Crowdfunding Real Estate in the United States: Is it also
viable for commercial residential real estate in the
Netherlands?
Source: Canadian Real Estate Magazine
Thesis
MSc EntrepreneurshipGerrit ter Braake VU 2566922 | UvA 10854622
Supervisor: R. C. W. van der Voort July 01, 2015
“Change is the law of life and those who
look only to the past or present are certain
to miss the future”
—John F. Kennedy—
Table of contents
TABLE OF CONTENTS 3
ABSTRACT 5
1 INTRODUCTION 6
1.1 CONTRIBUTION 10
1.1.1 THEORY 10
1.1.2 PRACTICE 10
2 WHAT IS CROWDFUNDING? 11
2.1 THE ECONOMIC MODEL 16
2.2 MOTIVES 18
2.2.1 INVESTORS’ MOTIVES 18
2.2.2 MONEY SEEKERS MOTIVES 19
2.3 INFORMATION ASYMMETRY 21
2.3.1 THE AGENCY PROBLEM 22
2.3.2 MORAL HAZARD 22
2.3.3 ADVERSE SELECTION 22
2.4 POTENTIAL PITFALLS OF CROWDFUNDING 23 3. CROWDFUNDING IN THE U.S. AND THE NETHERLANDS 25
3.1 CROWDFUNDING IN THE U.S. 25
3.1.1 LIMITATIONS AND REGULATIONS BY THE GOVERNMENT 26 3.2 CROWDFUNDING IN THE NETHERLANDS 28
3.2.1 LIMITATIONS AND REGULATIONS BY THE GOVERNMENT 30
4. THE U.S. REAL ESTATE MARKET 33
4.1 COMMERCIAL SECTOR 34
5. REAL ESTATE CROWDFUNDING IN THE U.S. 37 5.1 ROLE OF CROWDFUNDING PLATFORMS 41
5.2 THE FUTURE 43
5.3 POTENTIAL PITFALLS 43
6. THE DUTCH MODEL 46
6.1 COSTS OF INVESTMENT 49
6.2 RETURN ON INVESTMENT 50
6.3 TARGETING POTENTIAL INVESTORS 51
7. RESEARCH METHOD 54 8. PRACTICAL IMPLICATIONS 56 8.1 SCALABILITY 56 8.2 UNIQUENESS 57 8.3 COMPANY STRUCTURE 58 8.4 REGULATIONS 59
8.5 GETTING AWAY FROM FINANCING WITH THE BANK 60
8.6 THE MODEL AFTER THE INTERVIEWS 61
9. CONCLUSION 64
9.1 LIMITATIONS AND FUTURE RESEARCH 65
REFERENCES 66
APPENDICES 75
APPENDIX A: START VALUE DUTCH MODEL 75
APPENDIX B: CASH FLOW STATEMENT 76
APPENDIX C: HOW TO START A CROWDFUNDING CAMPAIGN? 77 APPENDIX D: MAARTEN DE JONG – ONEPLANETCROWD 78
APPENDIX E: PETER DE VRIES -‐ RABOBANK 80
APPENDIX F: KLAAS KROOT – FOI OPLEIDINGSINSTITUUT 87 APPENDIX G: AMRESH BAJNATH – BELAGGIO VASTGOED 91
APPENDIX H: ROBERT KAT – DTZ ZADELHOFF 96 APPENDIX I: HANS COEBERGH – COWHILL 102 APPENDIX J: BERT WIJNVEEN – BERKHOUWE VASTGOED 108
APPENDIX K: WILLEM KREULEN – MTH ACCOUNTANTS 113
APPENDIX L: BART LEVER – LEVER NETWERK NOTARISSEN 117
APPENDIX M: PROFESSOR ARMIN SCHWIENBACHER 122
APPENDIX N: CASH FLOW STATEMENT 50% MORTGAGE 126
APPENDIX O: CASH FLOW STATEMENT 0% MORTGAGE 127
Abstract
This study addresses the viability of crowdfunding commercial residential real estate in the Netherlands. In this study, commercial residential real estate is defined as residencies for students and starters on the labor market in Amsterdam. Crowdfunding gives a manager, an individual with knowledge and experience in the real estate market, the possibility to collect capital in a more efficient way. In this study, a crowdfunding model for the Dutch market is developed by combining theoretical insights from crowdfunding and asset real estate studies, and recent research in the American real estate crowdfunding market with at hand research data gathered from the Crowdfunding day and the professional real estate fair (PROVADA). Subsequently, this model was tested by conducting 10 expert interviews with individuals that are active in one of four pillars that make up the model. These pillars are financing, the potential investor, the manager, and the real estate fund. These interviews revealed several practical implications; two of the practical implications, uniqueness and get away from the bank, were mentioned by most interviewees. Adding them advanced the model, making it a viable basis to crowdfund real estate in the Netherlands.
