepreneurial firms. as defined in the national regulation of prospectus and Traditional research on securities regulation, such as registration requirements. This enables firms to raise that by La Porta et al. (1997, 1998), who focus on the external finance while avoiding incurring significant impact of legal rules on stock markets and economic compliance costs. In many countries, the capital raised growth, considers measures of investor protection that in equity crowdfunding campaigns falls under exemp- mostly apply to large and publicly traded corporations. tions, most importantly with regard to the total amount Our approach here is different, because we concentrate of the offer. Other exemptions refer to the maximum on smaller firms, which are most likely to benefit from number of investors to whom the offer is made, the available exemptions. Regarding the exemptions in minimum contribution imposed on investors, the mini- securities law, countries differ along the minimum mum denomination of the securities offered, and wheth- issuance size that requires compliance with prospectus er the offer is made to qualified investors only. and registration requirements that define responsibilities Recently, regulators around the world have realized and liabilities of management concerning information the economic potential of equity crowdfunding and disclosure. Such differences enable us to explore the started easing the national securities regulation for impact of exemptions and, thus, investor protection for crowdfunding activities that take place in the Internet. small issuances on equity crowdfunding. Therefore, our At least seven jurisdictions have reformed their securi- approach takes the perspective proposed by Acs et al. ties regulation to suit the needs of equity crowdfunding (2016) in that, it examines the impact of country- more effectively, while also protecting investors from specific institutional arrangements on the pursuit of fraud up to a certain level and reducing legal uncertainty micro-level opportunities to create and fund new for issuing firms. In what follows, we investigate how ventures. legislators have tried to unwind the inefficiency at the This paper aims to understand how securities regula- firm level that will be the basis of our theoretical model. tion affects equity crowdfunding, in particular, the ex- The main reforms are summarized in Table 1. emptions to prospectus and registration requirements. In a first step, we therefore provide an overview of the legal regime as well as regulatory reforms that have recently taken place in different jurisdictions (Section 2). The initial compliance costs of a typical IPO often exceed $1,000,000 because issuers must conduct a due diligence, hire a legal counsel and In a second step, we present a theoretical framework underwriter, pay SEC filing fees, state securities filing fees, stock based on small firms deciding between raising their exchange or OTC registration fees, accounting fees and an increased funds from professional investors (venture capital funds, D&O insurance premium (Bagley and Dauchy 2003). For equity business angels) and launching an equity crowdfunding crowdfunding, costs are lower because smaller and simpler firms that do not seek a public listing make offers. Still, according to Darren campaign (Sections 3 and 4). Finally, although data Westlake, founder of the UK portal Crowdcube, costs for such pro- collection is limited because markets are still nascent, spectus approvals are in the range between £20,000 and £100,000 in we offer the first evidence on how the equity the UK. Should securities regulation promote equity crowdfunding? 581 Table 1 Overview of Reforms Reform Maximum issue Maximum amount sold to investor Regulation Disclosure requirements Investor education w/o prospectus of gatekeeper Austria Aternativfinanzierungsgesetz EUR 5,000,000 Single issuer limits 10% of net Trade Minimum information disclosure (AltFG) 2015, previous (previously investable financial assets or authority regarding the issuer and financial reform of the €250,000, twice the monthly net income; or security instrument for issues larger than Kapitalmarktgesetz in before that max. EUR 5000 in case the regulator EUR 250,000 (stocks and bonds) 2013 EUR 100,000) investor has a net income of can and EUR 1,500, 000 (other EUR 2500 or less authorize investments) information disclosure platform requirements (e.g., annual statements) required for issues up to EUR 5,000,000 simplified prospectus Belgium Loi du 25 avril 2014 portant EUR 300,000 if Single issuer limit EUR 1000 for des dispositions diverses, no investor can issues between EUR 100,000 published at the official invest more and EUR 300,000; no single journal Moniteur Belge on than EUR issuer limit for issues below 7 May 2014 nr. 36946 1000; EUR 100,000 otherwise, EUR 100,000 France Ordonnance nr. 2014–559 of EUR 1,000,000 Securities Obligation of the issuers to supply Investors must undergo a test 30 May 2014; Decret (previously regulator simplified documentation to the that determines their risk d’Application nr. 2014– EUR 100,000) authorizes investors, but not subject to approval profile, the results of which 1053 of 16 September platform by the securities regulator must be in line with the 2014 risks involved in equity crowdfunding Germany Kleinanlegerschutzgesetz EUR 2,500,000 Single issuer limit EUR 1000 of Trade Small information leaflet 2015 (previously investor does not want to authority EUR 100,000) provide personal information); authorizes otherwise, twice the monthly net platform income; max. EUR 10,000 Italy Decreto Legge n. 179/2012 EUR 5,000,000 and DecretoLegge n. 33/ (previously 2015 EUR 100,000)* UK PS14/4 2014 EUR 5,000,000 Aggregate limit of 10% of net Securities Retail clients need to seek (previously investable financial assets regulator financial advice EUR authorizes 5,000,000) platform USA JOBS act (Title III) 2012 USD 1,000,000 Aggregate limit of USD 2000 to Securities If the overall amount of the issue is Funding portal or broker- (previously USD 100,000 annually regulator $l00,000 or less, issuers must dealer needs to provide dis- USD 0) authorizes provide the most recent income tax closures, including 582 Hornuf and Schwienbacher Table 1 (continued) Reform Maximum issue Maximum amount sold to investor Regulation Disclosure requirements Investor education w/o prospectus of gatekeeper depending on the income and net funding returns and financial statements, disclosures related to risks wealth portal or which must be certified by the and other investor educa- broker- principal executive officer. For tion materials. dealer issues of more than $100,000 but less than $500,000, financial state must be provided and reviewed by a public accountant, who should be independent from the issuer. The accountant must use professional standards and procedures for the review. For issues of more than $500,000, the issuer must provide audited financial statements. *Only Binnovative startups^ and Binnovative SME’s^ eligible: [a] the incorporation and business operations of the firm should have taken effect no more than 48 months ago; [b] the management is located in Italy, and the main business activities take place there; [c] the annual turnover in the second year of business as stated in the last accounts does not exceed €5,000,000; business activities of the firm take place in Italy; [d] the firm does not and did not make payouts to shareholders using previous corporate profits; [e] the sole or main purpose of the firm is to develop, produce, and sell innovative products or services with a high-technological value; [f] the firm was not established as part of a merger, de-merger, or sale of a corporation or corporate entity; and; [g] the firm fulfills at least one of the following conditions: (1) the firm invests at least 15% of the greater of the annual production costs or the production value in R&D; (2) one-third of the employees, who have obtained a PhD, are enrolled in a university PhD program or two-thirds of the employees have obtained an academic degree or have worked for more than 3 years in a private or public research institution; or (3) the firm owns a patent on an industrial, biotech or electronic semiconductor innovation or owns the right on a software, which is registered in the pubic software register, related to the purpose of the corporation. Article [a] does not apply to Binnovative SME’s^. However, they need to provide an audited balance sheet to investors. Should securities regulation promote equity crowdfunding? 583 2.1 USA In addition, the US legislator strives to protect inves- tors through limiting the amount that an investor may As a principal rule of the US securities law, securities invest in the entire market (aggregate limit). According that are offered to the general public must be registered to the JOBS Act, this aggregate limit shall not exceed with the SEC. This is to protect investors from securities the greater of either $2000 or 5% of the annual income fraud by holding the issuer and underwriter of the secu- or net worth of an investor if either the annual income or rity liable in case of material misstatements or omissions the net worth of the investor is less than $100,000. If the of material facts. However, to account for the needs of annual income or the net worth of the investor is equal to small offerings, exemptions to this rule exist. For exam- or exceeds $100,000, the aggregate limit sold to the ple, accredited investors who can fend for themselves or investor shall not exceed 10% of either its annual in- public offers up to $5,000,000 have been exempted come or net worth, with the respectively greater value from registration with the SEC. However, while the applying. In any case, the maximum aggregate limit sold former exemption does per definition not apply to the to a single investor shall not exceed $100,000. larger crowd, the latter exemption was of no use for Finally, Section 4A(b) of the Securities Act defines equity crowdfunding because the registration at the state the type of information that must be disclosed to poten- level was still required, making a geographically dis- tial investors. If the overall amount of the securities issue persed offer prohibitively expensive. is equal to or below $100,000, issuers must provide their It was mainly for this reason that the US Congress most recent income tax returns and financial statements, passed detailed rules specifically tailored to equity which must be certified by the principal executive offi- crowdfunding. On April 5, 2012, the JOBS Act was cer of the issuer. For issues of more than $100,000 but signed into law, amending the existing exemptions for less than $500,000, financial statements must be provid- ed and reviewed by a public accountant, who should be raising capital under Section 4(6) of the Securities Act. According to Title III of the JOBS Act (also referred to independent from the issuer. Furthermore, the accoun- as CROWDFUND Act), issuers can now raise an over- tant must use professional standards and procedures for all amount of up to $1,000,000 during a 12-month the review. For issues of more than $500,000, the issuer period without filing a registration statement with the must provide audited financial statements. SEC or at the state level. The legislator tied this exemp- In summary, the US equity crowdfunding legislation tion, however, to three conditions: the usage of a broker- has not only established a maximum value for offers dealer or funding portal, limitations on the amount that without a prospectus but also set thresholds for the can be sold to individual investors, and disclosure re- amounts an individual can invest. By considering the quirements for the issuers. compliance costs associated with the provision of infor- According to Section 4(6)(C) of the Securities Act, mation, the JOBS Act further outlined a three-step ap- issuers can now offer or sell securities without a regis- proach on information disclosure. These regulatory tration statement if the transactions is conducted through measures were combined with the establishment of a a broker-dealer or funding portal as defined in private gatekeeper. Section 3(a)(4) and Section 3(a)(80) of the Securities Exchange Act. In this way, the JOBS Act de facto 2.2 Selected reforms in the European Union established a private gatekeeper for equity crowdfunding issues, which is supposed to ensure the The prospectus regulation in the EU has been harmo- correctness and completeness of the securities offered. nized for offers larger than €5,000,000 through direc- However, the JOBS Act did not make explicit that tives that were enacted through national implementation funding portals would be liable for material misstate- laws by the respective EU member states. Therefore, it ments or the omission of material facts by the issuer. is useful to first present EU-level regulation for prospec- While the JOBS Act explicitly states that equity tus regulation before discussing the recent reforms un- crowdfunding issuers will be liable for such offenses, dertaken by individual jurisdictions. it could be argued that the liability of the funding portal A main attempt to harmonize regulation on registra- can be derived from Rule 10b-5 of the Code of Federal tion statements was made with the Directive 2003/71/ Regulations (CFR) as well as the previous Supreme EC of 4 November 2003, which specifies when and how Court decisions (Knight et al. 2012). a prospectus must be published if securities are offered 584 Hornuf and Schwienbacher to the general public. More recently, it was amended by a very narrow exemption, which might lead to a the Directive 2010/73/EU of 24 November 2010, which, considerable amount of legal uncertainty. among other things, modified the extent of certain ex- emptions. Exemptions to publishing a prospectus apply 2.2.2 Austria if at least one of the following criteria is met: In July 2013, the Austrian legislator changed the national [a] The offer is addressed solely to qualified investors; securities law (KMG, Kapitalmarktgesetz)and raised the [b] The offer is addressed to fewer than 150 natural or critical threshold for issues without a prospectus from legal persons per member state, other than quali- €100,000 to €250,000. In October 2013, the first equity fied investors; crowdfunding was then offered to investors by the portal [c] Investors purchase securities for a total consider- 1000×1000, with the first issuer Woodero raising a total of ation of at least €100,000 per investor; €166,950 after a nearly eight-week funding period. The [d] The denomination per unit amounts to at least amount clearly exceeded the initial value of the critical €100,000; and threshold for issues without a prospectus, indicating that [e] The offer of securities represents a total consider- issuers would have been constrained under the earlier ation of less than €100,000 over a 12-month regulation. In 2015, Austria adopted a new regulation period. (Alternativfinanzierungsgesetz; see Schwienbacher 2016, for a discussion) and allows issues up to €5,000,000 In addition to these exemptions, Directive 2010/73/ requesting only a very simplified prospectus from the EU allows national regulators of the EU member states issuer (see the Alternativfinanzierings-Informations- to increase the amount in point [e] up to €5,000,000. verordnung). 