2.1 Defining equity crowdfunding
Crowdfunding combines the idea of micro-finance with crowdsourcing (Mollick
2013). In the USA, crowdfunding campaigns are run under either the donation or the reward model. Under the former, backers donate money to support a philanthropic project without expecting any compensation. Under the latter, backers are promised tangible or intangible perks, such as a supporter coffee mug or being mentioned on the campaign website. For some of the most popular projects, rewards resemble a pre-purchase of the product or service to be developed by the founder. In the case of the Pebble smartwatch, for example, 68,929 backers spent more than 10 million USD in total to obtain a watch that connects with the smartphone. The first 200 backers pre-purchased a black watch for 99 USD. Another 40,799 backers then prepaid 115 USD for the very same watch. The remaining backers prepaid a slightly higher amount to obtain a fancier version of the watch.
The crowdfunding business model is different from crowdlending, in which backers invest in consumer or business loans to receive a pre-determined periodic interest payment from debtors. Equity crowdfunding is a combination of crowdfunding and crowdlending. Backers spend money in equity crowdfunding campaigns to support a founder, who is working to develop a sustainable product or service, and expect a monetary return after the investment contract expires or the start-up company is bought by a venture capitalist. In the majority of the equity crowdfunding campaigns, however, backers do not pre-purchase the product or service to be developed. In the USA, equity crowdfunding was restricted for a long time to accredited investors and did not take place in any significant manner. Although in 2012 the USA was the first jurisdiction to pass a law specifically regulating equity crowdfunding activities, the Securities and Exchange Commission implemented specific rules on Title III of the Jumpstart Our Business Start-ups (JOBS) Act only in May 2016. At that time, equity crowdfunding by soliciting the general public became legal.
Under German securities law, equity crowdfunding by non-accredited investors has always been possible. Since 2011, more than 30 equity crowdfunding portals began operating. The crowd participates in the future cash flows of a firm by investing in mezzanine financial instruments. Most founders do not offer common shares in a private limited liability company (LLC), as a notary needs to be involved to allow for the transfer of such shares (Braun et al.
2013). Moreover, the minimum capital requirement as well as the operating costs of a public LLC (which does not require the involvement of a notary to transfer shares) often overburdens the founders of a start-up company. Common shares of a public LLC are therefore rarely used in equity crowdfunding campaigns. As a result, German start-ups most often use profit-participating loans, cooperative certificates, and silent partnerships when running an equity crowdfunding campaign, which then replicate the future cash flows of the firm.
2.2 Innovestment
One of the oldest German equity crowdfunding portals is Innovestment. The start-up particular completed its first successful campaign through the portal on December 25, 2011, the same year market leader and first-mover Seedmatch appeared on the equity crowdfunding market. In many respects, Innovestment is similar to Seedmatch and many other equity crowdfunding portals in Europe (Hornuf and Schwienbacher
2014). Before a campaign goes online, Innovestment and the founders must agree on a valuation of the start-up, and even before that, the founders of the start-up must decide how much capital they want to raise. After considering the financial needs of the firm and the value of the firm that was negotiated, Innovestment adapts a standardized financial contract (a silent partnership agreement) replicating an equity share in the start-up. Becoming a silent partner allows investors to participate in the future cash flows of the firm during the lifespan of the contract and again when the silent partnership agreement expires.
Many start-ups running campaigns on Innovestment intended to raise EUR 100,000 and offered EUR 1000 investment tickets to backers. If the initial valuation of the start-up was, for example, negotiated to be EUR 1,000,000 and the firm raised EUR 100,000, backers buying a single investment ticket obtained a right on 0.091 % of the cash flow, provided that the price of the investment ticket did not rise during the auction. It is important to note that backers who ultimately become silent partners of a start-up do not receive any of the rights attached to a common equity share, such as voting rights; however, they also do not participate in the losses of the start-up. Furthermore, the silent partnership agreements Innovestment uses are senior to ordinary shares and shareholder loans but rank after all ordinary liabilities. These usually expire after three to 7 years and cannot be traded on a secondary market after the initial allotment takes place.