1 Introduction
In the recent years, crowdfunding has become a novel way for entrepreneurs, individuals and charities to finance new projects and ventures. Crowdfunding provides the possibility to raise capital through an open platform on the Internet. These projects can be very diversified in their goals and magnitude. They can vary from small artistic projects, through raising money for charity, to entrepreneurs who are seeking many thousands of euros in seed capital as an alternative to traditional venture capital investment (Schwienbacher and Larralde, 2010). Others say that crowdfunding should only be for purposes of philanthropy and not for raising capital for ‘serious’ business plans (Couwenbergh, 2015). Despite increased attention from founders, investors, lawmakers and policymakers, the concept of crowdfunding is, in general, not yet fully understood (Griffin, 2012). However, research shows that this new concept of cooperative investing is becoming a more preferred way of investing wealth driven by developments such as the rise of the sharing economy (Turnbull, 2015). Within the professional accounting and consultancy sector, crowdfunding is becoming a legitimate part of business, since Deloitte, Accenture, EY, and KPMG describe crowdfunding as a top trend in their sector. This is clearly true; in 2014, over $16 billion has been raised through crowdfunding, with $1 billion of that amount being raised specifically for real estate (Massolution, 2015a). The idea of crowdfunding is grounded in the concept of crowdsourcing. This is a way of using individuals to obtain ideas, feedback, and solutions for the development of corporate activities (Bayus, 2013; Howe, 2008; Kleemann et al., 2008; Poetz & Schreier, 2012). According to Brabham (2008), Schwienbacher & Llarralde (2010) and Belleflamme et al. (2010), crowdsourcing achieved worldwide recognition through the article “The rise of crowdsourcing” from Howe (2006). In this article, Howe (2006) gives the following definition of crowdsourcing:
“Crowdsourcing represents the act of a company or institution taking a function once performed by employees and outsourcing it to an undefined (and generally
large) network of people in the form of an open call”.
The company Peanuts Planters already used the idea of crowdsourcing in 1916. They invited the public to a competition for designing their new company logo (Gibbons, 2012). Despite the huge amount of research that has been conducted on social networks and online communities in the field of Human Computer Interaction (HCI), only a few scholars have examined crowdfunding (Gerber et al., 2012). The primary goal of crowdfunding is to raise capital (Vliet, 2011). However, companies nowadays also use it in their marketing and/or sales strategy. An important characteristic of crowdfunding is the extra benefits that crowdfunders receive for participating. The benefits for crowdfunders vary in different forms of crowdfunding, ranging from an equity-‐based model, profit sharing and lending schemes, to outright donations (Belleflamme et al., 2014). The crowdfunding market should not be evaluated by the size of the sector. Instead, it should focus on the impact the sector has on the economic growth and its role as a catalyst in spurring entrepreneurial initiatives (Schwienbacher, 2014), as one of the main barriers to innovation is the availability of early-‐stage funding (Cosh, et al., 2009). One of the most well-‐known and successful crowdfunding campaigns was the smart watch Pebble. With their first campaign in 2012, they raised $10.3 million and, in 2015, they raised another $20.3 million, leaving the company with a total of $30.6 million from reward-‐based campaigns (Dredge, 2015). In a letter to the government, the Dutch Minister of Finance, Mr. Dijsselbloem (2015), also illustrates the importance of crowdfunding for financing and growth of small and medium enterprises (SMEs) in the Netherlands.
The crowdfunding sector in the United States (U.S.) is ahead of the European crowdfunding sector. Last year, the total capital raised through crowdfunding was $9.46 billion in the U.S. and $3.26 billion in Europe (Massolution, 2015b).
