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Financing Efficiency of Securities-Based Crowdfunding

David C. Brown, Shaun W. Davies,

Based on: The Review of Financial Studies, 2020, 33(9), 3975–4023 DOI: https://doi.org/10.1093/rfs/hhaa025


Crowdfunding, which is increasing in popularity, often requires sufficient pledges to proceed.  This feature tempts investors to fund projects they are skeptical about, distorting investment.

 

Imagine you can invest in a start-up's equity offering listed on a crowdfunding platform. The entrepreneur has committed to an all-or-nothing financing threshold; if total pledged capital exceeds the threshold, the entrepreneur will undertake the venture using the pledged investments. Alternatively, if pledged capital does not meet the threshold, the entrepreneur will cancel the venture and return the investments. You analyze the new start-up's investment materials and form an opinion of its prospects. Based on your review of the materials, you believe that the start-up will not be profitable, but you are not absolutely certain. Traditional wisdom suggests you should pass on investing because you expect to lose money. However, in this setting, that traditional wisdom may be incorrect–it may be profitable to invest despite your negative opinion!

To see why you may want to invest, consider what happens if you are correct that the venture is a dud and is likely to fail. If it is a dud, many other investors will reach the same conclusion and choose not to invest, preventing the start-up from meeting the all-or-nothing threshold. In this case, your investment is returned and you have lost nothing.  However, if you are wrong and the venture is actually a slam dunk, many other investors will invest and the venture will be undertaken. In this alternative case, you now have ownership in a profitable company. Investing in start-ups via crowdfunding appears to be riskless! This thought experiment highlights that all-or-nothing thresholds create a hedge for investors; good ventures are more likely to be undertaken and bad ventures are more likely to be canceled. This hedge is the “loser's blessing.”

Unfortunately, the loser's blessing does not provide riskless returns to investors. Just like you, other investors also have incentives to ignore their negative opinions and free ride on others' information. As investors invest without good opinions, the total capital pledged to a venture becomes disconnected from the venture's actual quality. In the extreme case in which everyone succumbs to the loser's blessing, good and bad ventures attract the same amounts of capital and cannot be told apart. In other words, financing is inefficient. When investors finance all ventures, good and bad, the potential for riskless returns disappears.

Financing inefficiencies are not just problematic for investors, they also adversely affect entrepreneurs. When financing is inefficient, some entrepreneurs with good business plans will fail to reach their financing thresholds, while others with bad business plans will receive financing and pursue those bad ventures. Both sets of entrepreneurs are harmed. Those with good plans have been denied value-creating capital, and those with bad plans will likely waste much of their time, and potentially their own capital, pursuing a failing venture. By reducing financing efficiency, the loser's blessing may prevent securities-based crowdfunding from becoming a viable source of start-up capital.

To make the loser's blessing less abstract, consider an example. Suppose a large crowd of small investors with $1 million of total capital has the opportunity to crowdfund a new start-up that requires $500,000. The venture will succeed half the time, yielding a payoff of $1,000,000, and fail half the time yielding zero. Each investor forms her opinion about whether the venture will succeed or fail and is correct with 75% probability. If investors only contribute after forming a good opinion, a good venture would raise $750,000 and a bad venture would raise $250,000 (failing to reach the all-or-nothing threshold). In this scenario, financing would be perfectly efficient, as the fundraising process would perfectly screen the venture (i.e., only a good venture is funded). However, only contributing after forming a good opinion cannot be the best strategy for investors, as the loser's blessing will encourage all investors to contribute regardless of their opinions. If all investors contribute regardless of their opinions, the fundraising process would no longer separate good and bad ventures, as all ventures would raise $1,000,000. With both good and bad ventures being financed, the venture would succeed just half the time, leaving investors with an expected net payoff of zero (i.e., 50% X $1,000,000 – $500,000=0). Thus, the possibility of a loser's blessing means that the fundraising process will reflect little to no information because investors ignore their own opinions and free ride on the information of others. As a result, the crowdfunding platform fails to properly allocate capital to the best ventures.

The possibility of a loser's blessing casts doubt on the hope that securities-based crowdfunding will be as successful as its predecessor, rewards-based crowdfunding (e.g., KickStarter and Indigogo). Rewards-based crowdfunding has successfully harnessed the ``wisdom of the crowd'' by allowing consumer-investors to communicate their tastes to entrepreneurs. Through rewards-based presales, only the popular, and likely profitable, ventures meet their all-or-nothing thresholds and are undertaken. With rewards-based crowdfunding, financing efficiency is not hindered by the loser's blessing because contributions are made based on individuals' preferences for the products (private values), and those preferences do not depend on their peers' preferences. In contrast, securities-based crowdfunding ``sells'' investment cash flows (a common value good) and other investors' opinions are valuable in assessing those cash flows' fair value. Thus, the common value component to securities-based crowdfunding causes the loser's blessing to have bite and suggests that securities-based crowdfunding may be ineffective in harnessing the wisdom of the crowd. However, there are means to mitigate the loser's blessing.

An entrepreneur can mitigate the loser's blessing by increasing the price of the offering. In addition to the direct benefit of increasing the amount raised from each participating investor, a higher price discourages investors from free-riding on the information of others.  However, higher offering prices also discourage investors from participating because they leave investors more exposed to the winner's curse (the well-known economic tension related to buyer's remorse; if you end up holding a large ownership position in a new venture, you likely overpaid for it). Strategic pricing cannot always mitigate both the loser's blessing and winner's curse, and both investors and the entrepreneur suffer.

An alternative approach to mitigating the loser's blessing is to reduce the fundraising threshold.  Doing so means that more ventures are funded, which reduces the extent to which an investor can count on other investors to screen out low-quality projects. Lowering the incentive to invest without good information improves financing efficiency, but it is not a perfect solution–some undeserving ventures will secure investor capital and subsequently fail.

Entrepreneurs and crowdfunding platforms can also improve financing efficiency by limiting the factors that lead to greater inefficiencies. Perhaps somewhat obvious, the possibility of a loser's blessing is minimal if investors can easily judge real demand for a venture's product based on the venture's disclosures, their own preferences, and the preferences of their peers. This suggests that consumer-focused ventures, in particular, fashion products or local services, will exhibit better crowdfunding outcomes as investors can utilize their own tastes in their contribution decisions. Perhaps less obvious, financing efficiency is higher with an intermediate number of investors. On the one hand, a larger number of investors implies more information about a venture's quality, which benefits efficiency.  On the other hand, more investors increase each investor's incentive to free ride, which hampers efficiency. Therefore, the problems associated with the loser's blessing grow worse with the number of investors, and eventually overwhelm the direct benefit of gaining access to a larger crowd. This tension suggests that entrepreneurs may be attracted to crowdfunding platforms with restricted memberships and better financing efficiency.

Crowdfunding has become very popular in recent years, due mainly to the successes of rewards-based crowdfunding. Proponents of securities-based crowdfunding hope that it will soon enjoy similar growth and success. However, the financial incentives inherent in security-based crowdfunding give rise to the loser's blessing. The loser's blessing leads investors to ignore their opinions when making investment decisions, reducing financing efficiency and limiting entrepreneurs' abilities to harness the wisdom of the crowd. For securities-based crowdfunding to succeed, entrepreneurs and crowdfunding platforms should mitigate the loser's blessing by raising offering prices, lowering funding thresholds, limiting the pool of eligible investors, and, if feasible, increasing disclosures to investors.



David C. Brown

Associate Professor of Finance

Eller College of Management at the University of Arizona.



Shaun W. Davies

Associate Professor of Finance

Leeds School of Business

University of Colorado, Boulder