2.2.3 UK 2.2.1 Italy In the UK, equity crowdfunding currently takes place The Italian legislator amended the existing securities under the general securities regulation, more precisely law (TUF, Testo Unico della Finanza) and adopted the Financial Services and Markets Act 2000. In Octo- the first specific equity crowdfunding legislation in ber 2013, the Financial Conduct Authority (FCA) initi- Europe. On October 20, 2012, the Decreto Legge n. ated a consultation on a specific equity crowdfunding 179/2012 went into effect. Exemptions now apply to regulation. The new rules were enacted in April 2014 innovative startups and after the implementation of and aim to make equity crowdfunding Bmore accessible Decreto Legge n. 33/2015 in 2015 also to innovative to a wider, but restricted, audience^ of investors, while small and medium-sized enterprises (SMEs) that also ensuring that Bonly those retail investors who can offer common equity shares via online portals. understand and bear the various risks involved are in- Innovative startups and SMEs complying with the vited toinvestinunlistedsharesordebtsecurities^.The law can now make offerings of up to €5,000,000 FCA only allows the brokering of securities to sophis- without the obligation to register a prospectus. The ticated investors, high net worth investors, corporate legal definition of an innovative startup and SMEs is finance contacts, or venture capital contacts, retail cli- geared to firms, which are not registered with a ents who confirm that they will receive regulated invest- regulated market or a multilateral trading facility ment advice or investment management services from and fulfill a lengthy catalog of criteria (see Table 1 an authorized person, or retail clients who certify that for further details). Although the Italian securities they will not invest more than 10% of their net investible regulator Consob was required to set up a public assets in unlisted shares or unlisted debt securities. register and define disclosure requirements for innovative startup and SME issuers, it did not have 2.2.4 France to define which exemptions and critical threshold for issues without a prospectus would apply for non- As a member state of the EU, France implemented the innovative startups and SMEs. In summary, the Prospectus Directive 2010/73/EU and thus applies the Italian equity crowdfunding regulation established same rules as other EU jurisdictions, with some Should securities regulation promote equity crowdfunding? 585 adaptations. The exemption for security offers with a campaign takes place on an Internet portal that total amount of less than €100,000 holds. However, for has receivedformalapprovalfromthe AMF. the range between €100,000 and €1,000,000, an addi- [d] Obligation of the issuers to supply simplified doc- tional exemption applies if the total amount raised does umentation to the investors, as described in the not exceed 50% of the existing equity capital of the firm. reform (but not subject to approval by the AMF). For example, a firm can raise €200,000 without a pro- spectus and registration if it already possesses equity capital of at least €400,000. This is unlikely to occur for 2.2.5 Belgium firms relying on equity crowdfunding, because they generally have little capital on the balance sheet before In 2014, Belgium introduced a reform as a way to foster a successful campaign. The French portal Anaxago does equity crowdfunding while at the same time acting not use the €100,000 limit to exempt firms from the cautiously to avoid a bubble. The new regulation allows prospectus regulation but rather limits the offer to fewer issuances up to €300,000 provided no investor is than 150 non-accredited investors. Consequently, inves- allowed to invest more than €1000 per campaign. Un- tors are required to participate with high minimum like in the USA, the Belgian regulator has defined the tickets, as only a subset of the solicited people may amount that an investor may invest in the same issuer eventually invest. The advantage is that the total amount (single issuer limit) not the overall market. The law of the equity issuance is not limited to €100,000. For the requires that issuers explicitly state this single issuer offerings successfully completed so far, the average limit in the offer. If the single issuer limit is not imposed, number of crowdinvestors on Anaxago is 25, with an issuers remain limited at raising no more than €100,000. average amount raised of more than €320,000. However, the Belgian market remains small and most offers are even today below €100,000. Importantly, French portals need to obtain a license from the French securities regulator AMF because they act as financial intermediaries and thus are sub- 2.2.6 Germany ject to their own rules. The former legal status and requirements in terms of capital imposed on financial Unlike other European countries, Germany recently passed intermediaries made it costly for portals to comply. a specific legislation and for a long time followed a laissez- On February 14, 2014, the ministry of economic faire approach towards equity crowdfunding, which had affairs and finance announced measures to facilitate taken place within the scope of the existing securities law. equity crowdfunding that have become effective in As a general rule, the German Securities Prospectus Act autumn 2014. Among other things, the new regulation (WpPG, Wertpapierprospektgesetz) and the Investment contains the following items: Act (VermAnlG, Vermögensanlagengesetz) set the critical threshold for security and investment issues without a [a] The creation of a special legal entity for accredited prospectus equal to €100,000(Section3Abs.2 Satz 1 equity crowdfunding portals, which differs from Nr. 5 WpPG). However, the definition of what constitutes the one that other financial intermediaries use (so- an investment under the Investment Act was not all- called Conseiller en Investissement Participatif). encompassing and left out subordinated profit- No minimum equity capital is required for this participating loans. This omission left scope for the issuers legal entity. However, it must comply with trans- either to comply with the existing exemptions and raise up parency rules that ensure that the crowd obtains to €100,000 or to bypass the relevant laws altogether by Bfair^ and Bunbiased^ information on the offers. structuring the investment contract in a way that allowed [b] Investors must undergo a test that determines their for offers of unlimited amounts. risk profile, the results of which must be in line On 23 April 2015, the German Parliament passed the with the risks involved in equity crowdfunding. Small Investor Protection Act (Kleinanlegerschutzgesetz) Crowdinvestors must also be made aware when to regulate equity crowdfunding more specifically. Accord- registering at the portal of the risks involved in ing to the new regulation, firms can offer up to €2,500,000 equity crowdfunding. without the obligation to register a prospectus. Similar to [c] The threshold of exemption is increased to the US JOBS Act, the amount sold to a single investor €1,000,000, provided the equity crowdfunding shall generally not exceed €1000. Investors might invest 586 Hornuf and Schwienbacher up to €10,000 per campaign if their wealth exceeds to be agnostic about the absolute size of these two forms of €100,000. If the investor does not have that amount of additional value, we focus on the difference between the assets, the limit is twice the investor’s monthly net income, two. To abstract from discounting future values and with- but in any case not more than €10,000. Most importantly, out loss of generality, let us assume all the parties are risk- this new rule again holds only for specific forms of invest- neutral and the risk-free rate equals zero. This simplifying ments (subordinated profit-participating loans), which did assumption implied a discount rate of zero. previously not fall under the definition of an investment. For other types of investments, which are commonly used 3.1 Issuing firms in crowdfunding campaigns as well (silent partnerships and non-securitized participation rights), firms will only We consider an economy populated by a continu- be able to offer €100,000 without the obligation to register um of firms uniformly distributed along the capital aprospectus(Klöhnetal. 2016). needs dimension θ~[0;Θ], which specifies the level of their individual investment opportunities. Firms have a return on investment (ROI) of v > 0 (iden- 3 Model description tical for all firms), with i ϵ {C,P}, up to the level θ̃ and 0 beyond. Thus, the amount θ̃ represents In this section, we develop a theoretical framework that external capital needs as well as desired invest- allows us to examine the impact of exemptions to pro- ment size. Subscript C corresponds to equity spectus regulation on the fundraising decisions of small crowdfunding, while P to professional investors. firms, who can decide between active, professional in- We consider that the type of financing affects the vestors (such as venture capital funds or business an- ROI, since each type of investor may add value. gels), and the crowd (general public). The model offers a Under this setting, a firm raising and investing setting that considers the issuance of non-listed securi- an amount θ ≤ θ will generate a value of (1 + v ) ties without a registered prospectus. It focuses on the θ, resulting in a net present value (NPV) of v θ.If main exemption from the prospectus regulation, namely, not adequately monitored, entrepreneurs can divert the total amount of the offer. The proposed analysis will afraction δ > 0 of the NPV so that shareholders help understand how the emergence of equity eventually receive only a value of (1-δ)v θ.Entre- crowdfunding as an alternative source of equity finance preneurs privately receive (1-x)δv θ from this di- to professional investors affects the firm’s choice of version, where 0 ≤ x ≤ 1; the remaining fraction x financing source and ultimately optimal regulation. This (i.e., the value xδv θ) is lost so that it generates an in turn may offer guidance in the question whether inefficiency for all shareholders. Entrepreneurs are regulation should promote equity crowdfunding. impacted in two ways: as shareholders, entrepre- To this end, we rely on a theoretical framework that is neurs lose value due to diversion in a similar way based on managerial rent diversion (Shleifer and as any other shareholder; as managers, they gain Wolfenzon 2002). Managers divert rents away when not as they divert some value privately. Depending on properly monitored. While professional investors are as- the relative size of the two opposing effects, en- sumed able to cope with such managerial inefficiency, the trepreneurs may overall gain or lose. To restrict crowd is assumed not able to adequately monitor the the analysis to the case in which diversion is management. Further, we introduce the fact that the two optimal in the absence of adequate monitoring, types of investors offer adding value, either through active we impose the following condition under equity participation in the firm by professional investors crowdfunding (the derivation is provided in the (Gompers and Lerner 2000) or wisdom of the crowd in next section): which crowdinvestors offer their ideas and feedback to the entrepreneur (Hornuf and Schwienbacher 2016). In order Diversion Condition : x < 1=½ ðÞ 1 þ v ðÞ 1−f 3 c The crowd may at times also enjoy other, non-financial benefits from participating as shareholder in the development of startups (Belleflamme et al. 2014). We abstract from these extra benefits here, The diversion condition ensures that, in equilibrium, as these are more likely to be important in other forms of crowdfunding. entrepreneurs will divert corporate resources whenever Should securities regulation promote equity crowdfunding? 