The latest trend in crowdfunding in the U.S. is real estate. Real estate is a collective noun for everything that has to do with buildings, not only the property themselves but also its management. Last year, venture capitalists invested in three real estate platforms: Realty Mogul, RealCrowd and Groundfloor (Clifford, 2014). In 2014, venture capitalists invested more than $250 million in real estate crowdfunding platforms (Massolution, 2015a). At the beginning of 2015, BD Bacatá will open its doors in Bogota and be Colombia’s tallest skyscraper. What makes this project so unique is that 3,100 investors financed it, investing $171.8 million (an average of $55,419,35 per investor) through crowdfunding (Raskin, 2014), making it the largest funded project to date.1 According to a report from Massolution (2015a), real estate crowdfunding
was a $1 billion industry in 2014, with investments ranging between $100,000 and $25,000,000. They expect that this will grow to more than $2.5 billion in 2015, representing a growth of 150% in one year.
The reason for this increase in crowdfunding real estate could be because real estate is a unique commodity due to its durability. According to Turnbull (2015), owning quality real estate is one of the best investments that investors can make, since it generally increases in value over the investment period while generating income at the same time.. This increase will not only be there due to the Jumpstart Our Business Startups (JOBS) Act, Title II, but also due to the increase of institutional investors on the crowdfunding market (Massolutions, 2015). The JOBS Act and its implications will be further elaborated on in the second chapter. The idea of collecting capital from different individuals or companies is not a new concept. In the 1980s, the concept of a Real Estate Investment Trust (REITs) was developed as a vehicle to access a more diversified portfolio; by aggregating several investors a REIT could increase its purchasing power (Massolution, 2015). In April 2015 the Dutch crowdfunding consultancy company Douw & Koren (n.d.) wrote thattwo real estate crowdfunding platforms (SamenInGeld & 2fund.nl) were active in the Netherlands and two more platforms were planning
1 De dato June 8th, 2015
on going online in 2015(Crowd Building & BouwAandeel). Already in June 2015, more than six real estate crowdfunding platforms were available online. This shows that rapid adoption the idea of real estate crowdfunding in the Dutch market. As stated before, real estate is an all-‐encompassing word. For the demarcation of the research the focus will be on the commercial residential real estate market in Amsterdam. This part of the real estate market is interesting to invest in since it kept its value during the financial crisis of 2008. Therefore only the commercial residential market is elaborated on in this thesis. For that reason, the research question in this thesis will be:
Could crowdfunding commercial residential real estate be economically viable in the Netherlands?
In this thesis, the concept of crowdfunding is elaborated with the focus on the real estate sector. Within the real estate sector I address the commercial residential real estate. From there on I created a model for crowdfunding real estate in the Dutch real estate sector. To do so, firstly I elaborated crowdfunding by explaining the concept, potential pitfalls, the motives for investors and money seekers to use crowdfunding, and possible information asymmetries that occur. In the next chapter the crowdfunding sector in the U.S. and the Netherlands, and their respective rules and regulations are elaborated. In the fourth chapter commercial real estate as an asset and his characteristics are described. Then the U.S. crowdfunding real estate is addressed on the basis of the industry report about crowdfunding real estate from Massolution (2015a). Subsequently, in chapter six, I will establish a model based on the U.S. real estate crowdfunding market and experience gathered from attending the Crowdfunding Day and master classes during the Dutch real estate fair for professionals (PROVADA). In this study this model is tested, this is done by conducting expert interviews with managers from respected real estate companies like DTZ Zadelhoff, Berkenhouwe Vastgoed and Cowhill, and with other professionals specialized in crowdfunding and/or real estate like Bouwaandeel.nl, an accountancy firm and notary. These interviews will generate practical implications that make clear
what will be needed to make the model a success in the Netherlands. From these practical implications the most mentioned implications by the interviewees are added into the model. In the last chapter the limitations of this study and possibilities for future research are elaborated. Furthermore, the research question is answered.
1.1 Contribution
In this part, I discuss the theoretical and practical contributions that this thesis will make. It is important to understand the concept of crowdfunding because the (small) contribution of individuals, both founder and investor, can lead to the creation of new projects and ventures, the realization of social projects. These can fundamentally impact how the economy and society functions as it changes how, why, and which products and services are brought into the market. As banks are increasingly reluctant to invest in the start-‐up phase of new ventures, the importance of crowdfunding can increase over the next few years.
1.1.1 Theory
Research in the field of crowdfunding is relatively recent, and in the specialized field of real estate crowdfunding, almost no research has been carried out. This research aims to contribute to the literature by analyzing the real estate crowdfunding market of the U.S. and subsequent incorporating this knowledge by implementing the potential success of American real estate crowdfunding platforms in the Dutch real estate sector, I develop a model for making commercial residential real estate crowdfunding possible in the Netherlands.