While in many respects Innovestment is similar to all other European equity crowdfunding portals, it also differs in one important respect and therefore is worth analyzing in further detail. European equity crowdfunding portals uniformly allocate equity shares or one of the aforementioned financial instruments through a fixed-price first-come, first-served allocation mechanism. That is, the portal stipulates a fixed price per investment ticket that usually applies for all its investors and campaigns. The number of tickets being offered during a campaign is then determined by the overall funding limit as defined by the founders and the fixed price per ticket. The lower the price per ticket, the more tickets can be sold given the particular funding limit. As a result, the portal stops selling silent partnership agreements to the crowd when the funding limit and, thus, the pre-determined number of tickets are reached.
Innovestment has deviated from stipulating a fixed price per investment ticket and instead has adapted a multi-unit second-price auction. In theory, under a sealed-bid second-price auction, a dominant strategy for backers is to reveal their true willingness to pay for the cash flow rights in a start-up company (Kagel and Levin
2001). The Innovestment auction is particular as it involves three stages. Before describing these three stages in more detail, we note that it is only at the end of a pre-determined funding period (usually 30 days
2) that units are allotted to the investors and a legal transfer of money as well as silent partnership agreements takes place. Before that, backers only commit to buying cash flow rights according to their bids, and funds are frozen on a trust account. Moreover, the portal reveals only three types of information to backers: the current price per ticket, the overall funding amount reached, and, thus, whether the funding goal was reached or not. Nevertheless, individual bids by other investors are sealed (see Fig.
3 in the ‘
Appendix’ for the entry mask).
During the first phase of the auction, backers can make pledges by specifying the number of tickets they want to buy and the price they are willing to pay for each ticket. Innovestment and the start-up determine a lower threshold for the price of a single investment ticket, which is often determined to be EUR 1000. Everyone who pledges money is allotted the desired number of tickets during the first phase of the auction, and the lowest bid applies to everyone. In principle, there is no reason for investors to outbid the lower threshold at this phase, as there is yet no scarcity in tickets and indicating their true willingness to pay would only drive up the price per ticket. However, backers may anticipate that the auction will run in the second phase and indicate their true willingness to pay for cash flow rights from the outset to avoid the potential transactions cost of being outbid and bidding again later.
3 Importantly, the Innovestment auction also operates under an all-or-nothing funding model (Cumming et al.
2015). Under this model, Innovestment and the start-up determine a minimum funding goal that needs to be reached within a pre-determined funding period. If the minimum funding goal is not reached within this time frame, the capital pledged by the backers is returned to them.
The second phase of the auction begins when a pre-determined number of investment tickets are sold to the crowd. The number of tickets, and thus the beginning of the second stage of the auction, is not known to the Innovestment backers until the second stage is finally reached. The number of investment tickets sold by the end of the first auction phase also determines the number that is available throughout the second phase and is then kept constant. From now on, investors can only outbid each other by posting higher prices. Backers anticipating that the second stage of the auction will be reached should now rationally reveal their true willingness to pay, given that this phase of the Innovestment auction is equivalent to a Vickrey (
1961) auction. Importantly, the second phase of the auction is not restricted to investors from the first phase. Every investor who is registered on the portal can still join the bidding process. The second phase continues until the funding limit is reached. After that, the auction enters the third stage, during which all registered users can still outbid investors. At this point, however, it is no longer possible to increase the overall sum of funds received by the start-up. Higher bids consequently result in the overall number of investment tickets being reduced. Because the overall sum of funds stays constant, while the number of tickets is reduced, the cash flow rights the start-up must sell for a given amount of capital are decreased.
4
What should be clear to the crowd is that the different phases of the auction mechanism have no hard-ending rule; that is, silent partnership agreements cannot sell out as their availability only depends on backers’ willingness to pay. Everyone can invest at each phase of the auction until the pre-determined funding period ends. Thus, unlike under the fixed-price first-come, first-served allocation mechanism, in which it might be risky for the crowd to postpone an investment decision, investors have an incentive to reveal their true willingness to pay and may theoretically invest at any time of the funding period under the multi-unit second-price auction mechanism.