587 they are not constrained by shareholders or regulation. If to the venture capital markets, combined with the the condition is not met, then the entrepreneur will not standard restrictions that venture capital funds typ- divert any resources even in the absence of monitoring ically cannot invest more than a certain amount or since he would lose more in profits as shareholder than percentage of total funds in a single portfolio what he gets from diverting privately. company (Metrick 2007). The second source of funding considered here is equity crowdfunding. Crowdinvestors may want to 3.2 Funding choices: professional investors versus impose similar corporate governance and disclo- equity crowdfunding sure rules that mitigate agency costs. However, even if such governance rules were included in a We assume that firms have no internal funds available contract, crowdinvestors could not enforce them and thus need to raise the entire capital externally. For because of coordination problems that result from simplicity, we assume that the entrepreneur initially free riding. The crowd is dispersed and rather owns 100% of the firm. When raising capital, entrepre- passive. We consider this to be a reasonable as- neurs give up a fraction (1-α)ofthe equity,with sumption for the market, given the type of indi- 0 ≤ α ≤ 1. The value of α is determined so that the viduals participating in equity crowdfunding cam- crowd or professional investors are willing to invest paigns. In addition, the crowd does not sit on the under a take-it-or-leave-it offer, while facing an oppor- board of directors of the firms. tunity cost of 0. Portals incur costs from managing the website Professional investors can enforce internally ef- and preparing the firm for the campaign, including fective governance rules. They traditionally do en- drafting investment contract and some of the basic force contracts, because they hold larger equity due diligence. In practice, these costs are passed stakes and participate on the board of directors. on to the firms. We consider a percentage fee, Moreover, they generally draft tailored contracts since the bulk of the portals use such a fee struc- that enable effective intervention in case founders ture. Let us define the fee by f > 0, which is do not behave due diligently. However, interven- charged to the firm after a successful campaign. tion by professional investors is time-consuming and thus costly. For costs, we define them by the 3.3 The regulator variable M > 0. We regard costs M as monitoring and management costs that investors incur. The regulator imposes registration and ex ante To derive practice-relevant implications, we in- disclosure requirements for any security offer to troduce the fact that the availability of finance the general public above a given threshold amount from professional investors varies across countries. T ≥ 0, which can be larger or smaller than S.This While venture capitalists and business angels are view is consistent with real-world exemptions, as well-developed and able to inject very large we have shown in Section 2. A higher threshold amounts in startups in some countries like the value of T implies a lower investor protection in USA, these amounts tend to be smaller in other general, because fewer firms comply with securi- countries especially in continental Europe. Thus, ties regulation. let us consider the maximum amount professional Complying with these requirements leads to fixed investors can provide to be denoted by S.The costs of C > 0 for the firms, which may differ from parameter S proxies for the development of the monitoring costs M incurred by professional investors. venture capital and business angel market in a These compliance costs may arise for different reasons; country. This assumption can be motivated by the some may be incurred by filing with the regulator, while fact that the size of venture capital funds varies others may be due to the disclosure of relevant informa- across countries due to a smaller supply of capital tion to investors. We assume firms complying with Under M, we consider any costs other than B‘effort costs^’ that would disclosure regulation can no longer divert value for lead to moral hazard. Thus, we assume costs M as those costs that are private purposes. Consistent with practice, we assume borne by investors by the sake of being B‘sophisticated^’.These costs that firms can only seek compliance with the regulator if include legal costs as well as costs incurred from running a manage- ment firm. their capital needs are larger than T.In what follows, we 588 Hornuf and Schwienbacher assume that costs C are too high for the firms considered following gains for the entrepreneur: (1 − xδ)v θ(1 − f). in our baseline model. Any firm with θ̃ > T will not raise more than T,as We consider a benevolent regulator who maximizes otherwise the firm would need to obtain a costly prospec- total welfare in the economy that is the sum of value tus approval; thus, gains are capped at (1-xδ)v T(1-f). The ̃ ̃ created by the firms seeking external finance. Thus, the portal receives the total fees of fθ from the firm raising θ. regulator balances the social costs and benefits generat- Case [2]: under professional investor finance, the ed by setting the variable T. entrepreneur will raise a capital amount of θ ≤ S and receives α(1 + v )θ̃, subject to investor at least breaking ̃ ̃ even in the investment: (1 − α)(1 + v )θ =[θ +M]. Here, 3.4 Time line only financial returns accrue to the entrepreneur, since no diversion takes place. Thus, the entrepreneur receives We consider the following time line. At time t =0,the ̃ ̃ v θ − M. Any firm with θ > S will have its gains capped regulator sets T, which becomes public knowledge. At at v T − M. t = 1, the firm decides whether to raise funds from a Both outcomes under [1] and [2] are depicted in professional investor or through equity crowdfunding. At Fig. 1 whenever S > T. It is straightforward to derive t = 2, entrepreneurs make investment decisions, by decid- the threshold level of T, called Ṯ that makes equity ing how much to raise and thus offer a fraction (1-α)of crowdfunding as efficient as professional investors: ownership. Finally, at t = 3 firms realize their payoffs, which are then distributed. Consistent with rational behav- T such thatðÞ 1−xδ v TðÞ 1−f ¼ v T −Mor : c p ior, we solve the game by backward induction and maxi- " # mize firm value based on the entrepreneur’s perspective. T ¼ M= v −ðÞ 1−xδ vðÞ 1−f p c 4 Optimal choice of funding and securities regulation Therefore, equity crowdfunding is the optimal choice of entrepreneurs seeking capital lower than Ṯ, and oth- 4.1 Optimal outcome for the entrepreneur erwise opting for professional investors is optimal. Above the amount S, professional investor can no longer In this section, we derive the optimal choice of funding. supply the full amount, so that the firm needs to seek We first consider the outcome under equity prospectus approval from the regulator. Note that fees crowdfunding and professional investors separately charged by portals also affect the threshold, since fees and then compare them. reduce the amount left for investments and thus the Case [1]: under equity crowdfunding, an entrepreneur overall profitability of the firm. Higher portal fees re- with given capital needs θ ≤ T receives α[(1 + duce profits under equity crowdfunding, making it less v )θ̃(1 − f) − δv θ̃(1 − f)] + (1 − x)δv θ̃(1 − f), subject to c c c attractive relative to professional investors. The result is the crowd at least breaking even in their investment: a lower Ṯ. Moreover, differences in adding value be- (1 − α)[(1 + v )θ̃(1 − f) − δv θ̃(1 − f)] = θ̃. The first term c c tween the crowd (v ) and professional investors (v )shift c p in the first equation represents the financial gains to the the threshold Ṯ.Anincrease in v relative to v increases c p entrepreneur of also being a shareholder (net of diversion Ṯ, which is consistent with equity crowdfunding becom- ̃ ̃ costs δv θ(1 − f)), the second one (1 − x)δv θ(1 − f) her c c ing more profitable and thus more attractive relative to private benefits from diversion. This leads to the professional investors. When S < T (the venture capital and angel market is These simple formulas allow to formally derive the Diversion Con- poorly developed), a discontinuity occurs. The size of dition, where we need to solve the following condition α[(1 + v )θ̃(1 − f) − δv θ̃(1 − f)] + (1 − x)δv θ̃(1 − f) > α[(1 + v )θ̃(1 − f)], c c c c the discontinuity depends on the magnitude of the dif- subject to (1 − α)(1 + v )θ̃(1 − f) = θ̃. The left-hand side of the ference between S and T, as depicted in Fig. 2.Also, inequality is the entrepreneur’s profits under equity crowdfunding there is an area (gray shaded in Fig. 2)that represents when diverting value from shareholders (as stated above); the right- hand side is her profits when not diverting; finally, the second equation firms with capital needs (θ̃) that are larger than the gives the equilibrium financing condition for the crowd under the threshold T. These firms can only raise the amount T, assumption that the entrepreneur does not divert any profits. Substitut- since raising more would lead to less profit due to the ing α from the second equation into the inequality leads to the Diver- sion Condition as stated above. lack of larger amounts from professional investors and Should securities regulation promote equity crowdfunding? 589 Fig. 1 Financing outcomes when Financing Outcomes when S>T S > T. INV-finance denotes the outcome under financing with professional investors, ECF- finance with equity crowdfunding. The x-axis represents the amount to be issued, while the y-axis the entrepreneur’sprofitlevel. The point Ṯ corresponds to the situation where the entrepreneur is indifferent between the two financing alternatives excessive inefficiencies under equity crowdfunding. of development and efficiency of the venture capital and These firms consequently forego some of their invest- business angel market. However, a note is warranted here. ment opportunities, because there is no source of capital Our optimal outcome abstracts from effects that such available to (efficiently) fund them. exemptions may have on the other firms seeking equity It is optimal for the entrepreneur to seek equity finance. Therefore, we will consider below the lowest crowdfunding below Ṯ for the same reason as above, possible exemption value as being the optimum, as it also but potentially also for larger amounts if the small offer minimizes any impact on other firms in the economy. exemption level T is large enough to make it worth- Formally, the optimal level of exemption for equity while. In the case depicted in Fig. 2, this is not happen- crowdfunding is as follows: ing, but would happen if T would be as large as T. Then, larger equity crowdfunding campaigns would occur. T can formally be derived as the solution to the following T* ¼ Tif T < S T* ¼ Tif T > S condition (assuming investors under prospectus approv- al add as much value as professional investors consid- ered so far; i.e., v ): This result yields the following empirical implica- tions. First, a more developed venture capital and busi- ness angels market enables a lower threshold Ṯ,since it ðÞ 1−xδ v T1ðÞ −f ¼ v T−Cor : c p has a higher S (professional investors can finance firms T ¼ C v −ðÞ 1−xδ vðÞ 1−f p c with larger capital needs as their funds are larger) and lower M (professional investors are able to do more cost-efficient contracting and monitoring). Thus, it does not require the regulator to set a higher level of 4.2 Market equilibrium under endogenous regulation exemption. For sufficiently large venture capital and Figures 1 and 2 are helpful in deriving the optimal level of Empirically, costs M may be proxied by the number of law firms and exemption, denoted below as T*, from the perspective of the quality of legal institutions, as this affects legal costs of drafting the securities regulator. This level is affected by the degree contracts and advising services for venture capital funds. 590 Hornuf and Schwienbacher Financing Outcomes when S<T Fig. 2 Financing outcomes when S < T. INV-finance denotes the where the entrepreneur is indifferent between equity crowdfunding outcome under financing with professional investors, ECF-finance and financing with a formal prospectus (if the threshold where with equity crowdfunding. The red line shows the outcome with a large enough to allow equity crowdfunding campaigns to be larger formal prospectus for either traditional capital markets or equity than , which is not the case in this figure; therefore, this range of crowdfunding campaigns above the small offerings exemption T, outcomes is indicated in a dotted box at the top of the figure as for which amounts of issuances must be larger than the threshold T. BECF^). The dotted part of the black and red lines represents The x-axis represents the amount to be issued, while the y-axis the possible outcomes if the regulator changes T entrepreneur’s profitlevel.The point T corresponds to the situation business angel markets, the exemption level can even be is T. This scenario corresponds to cases in which ven- substantially reduced. ture capital and business angel markets are underdevel- Moreover, when S > T (the more general case), oped. Overall, we expect regulators in countries with the condition derived above indicates that Ṯ is de- smaller venture capital and business angel markets to creasing in the following, exogenous parameters: have incentives to set less restrictive exemptions. extent of managerial rent diversion (the parameter δ), the degree of losses derived from such diversion 4.3 Empirical implications (the parameter x), and portal fees (the parameter f). For the ROI, the direction of impact depends on The parameter T can be directly interpreted as the level whether we consider v or v , as discussed above. c p of investor protection, in which a lower value of T A greater rent extraction possibility creates a higher represents more investor protection on average. The cost of capital under equity crowdfunding, since conclusions of our theoretical model lead to the follow- crowdinvestors will require a higher rate of return ing empirical predictions. First, more investor protection for purchasing securities from the firm. Similarly, leads to fewer equity crowdfunding campaigns, since greater losses from diversion and higher portal fees the bulk (if not all) of these campaigns take place under make again equity crowdfunding less valuable rela- securities regulation exemptions. This may eventually tive to professional investors, which reduces the create a smaller equity crowdfunding market, because optimal level of exemption. many firms will find it economically not worthwhile to For the opposite case where S < T (see Fig. 2), the seek prospectus approval by the national regulator. regulator has an incentive to increase T to compensate Others may seek financing from professional investors. for shortage of professional investors. The optimal level In the absence of any exemptions, smaller firms may Should securities regulation promote equity crowdfunding? 