1.1.2 Practice
The practical implications of this research are that the knowledge and the Dut h model can be used by Dutch real estate companies as a new way of financing real estate. Furthermore crowdfunding platforms can use it to set up platforms for the real estate sector. At the moment, several crowdfunding platforms struggle in the selection and application of business models. Furthermore, the topic is getting more and more attention from institutional investors and banks like Rabobank and ING because it has huge potential.
2 What is crowdfunding?
In emerging fields, it is difficult to find a complete definition. In several overviews of crowdfunding, the most widely used definition is taken from the article of Kleemann et al. (2008). Schweinbacher and Larralde (2010, p. 588) have redefined this definition as follows:
“An open call, essentially through the Internet, for the provision of financial resources either in form of donation or in exchange for some form of reward
and/or voting rights in order to support initiatives for specific purposes.” Belleflamme et al. (2014 p. 4) defined crowdfunding in almost the same way, with minor changes:
“Crowdfunding involves an open call, mostly through the Internet, for the provision of financial resources either in the form of donation or in exchange for the future
product or form of reward to support initiatives for specific purposes.” According to Mollick (2014), however, this definition potentially leaves out examples that are marked as crowdfunding in several research fields, examples such as peer-‐to-‐peer lending and fundraising for music groups.
The definitions as mentioned above supports two groups of money seekers in financing their projects. The first group comprises entrepreneurs who are trying to make their dreams come true and establish new ventures. The second group comprises small business owners who are trying to keep their businesses afloat or who are trying to let them grow (Stemler, 2013). In this chapter the concept of crowdfunding is elaborated to get a better understanding what crowdfunding is. First the different forms of crowdfunding are described. Furthermore the economic model, the motives for investor and money seeker, the information asymmetry and the potential pitfalls will be elaborated in this chapter.
Several crowdfunding platforms and articles give four different forms of crowdfunding (SterlingFunder, n.d.; Ryan, 2012; Schwienbacher & Larralde, 2010; AFM, 2014):
1. Donation-‐based crowdfunding, where individuals give money or other resources to the project because they want to support the cause of the project.
2. Reward-‐based crowdfunding, where in exchange for a reward (often the product or service that the new venture has in mind), individuals give money to the new venture. The new venture often uses price discrimination between individuals who pre-‐order and those who will buy it on the regular market in order to attract more investors (Belleflamme et al., 2013).
3. Equity-‐based crowdfunding, where individuals get a part of the equity and become co-‐owners of the new venture in exchange for their investment. In 2013, less than 5% of crowdfunding was equity-‐based (Massolution, 2013).
4. Debt crowdfunding, where individuals borrow money from the venture with a legally binding commitment to repay the loan at certain time intervals and at a certain interest rate.
Some include a fifth form of crowdfunding: royalty-‐based crowdfunding. In this type of crowdfunding, the individuals who invest in a new venture are able to claim a percentage of the revenue once the new venture generates revenue (Outlaw, 2013). Equity-‐based crowdfunding is especially becoming an interesting investment vehicle. According to the Financial Conduct Authority (2013, p.8), it is important to supervise equity-‐based crowdfunding, in this report known as crowdinvesting, more strictly than crowdfunding’s other forms. Figure 1 shows the financial forms of crowdfunding:
Figure 1: Different forms of crowdfunding (SterlingFunder, n.d.; Ryan, 2012; Schwienbacher & Larralde, 2010; AFM, 2014; Outlaw, 2013)
Crowdfunding became popular during the economic crisis of 2008 and has been a serious way of financing since 2013. In 2013, $6.1 billion was raised through crowdfunding; in 2014, it became $16.2 billion and the prediction for 2015 is $34.4 billion (Massolution, 2015b). There is no empirical evidence to show a significant relationship between the rise of crowdfunding and the economic crisis of 2008. In my opinion, however, there could be a logical relationship between these two events. Due to the economic crisis of 2008, there was a decrease in Venture Capitalists (VCs). Figure 2 shows on the next page that the amount of capital invested in Europe and the Netherlands by VCs decreased from 2007 to 2013.
The main problem is that it is, or was, harder for companies with a lack of credit, no proven track record of sales, and no performing record to gain capital from traditional channels (Fink, 2012). Requiring resources, especially finances, is one of the most important factors for a new venture’s success (Gompers and Lerner, 2004; Kortum and Lerner, 2000). Thus, new ventures must seek alternative ways of financing their new ventures. Crowdfunding could be a new way to make it possible for (new) ventures to start or expand their businesses.
