The Relevance of Investor Rights in Equity Crowdfunding
Lars Hornuf - Faculty of Studies and Economics, University of Bremen and Max Planck Institute for Innovation and Competition, CESifo;
Tobias Schilling, Faculty of Law, Humboldt-Universität zu Berlin;
Armin Schwienbacher - SKEMA Business School, Université Côte d'Azur
-- An often-advocated, important benefit of equity crowdfunding (ECF) is that entrepreneurs do not need to give up as much control as professional investors such as business angels (BAs) and venture capitalists (VCs) might request from them. Our recent CESifo Working Paper, "Are Equity Crowdfunding Investors Active Investors?", examines the impact of awarding different sets of control rights to crowd investors on the pricing, campaign outcome, the likelihood of receiving follow-on funding, and the ultimate survival of equity crowdfunded start-ups.
Exploring whether crowd investor participation affects venture outcome is important to advance understanding of the governance of entrepreneurial start-ups. Moreover, exploring the impact of these control rights on start-ups’ outcomes enables us to indirectly infer whether crowd investors are active or not. If they are active and enforce their given rights, allocating more control rights to crowd investors should have an economic impact, reduce the probability of firm failure, and increase the chances of follow-on funding.
In Germany, ECF platforms do not use standard participation rights of limited liability companies because transferring shares of a limited liability company requires the involvement of a notary, which is too expensive in the context of ECF. Instead, ECF contracts involve participating notes that enable offering specific rights to investors, such as cash-flow, control, and exit rights. When we refer to an active investor in ECF, we are therefore not implying the same activities exercised by VCs and BAs, which actively monitor and advise the entrepreneurs of their portfolio companies. This type of active involvement typically occurs through participation in boards of directors, which in most cases crowd investors are not part of, because they do not receive any voting rights and thus do not participate in shareholder meetings. Instead, we view an active crowd investor in our study as one who enforces the specific rights received. In ECF, this is the only way for crowd investors to become active in Germany and many other jurisdictions.
To test how important control rights are in ECF and whether they have an economic impact on the start-up, we hand-collected a representative sample of 256 contracts from 19 German ECF platforms and examined in detail the different rights offered to crowd investors when making an investment. Our sample includes successful and unsuccessful transactions because we collected the data before the campaigns started. In total, 17% of the campaigns were not successful, which is low compared to other countries.
We categorize the contract terms into different classes of rights, which we subsequently aggregate into three main classes: cash-flow, control, and exit rights. We further track the start-ups over time to determine whether they were able to raise the requested funds and, for those that succeeded, what happened afterward in terms of follow-on financing by professional investors and survival. This process enables us to identify how these start-ups have evolved. Moreover, we investigate whether crowd investors actively trigger insolvency proceedings or mention the enforcement of their contractual rights in investor communication blogs or popular media.
Taking the entrepreneurial perspective, we find that crowd investors are asked to pay higher prices if they receive more cash-flow and exit rights, consistent with the view that entrepreneurs believe that these rights are valuable to the crowd. However, from the investors’ perspective we find no evidence that differences in cash-flow and control rights affect campaign outcomes, suggesting that participation of crowd investors is not driven by the extent of cash-flow and control rights offered to them. Next, we examine the impact of certain contract terms on the likelihood that a start-up eventually went insolvent or was liquidated. If crowd investors were active, we would expect a significant impact on firm development. Estimating a hazard risk model allows us to investigate the impact of control rights held by crowd investors on firm survival. We find that none of the control rights affect the insolvency likelihood in a significant way, which is consistent with the notion that crowd investors are passive. Moreover, control rights have no impact either on the likelihood of receiving follow-on funding by professional investors, which is often considered a sign of further development of the start-up.
So far, we inferred investor activism indirectly only. An alternative notion consistent with our findings of a lack of evidence is that crowd investors are actively involved but their actions are ineffective such that there is no economic impact on the start-up. The lack of skills by crowd investors to exercise their rights effectively may lead to similar empirical results. To rule out this alternative hypothesis, we further explored our sample of crowdfunded start-ups in other ways.A direct sign of investors making use of their rights would be if they trigger insolvency proceedings or liquidation of the company. Therefore, we investigated whether investors took such actions by analyzing the opening of insolvency proceedings documents for all the start-ups that became insolvent. Some district courts in Germany do not systematically reveal the identity of the person or institution triggering insolvency, and all district courts delete the opening documents at the latest six months after the cancellation or the legal force of the termination of the insolvency proceedings. We have available data for 16 of the 67 start-ups that failed, and the pattern is clear. In all cases, insolvency was triggered by the company itself and, in one case, also by an insurance company. We find no evidence that investors helped trigger the insolvency in any of these cases. Similarly, we reviewed different communication blogs between investors and entrepreneurs, to identify possible enforcements by investors. This also did not give us any clear evidence that crowd investors actively seek to enforce their rights when conflicts arise.