591 even refrain from entering the market in the first place, crowdfunding campaigns. To achieve this goal, we offer since equity crowdfunding may be their only option in evidence that restrictive exemptions may create a terms of equity finance. The complete absence of an funding gap, where firms raise inefficiently low exemption (T = 0) leads to an exclusion of firms with the amounts of capital. lowest capital needs, which would not be started in the As our theoretical model predicts, firms may re- first place. This is especially true if there is not a suffi- strict their fundraising goal if the small offer exemp- ciently large, professional market available as main tion threshold is low. One good example is Germa- alternative source of seed capital. ny, which after the UK possesses one of the most Our main conclusion from this analysis is that regu- developed equity crowdfunding market in Europe lation maximizing investor protection hurts small firms (Hornuf and Schmitt 2016)but foralong time set and those relying on equity crowdfunding are likely to the critical threshold for the small offerings exemp- be smaller firms seeking seed or early-stage capital. This tion at the lower bound of €100,000. We illustrate is because these firms are too small to obtain funding that this regulation created a funding gap by relying from professional investors and thus may lack alterna- on the cases of Seedmatch and Companisto. More- tive sources of equity capital. Optimal securities regula- over, like many other continental European coun- tion therefore has to trade off the costs of ensuring tries, the German venture capital and business angel sufficient investor protection with the benefit of easier markets are much less-developed than in countries access to capital for startup firms, which can be an such as the USA and the UK. important driver for economic growth. The contracts that Seedmatch provided to issuers The extent to which exemptions to the prospectus were initially designed to comply with the German regulation are needed depends on the availability of Investment Act. All the initial 26 equity crowdfundings offered by Seedmatch used the alternative sources of capital, mostly from professional investors. Countries with well-developed markets of existing exemption, and a total of 24 issues had to professional and private investors may have fewer ex- be terminated at the threshold of the exemption at emptions. Interestingly, the USA has a well-developed €100,000, which indicates that issuers had higher professional investor market, which can compensate for capital needs. Moreover, as campaigns were some- the lack of exemptions needed to tap the crowd. This times funded very quickly, firms’ capital needs contrasts with Europe, where the angel and venture could have easily been satisfied by the crowd and capital markets are smaller. were only constrained by the existing threshold un- We further expect a substitution to occur away from der the Investment Act (see Fig. 3). professional investors, not for firms with lower capital Seedmatch and other portals soon realized the needs but with average levels. With equity crowdfunding, legally imposed funding constraint and tried to cir- these firms now have an alternative source of funding. For cumvent the existing securities legislation. On No- some firms, the latter may economically be more interest- vember 29, 2012, Seedmatch offered for the first ing, so that they seek funding from the crowd instead of time subordinated profit-participating loans, which professional investors. In fact, changing the level of small until July 10, 2015 were not classified as investment offer exemption T may have no impact on equity under the German Investment Act and thus did not crowdfunding activities in business sectors that are well- require the registration of a prospectus. While there covered by professional investors, except for very small was some legal uncertainty surrounding this issue, issuances. However, other areas may be affected more subordinated profit-participating loans allowed is- when poorly covered by professional investors. This may suers to raise unlimited amounts without the obliga- be more likely in areas with limited growth prospects. tion to draft and register a prospectus. The equity crowdfunding campaigns on Companisto show a similar trend after the portal switched contracts 5 Are existing exemptions too restrictive: some empirical evidence On November 29, 2012, it took Protonet only 48 min to raise €200,000 on Seedmatch. In May 2014, the same firm raised another €1,500,000in10hand8min,afterwhichthe founders decided to In this section, we illustrate the impact of exemptions as continue raising funds. Eventually, they raised €3,000,000 in a few defined in national securities regulation on equity days only. 592 Hornuf and Schwienbacher Seedmatch Fig. 3 Amounts raised in equity 3,000,000 crowdfunding campaigns on Seedmatch (N = 84), Companisto 2,500,000 (N = 47), and Innovestment (N = 47) in the period from 2,000,000 August 1, 2011 to January 1, 1,500,000 2016. The red lines separate the period before and after 1,000,000 subordinated profit-participating 500,000 loanswereusedtocircumventthe threshold of the small offering exemption as defined in the German securities law (T = €100,000). Before financial contracts circumvented the 7.5 m Companisto threshold, the average amounts 3,000,000 raised were €98,048 for Seedmatch campaigns and 2,500,000 €91,673 for Companisto cam- 2,000,000 paigns; thereafter, the amounts rose to €391,440 and €596,827, 1,500,000 respectively (including amounts pledged in unsuccessful cam- 1,000,000 paigns). Innovestment never 500,000 changed its investment contract to circumvent the threshold of the German securities law and ex- hibits an average funding amount of €60,085 per campaign (including amounts pledged in Innovestment unsuccessful campaigns). 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 to subordinated profit-participating loans on February average funding size at Innovestment was €60,085, 4, 2013. After the implementation of the new invest- somewhat below the threshold of €100,000, and in- ment contract, the funding volumes per campaign creased only slightly to €64,796 in the period when more than sextupled on Companisto, while on Seedmatch adopted subordinated profit-participating Seedmatch they almost quadrupled. The largest issue loans. funded under this contractual design raised a total of €7,500,000 for a real estate project. A comparison with Innovestment, which might serve as a control 6 Discussion and concluding remarks group because the portal has not adopted subordinated profit-participating loans, evidences that the increase This study discusses recent reforms in different countries in funding volumes does not merely reflect a general and presents some empirical evidence based on the Ger- trend in the selection of funding campaigns. The man experience in permitting non-accredited investors 9/1/11 9/1/11 9/1/11 11/1/11 11/1/11 11/1/11 1/1/12 1/1/12 1/1/12 3/1/12 3/1/12 3/1/12 5/1/12 5/1/12 5/1/12 7/1/12 7/1/12 7/1/12 9/1/12 9/1/12 9/1/12 11/1/12 11/1/12 11/1/12 1/1/13 1/1/13 1/1/13 3/1/13 3/1/13 3/1/13 5/1/13 5/1/13 5/1/13 7/1/13 7/1/13 7/1/13 9/1/13 9/1/13 9/1/13 11/1/13 11/1/13 11/1/13 1/1/14 1/1/14 1/1/14 3/1/14 3/1/14 3/1/14 5/1/14 5/1/14 5/1/14 7/1/14 7/1/14 7/1/14 9/1/14 9/1/14 9/1/14 11/1/14 11/1/14 11/1/14 1/1/15 1/1/15 1/1/15 3/1/15 3/1/15 3/1/15 5/1/15 5/1/15 5/1/15 7/1/15 7/1/15 7/1/15 9/1/15 9/1/15 9/1/15 11/1/15 11/1/15 11/1/15 1/1/16 1/1/16 1/1/16 Should securities regulation promote equity crowdfunding? 593 access to equity crowdfunding. While our analysis remains References exploratory, it contributes to the ongoing policy debate on how to regulate the market and to examine its potential Acs, Z. J., Audretsch, D. B., Lehmann, E. E., & Licht, G. (2016). impact on business finance. This debate is motivated by National systems of entrepreneurship. Small Business Economics, 46(4), 527–535. the fear expressed by some regulators and academics that Ahlers, G. K. C., Cumming, D., Günther, C., & Schweizer, D. entrepreneurs may take advantage of the less sophisticated (2015). Signaling in equity crowdfunding. Entrepreneurship crowd, by strategically avoiding to raise capital from so- Theory and Practice, 39(4), 955–980. phisticated investors (Hazen 2012;Griffin 2013). Bagley, C.E. and Dauchy, C.E. (2003) The entrepreneur’sguide to business law, 3rd Edition, Thomson West. Our simple theoretical framework generates key Belleflamme, P., Lambert, T., & Schwienbacher, A. (2014). policy implications in relation with alternative sources Crowdfunding: tapping the right crowd. Journal of of entrepreneurial finance. A central implication is that Business Venturing, 29(5), 585–609. benefits related to weaker investor protection that pro- Gompers, P., & Lerner, J. (2000). Money chasing deals? The mote equity crowdfunding markets are higher when the impact of fund inflows on private equity valuation. Journal of Financial Economics, 55,281–325. availability of venture capital and angel capital is scarce. Griffin, Z. J. (2013). Crowdfunding: fleecing the American The notion that strong investor protection can be harm- masses. Case Western Reserve Journal of Law, Technology ful is counter-intuitive to the traditional law and finance & the Internet, 4(2), 375–410. literature that focuses on large firms. A tailored regula- Hazen, T. L. (2012). Crowdfunding or fraudfunding? Social networks and the securities laws—why the specially tion may therefore be needed for equity crowdfunding, tailored exemption must be conditioned on meaningful as securities regulation primarily deals with regulating disclosure. NorthCarolinaLaw Review, 90, 1735– large issuances and therefore impose significant compliance costs that are prohibitively high for small Hornuf, L., & Schmitt, M. (2016). Success and failure in equity crowdfunding. CESifo DICE Report, 14(2), 16–22. firms. Moreover, a lack of specific regulation for equity Hornuf, L. and Schwienbacher, A. (2016) Crowdinvesting—angel crowdfunding may induce portals to resemble online investing for the masses? in: Handbook of Research on angel networks and thus offer little differentiation with Venture Capital: Volume 3. Business Angels: Edward Elgar existing sources of entrepreneurial finance. (Ed. C. Mason and H. Landström), 381–397. Klöhn, L., Hornuf, L., & Schilling, T. (2016). The regulation of Acknowledgments Open access funding provided by Max crowdfunding in the German small investor protection act: Planck Society. This article evolved as part of the research content, consequences, critique, suggestions. European project ‘‘Crowdinvesting in Germany, England and the USA: Company Law, 13(2), 56–66. Regulatory Perspectives and Welfare Implications of a New Knight, T. B., Leo, H., & Ohmer, A. (2012). A very quiet revolu- Financing Scheme,’’ which was supported by the German tion: a primer on securities crowdfunding and title III of the Research Foundation (Deutsche Forschungsgemeinschaft) un- JOBS act. Michigan Journal of Private Equity & Venture der the grant number HO 5296/1-1. We thank Jörn Block, Capital Law, 2,135–153. Mariela Borell, Massimo Colombo, Douglas Cumming, Sofia La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2006). What Johan, Adair Morse, Casimiro Nigro, Jay Ritter, Silvio works in securities Laws? Journal of Finance, 61,1–32. Vismara, two anonymous referees as well as the participants La Porta, R., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R. W. of the Second UC Berkeley Crowdfunding Symposium in (1997). Legal determinants of external finance. 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Open Access This article is distributed under the terms of the Vismara, S. (2016a). Equity retention and social network theory in Creative Commons Attribution 4.0 International License (http:// equity crowdfunding. Small Business Economics, 46(4), creativecommons.org/licenses/by/4.0/), which permits unrestrict- 579–590. ed use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, Vismara, S. (2016b). Information cascades among investors in provide a link to the Creative Commons license, and indicate if equity crowdfunding. Forthcoming: Entrepreneurship Theory changes were made. and Practice. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Small Business Economics Unpaywall

Should securities regulation promote equity crowdfunding?