Different forms of crowdfunding
non-‐oinancial
donation-‐
based reward-‐based
oinancial
equity-‐
Figure 2: VC investments in Europe and the Netherlands (Eurostat, 2014)
There are several reasons that (new) ventures want to use this new form of raising capital according to the report by Massolution (2015a). First of all, the method of getting in touch with potential investors is very efficient, both vertically and horizontally. By vertically they mean that money seekers can not only give potential investors a brochure of their project but that can also use videos, photos, interactive tools and links to other interesting material that has to do with the project. By horizontally, they mean that the money seeker is able to reach out to the entire world for investment. The crowdfunder is now not just confined to America or Europe, but instead has the possibility to reach any and every investor in the world. The second reason is that the money seeker can give periodic updates to his or her investors through the platform, not only before but also during and after the offer periods. The third reason is that it used to be too much more work to deal with a number of small investors, meaning that in the past they would often set a minimum investment of $100,000 or higher. With the introduction of the crowdfunding platforms, this negative side effect disappeared, as they were able to have efficient communication with their investors. The fourth reason is that with more potential investors, money
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VCs investment
seekers can get higher prices for their (new) ventures and improve their own deal economics. The fifth reason is that crowdfunding platforms take the stress of ‘managing’ investors away from the money seekers. Often, money seekers see the investor as an extra workload with which they have an obligation to communicate and inform them about the progress of the firm. By giving the money seekers the online back office to keep their investors up to date with sheets, business updates and other investor information it becomes much more easier to communicate with the investors. The sixth, and final, reason is that some of the real estate crowdfunding platforms fund the investment upfront. Hence, the money seeker immediately has the requested capital. The real estate crowdfunding platform incurs the risk of not being able to successfully place the investment on their platform. Furthermore, crowdfunding can be a way to test the desirability of your product or business in the consumer market. Also, banks are more willing to finance the rest of (new) ventures once they have seen evidence of money seekers achieving their goal through crowdfunding (Key, 2014).
According to Mollick (2014), projects that succeed are able to do so by a relatively small margin. The results of his research are shown in Figure 3 below:
Figure 3: Histograms of funding level (Mollick, 2014)
Both figures show the same trend: an exponentially decreasing line. However, the meaning is not the same in each. The line in the figure of failed projects shows that almost 50% of failed projects get 0% to 5% of their funding. The line ends with more than 95% of the failed projects that receive less than 40% of the
amount they need. In other words, it seems that when a project receives more than 40% of its pledged level, there is a significant change in comparison to the project that receives at least the full amount it needs. The line in the figure of successful projects shows that 50% of the projects receives up to 10% more than their goal. In total, 124 projects with goals over $100 received 10 times their goal, of which 44 were very large projects (over $100,000). 41 out of these 44 projects were hardware, software, games or product design projects.
Furthermore, the influence of social information plays an important role in the success of the campaign. Kuppuswamy and Bayus (2013) researched the role of social information in the dynamic behavior of investors with the data from Kickstarter. They held a panel on successfully and unsuccessfully funded projects that were listed on Kickstarter. The result of this research was that additional backer support is negatively correlated to already achieved backer support of the project. This implies that backers often do not support a project that has already received a lot of support because they think that the project will get its capital anyway. This result does not support the results shown in Figure 3 because then most of the crowdfunding campaigns would not get 100% of their required funding.
2.1 The economic model
Belleflamme et al. (2013) created a model in their report for the reward-‐ and equity-‐based form of crowdfunding. The economic model consists of two assumptions to simplify the model: 1) the entrepreneur enjoys a monopoly position in their market, and 2) consumers know the characteristics of the product before the purchase. The model from the report has two different formulas: one for pre-‐ordering and the other for profit sharing. In this thesis, only the profit sharing formula will be used. Table 1 illustrates the variables of the model. These variables will be further elaborated in what follows.
Variable Definition
K Fixed amount of money needed to start production
s Baseline quality of the good (normalized to 1)
that this variable is distributed uniformly between [0,1] for consumers
𝒏𝒄 Number of crowdfunders
𝚷, 𝝅𝟏, 𝝅𝟐 Total profits of the entrepreneur (Π), profits of the entrepeneur in the first period (𝜋!) and second period (𝜋!); bij definition Π = 𝜋!+ 𝜋!