Small Business EconomicsApr 4, 2017

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0921-898X
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10.1007/s11187-017-9839-9
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Small Bus Econ (2017) 49:579–593 DOI 10.1007/s11187-017-9839-9 Lars Hornuf & Armin Schwienbacher Accepted: 8 July 2016 /Published online: 4 April 2017 The Author(s) 2017. This article is published with open access at Springerlink.com . . . . Abstract In this paper, we show that too strong investor JEL classifications G20 G18 G38 K22 L26 protection may harm small firms and entrepreneurial ini- tiatives, which contrasts with the traditional Blaw and finance^ view that stronger investor protection is better. 1 Introduction This situation is particularly relevant in equity crowdfunding, which refers to a recent financial innova- tion originating on the Internet that targets small and BWe need to have some experience with [equity crowdfunding] before we take away the safety net innovative firms. In many jurisdictions, securities regula- … This is a new and dramatically different proce- tion offers exemptions to prospectus and registration re- dure with a high potential for fraud.^ quirements. We provide an into-depth discussion of recent John Coffee Jr. (Columbia University) regulatory reforms in different countries and discuss how they may impact equity crowdfunding. Building on a Securities regulation is a driving policy tool for en- theoretical framework, we show that optimal regulation suring strong investor protection and, thus, stock market depends on the availability of an alternative early-stage development (La Porta et al. 1997, 1998; La Porta et al. financing such as venture capital and angel finance. Fi- 2006). Traditionally, stronger securities regulations nally, we offer exploratory evidence from Germany on the emerged in response to the financial crises, accounting impact of securities regulation on small business finance. scandals, corporate governance problems, and financial innovations. For example, the United States (US) Con- . . gress adopted the Securities Act of 1933 and the Ex- Keywords Equity crowdfunding Crowdinvesting change Act of 1934 in response to the stock market . . Small business finance Securities regulation Investor crash of 1929 and the resulting Great Depression. These protection regulations were intended to mitigate the information asymmetries between securities issuers and investors, L. Hornuf (*) complementing former state-level legislation in place at Max Planck Institute for Innovation and Competition, 80539 Munich, Germany the time. Similar actions were taken in other developed e-mail: lars.hornuf@ip.mpg.de countries, most recently as a response to the financial crisis of 2008. L. Hornuf Securities regulation primarily concerns firms, which Department of Economics and Institute for Labour Law and Industrial Relations in the European Union, University of Trier, seek to place large security issues to the general public. Behringstraße 21, 54296 Trier, Germany Fervent debate about reforming securities regulation has arisen from the emergence of equity crowdfunding (also A. Schwienbacher (*) referred to as investment-based crowdfunding, Department of Finance and Accounting, Université Côte d’Azur - SKEMA Business School, Avenue Willy Brandt, 59777 Euralille, France e-mail: armin.schwienbacher@skema.edu Source: Wall Street Journal, 1 May 2014. 580 Hornuf and Schwienbacher securities crowdfunding, or crowdinvesting), which de- crowdfunding market is emerging and affected by the scribes a financial innovation in securities issuance that regulation in place (Section 5). Consistent with our gives small entrepreneurs access to the general public predictions, our empirical analysis indicates that firms (Ahlers et al. 2015; Hornuf and Schwienbacher 2016; raise inefficiently low amounts of money when the Vismara 2016a,Vismara 2016b). While transaction exemptions are restrictive. The German case best evi- costs made it unlikely in the past that small amounts dences these funding constraints. Finally, we discuss would be offered to the general public, the Internet now how the existing rules have performed so far and con- provides opportunities to do so. Equity crowdfunding clude (Section 6). has therefore become a viable alternative form of exter- nal finance for entrepreneurial firms in countries that permit the solicitation of the general public without the issuance of a costly prospectus. In this paper, we inves- 2 Recent reforms promoting equity crowdfunding tigate the impact of securities regulation on equity crowdfunding and whether securities regulation should In Europe, equity crowdfunding has challenged securi- promote equity crowdfunding in order to offer alterna- ties regulation because it makes use of the exemptions, tive source of finance to entrepreneurial firms. as defined in the national regulation of prospectus and Traditional research on securities regulation, such as registration requirements. This enables firms to raise that by La Porta et al. (1997, 1998), who focus on the external finance while avoiding incurring significant impact of legal rules on stock markets and economic compliance costs. In many countries, the capital raised growth, considers measures of investor protection that in equity crowdfunding campaigns falls under exemp- mostly apply to large and publicly traded corporations. tions, most importantly with regard to the total amount Our approach here is different, because we concentrate of the offer. Other exemptions refer to the maximum on smaller firms, which are most likely to benefit from number of investors to whom the offer is made, the available exemptions. Regarding the exemptions in minimum contribution imposed on investors, the mini- securities law, countries differ along the minimum mum denomination of the securities offered, and wheth- issuance size that requires compliance with prospectus er the offer is made to qualified investors only. and registration requirements that define responsibilities Recently, regulators around the world have realized and liabilities of management concerning information the economic potential of equity crowdfunding and disclosure. Such differences enable us to explore the started easing the national securities regulation for impact of exemptions and, thus, investor protection for crowdfunding activities that take place in the Internet. small issuances on equity crowdfunding. Therefore, our At least seven jurisdictions have reformed their securi- approach takes the perspective proposed by Acs et al. ties regulation to suit the needs of equity crowdfunding (2016) in that, it examines the impact of country- more effectively, while also protecting investors from specific institutional arrangements on the pursuit of fraud up to a certain level and reducing legal uncertainty micro-level opportunities to create and fund new for issuing firms. In what follows, we investigate how ventures. legislators have tried to unwind the inefficiency at the This paper aims to understand how securities regula- firm level that will be the basis of our theoretical model. tion affects equity crowdfunding, in particular, the ex- The main reforms are summarized in Table 1. emptions to prospectus and registration requirements. In a first step, we therefore provide an overview of the legal regime as well as regulatory reforms that have recently taken place in different jurisdictions (Section 2). The initial compliance costs of a typical IPO often exceed $1,000,000 because issuers must conduct a due diligence, hire a legal counsel and In a second step, we present a theoretical framework underwriter, pay SEC filing fees, state securities filing fees, stock based on small firms deciding between raising their exchange or OTC registration fees, accounting fees and an increased funds from professional investors (venture capital funds, D&O insurance premium (Bagley and Dauchy 2003). For equity business angels) and launching an equity crowdfunding crowdfunding, costs are lower because smaller and simpler firms that do not seek a public listing make offers. Still, according to Darren campaign (Sections 3 and 4). Finally, although data Westlake, founder of the UK portal Crowdcube, costs for such pro- collection is limited because markets are still nascent, spectus approvals are in the range between £20,000 and £100,000 in we offer the first evidence on how the equity the UK. Should securities regulation promote equity crowdfunding? 581 Table 1 Overview of Reforms Reform Maximum issue Maximum amount sold to investor Regulation Disclosure requirements Investor education w/o prospectus of gatekeeper Austria Aternativfinanzierungsgesetz EUR 5,000,000 Single issuer limits 10% of net Trade Minimum information disclosure (AltFG) 2015, previous (previously investable financial assets or authority regarding the issuer and financial reform of the €250,000, twice the monthly net income; or security instrument for issues larger than Kapitalmarktgesetz in before that max. EUR 5000 in case the regulator EUR 250,000 (stocks and bonds) 2013 EUR 100,000) investor has a net income of can and EUR 1,500, 000 (other EUR 2500 or less authorize investments) information disclosure platform requirements (e.g., annual statements) required for issues up to EUR 5,000,000 simplified prospectus Belgium Loi du 25 avril 2014 portant EUR 300,000 if Single issuer limit EUR 1000 for des dispositions diverses, no investor can issues between EUR 100,000 published at the official invest more and EUR 300,000; no single journal Moniteur Belge on than EUR issuer limit for issues below 7 May 2014 nr. 36946 1000; EUR 100,000 otherwise, EUR 100,000 France Ordonnance nr. 2014–559 of EUR 1,000,000 Securities Obligation of the issuers to supply Investors must undergo a test 30 May 2014; Decret (previously regulator simplified documentation to the that determines their risk d’Application nr. 2014– EUR 100,000) authorizes investors, but not subject to approval profile, the results of which 1053 of 16 September platform by the securities regulator must be in line with the 2014 risks involved in equity crowdfunding Germany Kleinanlegerschutzgesetz EUR 2,500,000 Single issuer limit EUR 1000 of Trade Small information leaflet 2015 (previously investor does not want to authority EUR 100,000) provide personal information); authorizes otherwise, twice the monthly net platform income; max. EUR 10,000 Italy Decreto Legge n. 179/2012 EUR 5,000,000 and DecretoLegge n. 33/ (previously 2015 EUR 100,000)* UK PS14/4 2014 EUR 5,000,000 Aggregate limit of 10% of net Securities Retail clients need to seek (previously investable financial assets regulator financial advice EUR authorizes 5,000,000) platform USA JOBS act (Title III) 2012 USD 1,000,000 Aggregate limit of USD 2000 to Securities If the overall amount of the issue is Funding portal or broker- (previously USD 100,000 annually regulator $l00,000 or less, issuers must dealer needs to provide dis- USD 0) authorizes provide the most recent income tax closures, including 582 Hornuf and Schwienbacher Table 1 (continued) Reform Maximum issue Maximum amount sold to investor Regulation Disclosure requirements Investor education w/o prospectus of gatekeeper depending on the income and net funding returns and financial statements, disclosures related to risks wealth portal or which must be certified by the and other investor educa- broker- principal executive officer. For tion materials. dealer issues of more than $100,000 but less than $500,000, financial state must be provided and reviewed by a public accountant, who should be independent from the issuer. The accountant must use professional standards and procedures for the review. For issues of more than $500,000, the issuer must provide audited financial statements. *Only Binnovative startups^ and Binnovative SME’s^ eligible: [a] the incorporation and business operations of the firm should have taken effect no more than 48 months ago; [b] the management is located in Italy, and the main business activities take place there; [c] the annual turnover in the second year of business as stated in the last accounts does not exceed €5,000,000; business activities of the firm take place in Italy; [d] the firm does not and did not make payouts to shareholders using previous corporate profits; [e] the sole or main purpose of the firm is to develop, produce, and sell innovative products or services with a high-technological value; [f] the firm was not established as part of a merger, de-merger, or sale of a corporation or corporate entity; and; [g] the firm fulfills at least one of the following conditions: (1) the firm invests at least 15% of the greater of the annual production costs or the production value in R&D; (2) one-third of the employees, who have obtained a PhD, are enrolled in a university PhD program or two-thirds of the employees have obtained an academic degree or have worked for more than 3 years in a private or public research institution; or (3) the firm owns a patent on an industrial, biotech or electronic semiconductor innovation or owns the right on a software, which is registered in the pubic software register, related to the purpose of the corporation. Article [a] does not apply to Binnovative SME’s^. However, they need to provide an audited balance sheet to investors. Should securities regulation promote equity crowdfunding? 