Variables specific to the model of profit sharing
𝚺 Community benefits for crowdfunders
∝ Share of profits that the entrepreneur will distribute to crowdfunders (with 0 ≤ ∝ ≥ 1)
Table 1: Definition of variables
To determine if the consumers want or do not want to invest in the new venture, the authors distinguish between consumers who are willing and consumers who are not willing to buy the product or service. The result is the incentive
constraint for investing:
𝜃 − 1 2+ 𝛼 𝑁! 1 4− 𝐾 𝑁! + Σ ≥ 0
The idea behind this equation is that the left side (𝜃 − !!) is the net utility from consuming the product. The next term (!!
!
!
!) is the share of the profit that potential investors (crowdfunders) receive. The third term (!!
!) is the amount of
capital (money) that the investors (crowdfunders) need to pay to the entrepreneur to compensate the entrepreneur for the equity that the investors (crowdfunders) receive. This term becomes smaller when the number of investors increases because then the total amount of capital K can be divided between more investors. The last term (Σ) is the community benefit for the investors (crowdfunders).
One remark for this equation is that in the real estate sector it is not the case that consumers can buy the product or service in the second period. If an individual invests, then you are part of the investment vehicle and it is not the case that there will be a result from this vehicle besides buying or creating real estate. Another remark is that, in my opinion, the variable of trust should also be given. As the whole process is online and investors often do not know who is behind
the (new) venture, they must have confidence in them and trust them with their capital.
2.2 Motives
For investors and money seekers, there are different motives behind why they want to use crowdfunding platforms. In this section, their motives will be further elaborated. First, the motives of the investors will be provided and, after that, the motives of the money seekers will be addressed.
2.2.1 Investors’ motives
According to a consumer panel of the Authority for Financial Markets (AFM) in the Netherlands (2014),2 investors are individuals who are highly educated and
have a higher than average net worth. They invest in crowdfunding for many reasons: it is a direct possibility to invest in (new) ventures, they find the return on investment attractive, they like the goals of the (new) ventures, or they find it interesting or instructive to invest through crowdfunding. Massolution (2015a) add that the demographic of investors is shifting toward the millennials but, even so, the ones with above average income and net worth. The psychological reasons as to why individuals give money are sympathy and empathy (Rick et al., 2007), guilt (Cialdini et al., 1981), happiness (Liu & Aaker, 2008) and identity (Aaker & Akutsu, 2009). Furthermore, every form of crowdfunding brings a different utility to the investor. With donation-‐based crowdfunding, investors make a social contribution to society; often this is an intrinsic motivation (Collins & Pierrakis, 2012), for instance, by supporting the Red Cross or an artistic movement. With reward-‐based crowdfunding, investors have the privilege of receiving the product or service before it is on the market, a first-‐mover advantage of investing in the new ventures before they produce anything. They also have social and intrinsic motivations for investing their capital (Collins & Pierrakis, 2012), for example, a new venture wants to start a new clothing brand. They attract investors with reward-‐based crowdfunding by sending them the
2 The consumer panel of the AFM consists of an interview with 128 consumers who are investing
or lending money through crowdfunding platforms or consumers who want to do it in the future. This panel is not representative for the whole Dutch population.
first T-‐shirt they produce. With equity-‐based crowdfunding, investors receive a share of the company in return for their investment. It is not clear if they become consumers themselves. The motivation to invest is financial, and sometimes in combination with social benefits (Collins & Pierrakis, 2012). With debt crowdfunding, investors use the crowdfunding platform to gain a higher return on their capital by taking the risk of lending money to (new) ventures. Their motivations are the same as equity-‐based crowdfunding. With royalty-‐based crowdfunding, it is not about a share in the company but the investors who want to support the (new) venture. When the company makes a profit, the investors want a return on their investment. The first two forms of crowdfunding (donation-‐ and reward-‐based) are for the personal utility of the investors and the last three forms of crowdfunding (equity-‐based, debt, and royalty-‐based) are for the financial utility of the investor.
Furthermore, crowdfunding gives the investor access to more diversified investment opportunities, not only in his or her territory or country but also globally. In addition, investors have the opportunity to invest in a number of different structures and return possibilities to diversify their portfolio. As the question of capital is on the crowdfunding platform, money seekers must be very transparent. Lastly, the investor is able to passively participate in the real estate project because the crowdfunding platform or money seeker is doing the administration, construction, and tenant relations (Massolution, 2015a). Before there was crowdfunding, individuals were often not able to invest in start-‐ups, outside very wealthy individuals who were part of a network of private bankers.