583 2.1 USA In addition, the US legislator strives to protect inves- tors through limiting the amount that an investor may As a principal rule of the US securities law, securities invest in the entire market (aggregate limit). According that are offered to the general public must be registered to the JOBS Act, this aggregate limit shall not exceed with the SEC. This is to protect investors from securities the greater of either $2000 or 5% of the annual income fraud by holding the issuer and underwriter of the secu- or net worth of an investor if either the annual income or rity liable in case of material misstatements or omissions the net worth of the investor is less than $100,000. If the of material facts. However, to account for the needs of annual income or the net worth of the investor is equal to small offerings, exemptions to this rule exist. For exam- or exceeds $100,000, the aggregate limit sold to the ple, accredited investors who can fend for themselves or investor shall not exceed 10% of either its annual in- public offers up to $5,000,000 have been exempted come or net worth, with the respectively greater value from registration with the SEC. However, while the applying. In any case, the maximum aggregate limit sold former exemption does per definition not apply to the to a single investor shall not exceed $100,000. larger crowd, the latter exemption was of no use for Finally, Section 4A(b) of the Securities Act defines equity crowdfunding because the registration at the state the type of information that must be disclosed to poten- level was still required, making a geographically dis- tial investors. If the overall amount of the securities issue persed offer prohibitively expensive. is equal to or below $100,000, issuers must provide their It was mainly for this reason that the US Congress most recent income tax returns and financial statements, passed detailed rules specifically tailored to equity which must be certified by the principal executive offi- crowdfunding. On April 5, 2012, the JOBS Act was cer of the issuer. For issues of more than $100,000 but signed into law, amending the existing exemptions for less than $500,000, financial statements must be provid- ed and reviewed by a public accountant, who should be raising capital under Section 4(6) of the Securities Act. According to Title III of the JOBS Act (also referred to independent from the issuer. Furthermore, the accoun- as CROWDFUND Act), issuers can now raise an over- tant must use professional standards and procedures for all amount of up to $1,000,000 during a 12-month the review. For issues of more than $500,000, the issuer period without filing a registration statement with the must provide audited financial statements. SEC or at the state level. The legislator tied this exemp- In summary, the US equity crowdfunding legislation tion, however, to three conditions: the usage of a broker- has not only established a maximum value for offers dealer or funding portal, limitations on the amount that without a prospectus but also set thresholds for the can be sold to individual investors, and disclosure re- amounts an individual can invest. By considering the quirements for the issuers. compliance costs associated with the provision of infor- According to Section 4(6)(C) of the Securities Act, mation, the JOBS Act further outlined a three-step ap- issuers can now offer or sell securities without a regis- proach on information disclosure. These regulatory tration statement if the transactions is conducted through measures were combined with the establishment of a a broker-dealer or funding portal as defined in private gatekeeper. Section 3(a)(4) and Section 3(a)(80) of the Securities Exchange Act. In this way, the JOBS Act de facto 2.2 Selected reforms in the European Union established a private gatekeeper for equity crowdfunding issues, which is supposed to ensure the The prospectus regulation in the EU has been harmo- correctness and completeness of the securities offered. nized for offers larger than €5,000,000 through direc- However, the JOBS Act did not make explicit that tives that were enacted through national implementation funding portals would be liable for material misstate- laws by the respective EU member states. Therefore, it ments or the omission of material facts by the issuer. is useful to first present EU-level regulation for prospec- While the JOBS Act explicitly states that equity tus regulation before discussing the recent reforms un- crowdfunding issuers will be liable for such offenses, dertaken by individual jurisdictions. it could be argued that the liability of the funding portal A main attempt to harmonize regulation on registra- can be derived from Rule 10b-5 of the Code of Federal tion statements was made with the Directive 2003/71/ Regulations (CFR) as well as the previous Supreme EC of 4 November 2003, which specifies when and how Court decisions (Knight et al. 2012). a prospectus must be published if securities are offered 584 Hornuf and Schwienbacher to the general public. More recently, it was amended by a very narrow exemption, which might lead to a the Directive 2010/73/EU of 24 November 2010, which, considerable amount of legal uncertainty. among other things, modified the extent of certain ex- emptions. Exemptions to publishing a prospectus apply 2.2.2 Austria if at least one of the following criteria is met: In July 2013, the Austrian legislator changed the national [a] The offer is addressed solely to qualified investors; securities law (KMG, Kapitalmarktgesetz)and raised the [b] The offer is addressed to fewer than 150 natural or critical threshold for issues without a prospectus from legal persons per member state, other than quali- €100,000 to €250,000. In October 2013, the first equity fied investors; crowdfunding was then offered to investors by the portal [c] Investors purchase securities for a total consider- 1000×1000, with the first issuer Woodero raising a total of ation of at least €100,000 per investor; €166,950 after a nearly eight-week funding period. The [d] The denomination per unit amounts to at least amount clearly exceeded the initial value of the critical €100,000; and threshold for issues without a prospectus, indicating that [e] The offer of securities represents a total consider- issuers would have been constrained under the earlier ation of less than €100,000 over a 12-month regulation. In 2015, Austria adopted a new regulation period. (Alternativfinanzierungsgesetz; see Schwienbacher 2016, for a discussion) and allows issues up to €5,000,000 In addition to these exemptions, Directive 2010/73/ requesting only a very simplified prospectus from the EU allows national regulators of the EU member states issuer (see the Alternativfinanzierings-Informations- to increase the amount in point [e] up to €5,000,000. verordnung). 2.2.3 UK 2.2.1 Italy In the UK, equity crowdfunding currently takes place The Italian legislator amended the existing securities under the general securities regulation, more precisely law (TUF, Testo Unico della Finanza) and adopted the Financial Services and Markets Act 2000. In Octo- the first specific equity crowdfunding legislation in ber 2013, the Financial Conduct Authority (FCA) initi- Europe. On October 20, 2012, the Decreto Legge n. ated a consultation on a specific equity crowdfunding 179/2012 went into effect. Exemptions now apply to regulation. The new rules were enacted in April 2014 innovative startups and after the implementation of and aim to make equity crowdfunding Bmore accessible Decreto Legge n. 33/2015 in 2015 also to innovative to a wider, but restricted, audience^ of investors, while small and medium-sized enterprises (SMEs) that also ensuring that Bonly those retail investors who can offer common equity shares via online portals. understand and bear the various risks involved are in- Innovative startups and SMEs complying with the vited toinvestinunlistedsharesordebtsecurities^.The law can now make offerings of up to €5,000,000 FCA only allows the brokering of securities to sophis- without the obligation to register a prospectus. The ticated investors, high net worth investors, corporate legal definition of an innovative startup and SMEs is finance contacts, or venture capital contacts, retail cli- geared to firms, which are not registered with a ents who confirm that they will receive regulated invest- regulated market or a multilateral trading facility ment advice or investment management services from and fulfill a lengthy catalog of criteria (see Table 1 an authorized person, or retail clients who certify that for further details). Although the Italian securities they will not invest more than 10% of their net investible regulator Consob was required to set up a public assets in unlisted shares or unlisted debt securities. register and define disclosure requirements for innovative startup and SME issuers, it did not have 2.2.4 France to define which exemptions and critical threshold for issues without a prospectus would apply for non- As a member state of the EU, France implemented the innovative startups and SMEs. In summary, the Prospectus Directive 2010/73/EU and thus applies the Italian equity crowdfunding regulation established same rules as other EU jurisdictions, with some Should securities regulation promote equity crowdfunding? 585 adaptations. The exemption for security offers with a campaign takes place on an Internet portal that total amount of less than €100,000 holds. However, for has receivedformalapprovalfromthe AMF. the range between €100,000 and €1,000,000, an addi- [d] Obligation of the issuers to supply simplified doc- tional exemption applies if the total amount raised does umentation to the investors, as described in the not exceed 50% of the existing equity capital of the firm. reform (but not subject to approval by the AMF). For example, a firm can raise €200,000 without a pro- spectus and registration if it already possesses equity capital of at least €400,000. This is unlikely to occur for 2.2.5 Belgium firms relying on equity crowdfunding, because they generally have little capital on the balance sheet before In 2014, Belgium introduced a reform as a way to foster a successful campaign. The French portal Anaxago does equity crowdfunding while at the same time acting not use the €100,000 limit to exempt firms from the cautiously to avoid a bubble. The new regulation allows prospectus regulation but rather limits the offer to fewer issuances up to €300,000 provided no investor is than 150 non-accredited investors. Consequently, inves- allowed to invest more than €1000 per campaign. Un- tors are required to participate with high minimum like in the USA, the Belgian regulator has defined the tickets, as only a subset of the solicited people may amount that an investor may invest in the same issuer eventually invest. The advantage is that the total amount (single issuer limit) not the overall market. The law of the equity issuance is not limited to €100,000. For the requires that issuers explicitly state this single issuer offerings successfully completed so far, the average limit in the offer. If the single issuer limit is not imposed, number of crowdinvestors on Anaxago is 25, with an issuers remain limited at raising no more than €100,000. average amount raised of more than €320,000. However, the Belgian market remains small and most offers are even today below €100,000. Importantly, French portals need to obtain a license from the French securities regulator AMF because they act as financial intermediaries and thus are sub- 2.2.6 Germany ject to their own rules. The former legal status and requirements in terms of capital imposed on financial Unlike other European countries, Germany recently passed intermediaries made it costly for portals to comply. a specific legislation and for a long time followed a laissez- On February 14, 2014, the ministry of economic faire approach towards equity crowdfunding, which had affairs and finance announced measures to facilitate taken place within the scope of the existing securities law. equity crowdfunding that have become effective in As a general rule, the German Securities Prospectus Act autumn 2014. Among other things, the new regulation (WpPG, Wertpapierprospektgesetz) and the Investment contains the following items: Act (VermAnlG, Vermögensanlagengesetz) set the critical threshold for security and investment issues without a [a] The creation of a special legal entity for accredited prospectus equal to €100,000(Section3Abs.2 Satz 1 equity crowdfunding portals, which differs from Nr. 5 WpPG). However, the definition of what constitutes the one that other financial intermediaries use (so- an investment under the Investment Act was not all- called Conseiller en Investissement Participatif). encompassing and left out subordinated profit- No minimum equity capital is required for this participating loans. This omission left scope for the issuers legal entity. However, it must comply with trans- either to comply with the existing exemptions and raise up parency rules that ensure that the crowd obtains to €100,000 or to bypass the relevant laws altogether by Bfair^ and Bunbiased^ information on the offers. structuring the investment contract in a way that allowed [b] Investors must undergo a test that determines their for offers of unlimited amounts. risk profile, the results of which must be in line On 23 April 2015, the German Parliament passed the with the risks involved in equity crowdfunding. Small Investor Protection Act (Kleinanlegerschutzgesetz) Crowdinvestors must also be made aware when to regulate equity crowdfunding more specifically. Accord- registering at the portal of the risks involved in ing to the new regulation, firms can offer up to €2,500,000 equity crowdfunding. without the obligation to register a prospectus. Similar to [c] The threshold of exemption is increased to the US JOBS Act, the amount sold to a single investor €1,000,000, provided the equity crowdfunding shall generally not exceed €1000. Investors might invest 586 Hornuf and Schwienbacher up to €10,000 per campaign if their wealth exceeds to be agnostic about the absolute size of these two forms of €100,000. If the investor does not have that amount of additional value, we focus on the difference between the assets, the limit is twice the investor’s monthly net income, two. To abstract from discounting future values and with- but in any case not more than €10,000. Most importantly, out loss of generality, let us assume all the parties are risk- this new rule again holds only for specific forms of invest- neutral and the risk-free rate equals zero. This simplifying ments (subordinated profit-participating loans), which did assumption implied a discount rate of zero. previously not fall under the definition of an investment. For other types of investments, which are commonly used 3.1 Issuing firms in crowdfunding campaigns as well (silent partnerships and non-securitized participation rights), firms will only We consider an economy populated by a continu- be able to offer €100,000 without the obligation to register um of firms uniformly distributed along the capital aprospectus(Klöhnetal. 