2.2.2 Money seekers motives
There are two types of money seekers in crowdfunding activities: 1) commercial (profit) money seekers who want to start a new venture and try to finance their ideas through crowdfunding, and 2) non-‐commercial (non-‐profit) money seekers who want to start a project, event or other, often artistic, movement for the utility of society. First, the commercial money seekers’ motives will be further elaborated and the non-‐commercial money seekers’ motives thereafter.
Commercial money seekers on crowdfunding platforms are mostly (new) ventures and individuals. For them, crowdfunding is: a relatively easy and quick way of financing, an alternative because they are not able to receive a traditional way of financing, or fitting with their business concept (innovatory or durability). It can also be a beneficial way of tapping into a new target audience (AFM, 2014). Another motive, according to Belleflamme et al. (2013), is that price discrimination (reward-‐based crowdfunding) results in an expansion of the money seekers’ potential market. Mollick (2014) describes it as demonstrating a demand for a company’s product or service. For example, Pebble, a smart watch, was rejected for venture capital funding. After that, they tried it on Kickstarter, raised over more than $20 million3 and were thereafter able to receive a large
amount of venture capital funding. Therefore, crowdfunding could be seen as a market analysis for early developers. When a project receives the amount it had pledged, or even more, it seems that there will be a market for the product or service.
Crowdfunding can also be used for marketing purposes by creating interest from the crowd in the early stage of development. Part of this marketing advantage could be attention in the press and other companies creating compulsory add-‐ ons or applications for your product (Mollick, 2014).
Non-‐commercial money seekers are often individuals with initiatives, for example, one-‐time projects, who use crowdfunding as a unique platform to raise money from society; this is often less than $1000 (Mollick, 2014). Otherwise it could be much harder for the organizer to increase capital for the event from his social and commercial circle. Consider a barbeque for the neighborhood, or a movie night in the Vondelpark, Amsterdam. When individuals are able to reach the crowd that has gathered for a one-‐time event through crowdfunding platforms, it creates a new fan-‐base for future events and their organizers.
3 De dato 28 maart (https://www.kickstarter.com/projects/597507018/pebble-‐time-‐awesome-‐
2.3 Information asymmetry
The first information asymmetry that occurs when using crowdfunding is that the (new) ventures do not know which of the active users of the crowdfunding platform has the highest utility for investing in their venture (Belleflamme et al., 2013). It could be the case that in the process of financing, the money seeker is not giving the right information, or that he knows more than potential investors. It could even be that the money seeker provides information that is misleading (AFM, 2014). The potential problem of over-‐ and underestimating new ventures is that the best new ventures will stay away from crowdfunding platforms because of the high possibility that the crowd will underestimate the value of the new venture (Dorff, 2014). In his report, Akerlof (1970) called this “the lemons problem”. By way of the lemon problem, Akerlof (1970) explained the problematic system of investing in a good car – there will always be a possibility that one will invest in a bad car, which Akerlof named “the lemon”. The lemon problem is created when all the bad cars are sold and the good cars are not sold. So, the bad cars tend to drive out the good car competition. As described by Belleflamme and Lambert (2014, p. 293), this same model can be introduced within crowdfunding:
“Platforms only manage to attract low-‐quality projects because high-‐quality entrepreneurs anticipate that they will not be identified as such by the contributors
and will therefore fail to raise the capital that they need.”
Another problem that can occur is that the investors have no idea what the quality of the product is because crowdfunding initiatives often rely on products that are not yet on the market in finished form (Belleflamme et al., 2013).
In their report, Belleflamme et al. (2013) state two situations of asymmetric information: 1) hidden information, when the understanding of quality is beyond the reach of the entrepreneur creating adverse selection, and 2) hidden action, when the entrepreneur does have an effect on the level of quality, creating a moral hazard. In this paragraph, we will further elaborate these two situations and include the problematic situation of agency.