2016). needs dimension θ~[0;Θ], which specifies the level of their individual investment opportunities. Firms have a return on investment (ROI) of v > 0 (iden- 3 Model description tical for all firms), with i ϵ {C,P}, up to the level θ̃ and 0 beyond. Thus, the amount θ̃ represents In this section, we develop a theoretical framework that external capital needs as well as desired invest- allows us to examine the impact of exemptions to pro- ment size. Subscript C corresponds to equity spectus regulation on the fundraising decisions of small crowdfunding, while P to professional investors. firms, who can decide between active, professional in- We consider that the type of financing affects the vestors (such as venture capital funds or business an- ROI, since each type of investor may add value. gels), and the crowd (general public). The model offers a Under this setting, a firm raising and investing setting that considers the issuance of non-listed securi- an amount θ ≤ θ will generate a value of (1 + v ) ties without a registered prospectus. It focuses on the θ, resulting in a net present value (NPV) of v θ.If main exemption from the prospectus regulation, namely, not adequately monitored, entrepreneurs can divert the total amount of the offer. The proposed analysis will afraction δ > 0 of the NPV so that shareholders help understand how the emergence of equity eventually receive only a value of (1-δ)v θ.Entre- crowdfunding as an alternative source of equity finance preneurs privately receive (1-x)δv θ from this di- to professional investors affects the firm’s choice of version, where 0 ≤ x ≤ 1; the remaining fraction x financing source and ultimately optimal regulation. This (i.e., the value xδv θ) is lost so that it generates an in turn may offer guidance in the question whether inefficiency for all shareholders. Entrepreneurs are regulation should promote equity crowdfunding. impacted in two ways: as shareholders, entrepre- To this end, we rely on a theoretical framework that is neurs lose value due to diversion in a similar way based on managerial rent diversion (Shleifer and as any other shareholder; as managers, they gain Wolfenzon 2002). Managers divert rents away when not as they divert some value privately. Depending on properly monitored. While professional investors are as- the relative size of the two opposing effects, en- sumed able to cope with such managerial inefficiency, the trepreneurs may overall gain or lose. To restrict crowd is assumed not able to adequately monitor the the analysis to the case in which diversion is management. Further, we introduce the fact that the two optimal in the absence of adequate monitoring, types of investors offer adding value, either through active we impose the following condition under equity participation in the firm by professional investors crowdfunding (the derivation is provided in the (Gompers and Lerner 2000) or wisdom of the crowd in next section): which crowdinvestors offer their ideas and feedback to the entrepreneur (Hornuf and Schwienbacher 2016). In order Diversion Condition : x < 1=½ ðÞ 1 þ v ðÞ 1−f 3 c The crowd may at times also enjoy other, non-financial benefits from participating as shareholder in the development of startups (Belleflamme et al. 2014). We abstract from these extra benefits here, The diversion condition ensures that, in equilibrium, as these are more likely to be important in other forms of crowdfunding. entrepreneurs will divert corporate resources whenever Should securities regulation promote equity crowdfunding? 587 they are not constrained by shareholders or regulation. If to the venture capital markets, combined with the the condition is not met, then the entrepreneur will not standard restrictions that venture capital funds typ- divert any resources even in the absence of monitoring ically cannot invest more than a certain amount or since he would lose more in profits as shareholder than percentage of total funds in a single portfolio what he gets from diverting privately. company (Metrick 2007). The second source of funding considered here is equity crowdfunding. Crowdinvestors may want to 3.2 Funding choices: professional investors versus impose similar corporate governance and disclo- equity crowdfunding sure rules that mitigate agency costs. However, even if such governance rules were included in a We assume that firms have no internal funds available contract, crowdinvestors could not enforce them and thus need to raise the entire capital externally. For because of coordination problems that result from simplicity, we assume that the entrepreneur initially free riding. The crowd is dispersed and rather owns 100% of the firm. When raising capital, entrepre- passive. We consider this to be a reasonable as- neurs give up a fraction (1-α)ofthe equity,with sumption for the market, given the type of indi- 0 ≤ α ≤ 1. The value of α is determined so that the viduals participating in equity crowdfunding cam- crowd or professional investors are willing to invest paigns. In addition, the crowd does not sit on the under a take-it-or-leave-it offer, while facing an oppor- board of directors of the firms. tunity cost of 0. Portals incur costs from managing the website Professional investors can enforce internally ef- and preparing the firm for the campaign, including fective governance rules. They traditionally do en- drafting investment contract and some of the basic force contracts, because they hold larger equity due diligence. In practice, these costs are passed stakes and participate on the board of directors. on to the firms. We consider a percentage fee, Moreover, they generally draft tailored contracts since the bulk of the portals use such a fee struc- that enable effective intervention in case founders ture. Let us define the fee by f > 0, which is do not behave due diligently. However, interven- charged to the firm after a successful campaign. tion by professional investors is time-consuming and thus costly. For costs, we define them by the 3.3 The regulator variable M > 0. We regard costs M as monitoring and management costs that investors incur. The regulator imposes registration and ex ante To derive practice-relevant implications, we in- disclosure requirements for any security offer to troduce the fact that the availability of finance the general public above a given threshold amount from professional investors varies across countries. T ≥ 0, which can be larger or smaller than S.This While venture capitalists and business angels are view is consistent with real-world exemptions, as well-developed and able to inject very large we have shown in Section 2. A higher threshold amounts in startups in some countries like the value of T implies a lower investor protection in USA, these amounts tend to be smaller in other general, because fewer firms comply with securi- countries especially in continental Europe. Thus, ties regulation. let us consider the maximum amount professional Complying with these requirements leads to fixed investors can provide to be denoted by S.The costs of C > 0 for the firms, which may differ from parameter S proxies for the development of the monitoring costs M incurred by professional investors. venture capital and business angel market in a These compliance costs may arise for different reasons; country. This assumption can be motivated by the some may be incurred by filing with the regulator, while fact that the size of venture capital funds varies others may be due to the disclosure of relevant informa- across countries due to a smaller supply of capital tion to investors. We assume firms complying with Under M, we consider any costs other than B‘effort costs^’ that would disclosure regulation can no longer divert value for lead to moral hazard. Thus, we assume costs M as those costs that are private purposes. Consistent with practice, we assume borne by investors by the sake of being B‘sophisticated^’.These costs that firms can only seek compliance with the regulator if include legal costs as well as costs incurred from running a manage- ment firm. their capital needs are larger than T.In what follows, we 588 Hornuf and Schwienbacher assume that costs C are too high for the firms considered following gains for the entrepreneur: (1 − xδ)v θ(1 − f). in our baseline model. Any firm with θ̃ > T will not raise more than T,as We consider a benevolent regulator who maximizes otherwise the firm would need to obtain a costly prospec- total welfare in the economy that is the sum of value tus approval; thus, gains are capped at (1-xδ)v T(1-f). The ̃ ̃ created by the firms seeking external finance. Thus, the portal receives the total fees of fθ from the firm raising θ. regulator balances the social costs and benefits generat- Case [2]: under professional investor finance, the ed by setting the variable T. entrepreneur will raise a capital amount of θ ≤ S and receives α(1 + v )θ̃, subject to investor at least breaking ̃ ̃ even in the investment: (1 − α)(1 + v )θ =[θ +M]. Here, 3.4 Time line only financial returns accrue to the entrepreneur, since no diversion takes place. Thus, the entrepreneur receives We consider the following time line. At time t =0,the ̃ ̃ v θ − M. Any firm with θ > S will have its gains capped regulator sets T, which becomes public knowledge. At at v T − M. t = 1, the firm decides whether to raise funds from a Both outcomes under [1] and [2] are depicted in professional investor or through equity crowdfunding. At Fig. 1 whenever S > T. It is straightforward to derive t = 2, entrepreneurs make investment decisions, by decid- the threshold level of T, called Ṯ that makes equity ing how much to raise and thus offer a fraction (1-α)of crowdfunding as efficient as professional investors: ownership. Finally, at t = 3 firms realize their payoffs, which are then distributed. Consistent with rational behav- T such thatðÞ 1−xδ v TðÞ 1−f ¼ v T −Mor : c p ior, we solve the game by backward induction and maxi- " # mize firm value based on the entrepreneur’s perspective. T ¼ M= v −ðÞ 1−xδ vðÞ 1−f p c 4 Optimal choice of funding and securities regulation Therefore, equity crowdfunding is the optimal choice of entrepreneurs seeking capital lower than Ṯ, and oth- 4.1 Optimal outcome for the entrepreneur erwise opting for professional investors is optimal. Above the amount S, professional investor can no longer In this section, we derive the optimal choice of funding. supply the full amount, so that the firm needs to seek We first consider the outcome under equity prospectus approval from the regulator. Note that fees crowdfunding and professional investors separately charged by portals also affect the threshold, since fees and then compare them. reduce the amount left for investments and thus the Case [1]: under equity crowdfunding, an entrepreneur overall profitability of the firm. Higher portal fees re- with given capital needs θ ≤ T receives α[(1 + duce profits under equity crowdfunding, making it less v )θ̃(1 − f) − δv θ̃(1 − f)] + (1 − x)δv θ̃(1 − f), subject to c c c attractive relative to professional investors. The result is the crowd at least breaking even in their investment: a lower Ṯ. Moreover, differences in adding value be- (1 − α)[(1 + v )θ̃(1 − f) − δv θ̃(1 − f)] = θ̃. The first term c c tween the crowd (v ) and professional investors (v )shift c p in the first equation represents the financial gains to the the threshold Ṯ.Anincrease in v relative to v increases c p entrepreneur of also being a shareholder (net of diversion Ṯ, which is consistent with equity crowdfunding becom- ̃ ̃ costs δv θ(1 − f)), the second one (1 − x)δv θ(1 − f) her c c ing more profitable and thus more attractive relative to private benefits from diversion. This leads to the professional investors. When S < T (the venture capital and angel market is These simple formulas allow to formally derive the Diversion Con- poorly developed), a discontinuity occurs. The size of dition, where we need to solve the following condition α[(1 + v )θ̃(1 − f) − δv θ̃(1 − f)] + (1 − x)δv θ̃(1 − f) > α[(1 + v )θ̃(1 − f)], c c c c the discontinuity depends on the magnitude of the dif- subject to (1 − α)(1 + v )θ̃(1 − f) = θ̃. The left-hand side of the ference between S and T, as depicted in Fig. 2.Also, inequality is the entrepreneur’s profits under equity crowdfunding there is an area (gray shaded in Fig. 2)that represents when diverting value from shareholders (as stated above); the right- hand side is her profits when not diverting; finally, the second equation firms with capital needs (θ̃) that are larger than the gives the equilibrium financing condition for the crowd under the threshold T. These firms can only raise the amount T, assumption that the entrepreneur does not divert any profits. Substitut- since raising more would lead to less profit due to the ing α from the second equation into the inequality leads to the Diver- sion Condition as stated above. lack of larger amounts from professional investors and Should securities regulation promote equity crowdfunding? 