2.3.1 The agency problem
The agency theory has his origin in the late ’60s and early ’70s when Wilson (1968) and Arrow (1971) introduced the problem that can occur when cooperating parties have different approaches toward risk. According to Eisenhardt (1989), there are two main problems that can occur in the agency relationship. The first agency problem that can arise is that the desires or goals of the client (principal) and the contractor (agent) are conflicted and that it is difficult and expensive for the principal to control and supervise the agent. The second is that when the principal and the agent have different approaches toward risk they could both prefer different actions because of their risk preferences. An agency problem that can occur within crowdfunding is when the money seeker (agent) takes more risk with the money of the investors (principals) than that the principals want. As it is often not the money (capital) of the money seeker, the agent is willing to take more risks because the potential profit lies with them.
2.3.2 Moral hazard
According to Belleflamme et al. (2013), the situations of hidden information (i.e. the realization of quality if an exogenous event) and of hidden action (i.e. the realization of quality is under an entrepreneur’s quality) are in general within the information asymmetries that are in favor of profit-‐sharing schemes. With crowdfunding, the potential investor has no idea what the quality of the product is, as they only know about it from the platform. When money seekers promise that they will create an A! quality product, it could easily be that they make a B quality product instead to save money.
2.3.3 Adverse selection
The money seeker can create adverse selection before the project starts by introducing the project on a crowdfunding platform. Money seekers could inform the potential investors with only a part of the entire proposition, or they do not give all the necessary information needed to accurately evaluate the success of the project.
Yet crowdfunding platforms can also have adverse selection. In a report from Massolution (2015a) on crowdfunding in the real estate sector, it is clear that several real estate crowdfunding platforms have used due diligence to give advice on whether or not the investment is ‘safe’, even though the crowdfunding platform receives a fee from the money seeker for letting them use the platform. In this case, there is a risk that the due diligence is not the truth because the crowdfunding platform gets fees from letting money seekers use their platform. Thus, in the case that the crowdfunding platform itself needs money, the platform might accept campaigns that are not safe but who do nevertheless get the seal of approval from the platform.
2.4 Potential pitfalls of crowdfunding
The potential risk for investors who invest through equity-‐based crowdfunding in new ventures is that these new ventures have a high failure rate and the securities are unlisted. Hence, there is a significant change of potential capital loss, risk of dilution, fewer possibilities for liquidation and, most of the time, there is limited information available on which to base investment decisions (ESMA, 2014). At the beginning of 2014, one of the first crowdfunded projects went bankrupt in the Netherlands. Restaurant Blauw, which already had restaurants in Amsterdam, Rotterdam and Utrecht, wanted to expand to Den Hague. For their restaurant in Rotterdam they had already crowdfunded €250,000 in 2012. So when they had the plan to open their fourth restaurant, they sought crowdfunding of €125,000 under the condition that they would pay 10% interest to their investors and pay back the loan within 36 months. Eighty investors invested between €100 and €40,000 in the new restaurant. After one year, the restaurant in Den Hague went bankrupt (Beuters, 2014).
A potential pitfall for crowdfunding could be that money seekers would not use the money to invest but embezzle money instead (Hazen, 2012). Seeing as the screening process is lighter than in the ‘standard’ financial world, fraudsters could be attracted to this market in order to embezzle money. In the Netherlands, the different crowdfunding platforms do not communicate with
each other about fraudsters (AFM, 2014), so why should they need to ask for money on a crowdfunding platform instead of going to the bank? Another potential pitfall could be that crowdfunding is an online marketplace for individuals who want to launder their money. The chance that this will be a significant problem for crowdfunding is low because investors need bank accounts at almost every crowdfunding platform available (AFM, 2014). As long as crowdfunding platforms do not accept cash money from investors, this will not be a problem.
Another potential pitfall could be that the lack of transparency. For example, crowdfunding platforms could ask for more money or raise their fee without informing the money seekers (AFM, 2014). When investors have a lack of awareness of these risks, this could lead to bad investment decisions or even to too much investment in failing new ventures (Schwienbacher, 2014). When new ventures try to raise capital trough crowdfunding, they must reveal their ideas of innovation to investors otherwise they will not invest. The potential risk for the new ventures is that competitors or other individuals will copy good ideas (O’Connor, 2014). Several of the pitfalls as aforementioned have a legal background. According to Wolfson & Lease (2011), there are five main topics that must be discussed and need definite answers for new legal questions that arise because the technological innovation is often ahead of the law. These topics are: employment law, patent inventorship, data security, copyright ownership, and security regulations of crowdfunding.
When the crowdfunding market keeps on growing, the potential risk is that the pitfalls of crowdfunding can have a negative effect on the whole economy of a country or region. It can also reflect financial instability in the market.