589 Fig. 1 Financing outcomes when Financing Outcomes when S>T S > T. INV-finance denotes the outcome under financing with professional investors, ECF- finance with equity crowdfunding. The x-axis represents the amount to be issued, while the y-axis the entrepreneur’sprofitlevel. The point Ṯ corresponds to the situation where the entrepreneur is indifferent between the two financing alternatives excessive inefficiencies under equity crowdfunding. of development and efficiency of the venture capital and These firms consequently forego some of their invest- business angel market. However, a note is warranted here. ment opportunities, because there is no source of capital Our optimal outcome abstracts from effects that such available to (efficiently) fund them. exemptions may have on the other firms seeking equity It is optimal for the entrepreneur to seek equity finance. Therefore, we will consider below the lowest crowdfunding below Ṯ for the same reason as above, possible exemption value as being the optimum, as it also but potentially also for larger amounts if the small offer minimizes any impact on other firms in the economy. exemption level T is large enough to make it worth- Formally, the optimal level of exemption for equity while. In the case depicted in Fig. 2, this is not happen- crowdfunding is as follows: ing, but would happen if T would be as large as T. Then, larger equity crowdfunding campaigns would occur. T can formally be derived as the solution to the following T* ¼ Tif T < S T* ¼ Tif T > S condition (assuming investors under prospectus approv- al add as much value as professional investors consid- ered so far; i.e., v ): This result yields the following empirical implica- tions. First, a more developed venture capital and busi- ness angels market enables a lower threshold Ṯ,since it ðÞ 1−xδ v T1ðÞ −f ¼ v T−Cor : c p has a higher S (professional investors can finance firms T ¼ C v −ðÞ 1−xδ vðÞ 1−f p c with larger capital needs as their funds are larger) and lower M (professional investors are able to do more cost-efficient contracting and monitoring). Thus, it does not require the regulator to set a higher level of 4.2 Market equilibrium under endogenous regulation exemption. For sufficiently large venture capital and Figures 1 and 2 are helpful in deriving the optimal level of Empirically, costs M may be proxied by the number of law firms and exemption, denoted below as T*, from the perspective of the quality of legal institutions, as this affects legal costs of drafting the securities regulator. This level is affected by the degree contracts and advising services for venture capital funds. 590 Hornuf and Schwienbacher Financing Outcomes when S<T Fig. 2 Financing outcomes when S < T. INV-finance denotes the where the entrepreneur is indifferent between equity crowdfunding outcome under financing with professional investors, ECF-finance and financing with a formal prospectus (if the threshold where with equity crowdfunding. The red line shows the outcome with a large enough to allow equity crowdfunding campaigns to be larger formal prospectus for either traditional capital markets or equity than , which is not the case in this figure; therefore, this range of crowdfunding campaigns above the small offerings exemption T, outcomes is indicated in a dotted box at the top of the figure as for which amounts of issuances must be larger than the threshold T. BECF^). The dotted part of the black and red lines represents The x-axis represents the amount to be issued, while the y-axis the possible outcomes if the regulator changes T entrepreneur’s profitlevel.The point T corresponds to the situation business angel markets, the exemption level can even be is T. This scenario corresponds to cases in which ven- substantially reduced. ture capital and business angel markets are underdevel- Moreover, when S > T (the more general case), oped. Overall, we expect regulators in countries with the condition derived above indicates that Ṯ is de- smaller venture capital and business angel markets to creasing in the following, exogenous parameters: have incentives to set less restrictive exemptions. extent of managerial rent diversion (the parameter δ), the degree of losses derived from such diversion 4.3 Empirical implications (the parameter x), and portal fees (the parameter f). For the ROI, the direction of impact depends on The parameter T can be directly interpreted as the level whether we consider v or v , as discussed above. c p of investor protection, in which a lower value of T A greater rent extraction possibility creates a higher represents more investor protection on average. The cost of capital under equity crowdfunding, since conclusions of our theoretical model lead to the follow- crowdinvestors will require a higher rate of return ing empirical predictions. First, more investor protection for purchasing securities from the firm. Similarly, leads to fewer equity crowdfunding campaigns, since greater losses from diversion and higher portal fees the bulk (if not all) of these campaigns take place under make again equity crowdfunding less valuable rela- securities regulation exemptions. This may eventually tive to professional investors, which reduces the create a smaller equity crowdfunding market, because optimal level of exemption. many firms will find it economically not worthwhile to For the opposite case where S < T (see Fig. 2), the seek prospectus approval by the national regulator. regulator has an incentive to increase T to compensate Others may seek financing from professional investors. for shortage of professional investors. The optimal level In the absence of any exemptions, smaller firms may Should securities regulation promote equity crowdfunding? 591 even refrain from entering the market in the first place, crowdfunding campaigns. To achieve this goal, we offer since equity crowdfunding may be their only option in evidence that restrictive exemptions may create a terms of equity finance. The complete absence of an funding gap, where firms raise inefficiently low exemption (T = 0) leads to an exclusion of firms with the amounts of capital. lowest capital needs, which would not be started in the As our theoretical model predicts, firms may re- first place. This is especially true if there is not a suffi- strict their fundraising goal if the small offer exemp- ciently large, professional market available as main tion threshold is low. One good example is Germa- alternative source of seed capital. ny, which after the UK possesses one of the most Our main conclusion from this analysis is that regu- developed equity crowdfunding market in Europe lation maximizing investor protection hurts small firms (Hornuf and Schmitt 2016)but foralong time set and those relying on equity crowdfunding are likely to the critical threshold for the small offerings exemp- be smaller firms seeking seed or early-stage capital. This tion at the lower bound of €100,000. We illustrate is because these firms are too small to obtain funding that this regulation created a funding gap by relying from professional investors and thus may lack alterna- on the cases of Seedmatch and Companisto. More- tive sources of equity capital. Optimal securities regula- over, like many other continental European coun- tion therefore has to trade off the costs of ensuring tries, the German venture capital and business angel sufficient investor protection with the benefit of easier markets are much less-developed than in countries access to capital for startup firms, which can be an such as the USA and the UK. important driver for economic growth. The contracts that Seedmatch provided to issuers The extent to which exemptions to the prospectus were initially designed to comply with the German regulation are needed depends on the availability of Investment Act. All the initial 26 equity crowdfundings offered by Seedmatch used the alternative sources of capital, mostly from professional investors. Countries with well-developed markets of existing exemption, and a total of 24 issues had to professional and private investors may have fewer ex- be terminated at the threshold of the exemption at emptions. Interestingly, the USA has a well-developed €100,000, which indicates that issuers had higher professional investor market, which can compensate for capital needs. Moreover, as campaigns were some- the lack of exemptions needed to tap the crowd. This times funded very quickly, firms’ capital needs contrasts with Europe, where the angel and venture could have easily been satisfied by the crowd and capital markets are smaller. were only constrained by the existing threshold un- We further expect a substitution to occur away from der the Investment Act (see Fig. 3). professional investors, not for firms with lower capital Seedmatch and other portals soon realized the needs but with average levels. With equity crowdfunding, legally imposed funding constraint and tried to cir- these firms now have an alternative source of funding. For cumvent the existing securities legislation. On No- some firms, the latter may economically be more interest- vember 29, 2012, Seedmatch offered for the first ing, so that they seek funding from the crowd instead of time subordinated profit-participating loans, which professional investors. In fact, changing the level of small until July 10, 2015 were not classified as investment offer exemption T may have no impact on equity under the German Investment Act and thus did not crowdfunding activities in business sectors that are well- require the registration of a prospectus. While there covered by professional investors, except for very small was some legal uncertainty surrounding this issue, issuances. However, other areas may be affected more subordinated profit-participating loans allowed is- when poorly covered by professional investors. This may suers to raise unlimited amounts without the obliga- be more likely in areas with limited growth prospects. tion to draft and register a prospectus. The equity crowdfunding campaigns on Companisto show a similar trend after the portal switched contracts 5 Are existing exemptions too restrictive: some empirical evidence On November 29, 2012, it took Protonet only 48 min to raise €200,000 on Seedmatch. In May 2014, the same firm raised another €1,500,000in10hand8min,afterwhichthe founders decided to In this section, we illustrate the impact of exemptions as continue raising funds. Eventually, they raised €3,000,000 in a few defined in national securities regulation on equity days only. 592 Hornuf and Schwienbacher Seedmatch Fig. 3 Amounts raised in equity 3,000,000 crowdfunding campaigns on Seedmatch (N = 84), Companisto 2,500,000 (N = 47), and Innovestment (N = 47) in the period from 2,000,000 August 1, 2011 to January 1, 1,500,000 2016. The red lines separate the period before and after 1,000,000 subordinated profit-participating 500,000 loanswereusedtocircumventthe threshold of the small offering exemption as defined in the German securities law (T = €100,000). Before financial contracts circumvented the 7.5 m Companisto threshold, the average amounts 3,000,000 raised were €98,048 for Seedmatch campaigns and 2,500,000 €91,673 for Companisto cam- 2,000,000 paigns; thereafter, the amounts rose to €391,440 and €596,827, 1,500,000 respectively (including amounts pledged in unsuccessful cam- 1,000,000 paigns). Innovestment never 500,000 changed its investment contract to circumvent the threshold of the German securities law and ex- hibits an average funding amount of €60,085 per campaign (including amounts pledged in Innovestment unsuccessful campaigns). 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 to subordinated profit-participating loans on February average funding size at Innovestment was €60,085, 4, 2013. After the implementation of the new invest- somewhat below the threshold of €100,000, and in- ment contract, the funding volumes per campaign creased only slightly to €64,796 in the period when more than sextupled on Companisto, while on Seedmatch adopted subordinated profit-participating Seedmatch they almost quadrupled. The largest issue loans. funded under this contractual design raised a total of €7,500,000 for a real estate project. A comparison with Innovestment, which might serve as a control 6 Discussion and concluding remarks group because the portal has not adopted subordinated profit-participating loans, evidences that the increase This study discusses recent reforms in different countries in funding volumes does not merely reflect a general and presents some empirical evidence based on the Ger- trend in the selection of funding campaigns. The man experience in permitting non-accredited investors 9/1/11 9/1/11 9/1/11 11/1/11 11/1/11 11/1/11 1/1/12 1/1/12 1/1/12 3/1/12 3/1/12 3/1/12 5/1/12 5/1/12 5/1/12 7/1/12 7/1/12 7/1/12 9/1/12 9/1/12 9/1/12 11/1/12 11/1/12 11/1/12 1/1/13 1/1/13 1/1/13 3/1/13 3/1/13 3/1/13 5/1/13 5/1/13 5/1/13 7/1/13 7/1/13 7/1/13 9/1/13 9/1/13 9/1/13 11/1/13 11/1/13 11/1/13 1/1/14 1/1/14 1/1/14 3/1/14 3/1/14 3/1/14 5/1/14 5/1/14 5/1/14 7/1/14 7/1/14 7/1/14 9/1/14 9/1/14 9/1/14 11/1/14 11/1/14 11/1/14 1/1/15 1/1/15 1/1/15 3/1/15 3/1/15 3/1/15 5/1/15 5/1/15 5/1/15 7/1/15 7/1/15 7/1/15 9/1/15 9/1/15 9/1/15 11/1/15 11/1/15 11/1/15 1/1/16 1/1/16 1/1/16 Should securities regulation promote equity crowdfunding? 593 access to equity crowdfunding. While our analysis remains References exploratory, it contributes to the ongoing policy debate on how to regulate the market and to examine its potential Acs, Z. J., Audretsch, D. B., Lehmann, E. E., & Licht, G. (2016). impact on business finance. 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Open Access This article is distributed under the terms of the Vismara, S. (2016a). Equity retention and social network theory in Creative Commons Attribution 4.0 International License (http:// equity crowdfunding. Small Business Economics, 46(4), creativecommons.org/licenses/by/4.0/), which permits unrestrict- 579–590. ed use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, Vismara, S. (2016b). Information cascades among investors in provide a link to the Creative Commons license, and indicate if equity crowdfunding. Forthcoming: Entrepreneurship Theory changes were made. and Practice.

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