UNIVERSITEIT VAN AMSTERDAM &VRIJE UNIVERSITEIT AMSTERDAM
Gülçin Altınok (11084278-2547183) Faculty of Economics and Business Administration
MSc. Entrepreneurship
E-mail: gulcinaltinok91@gmail.com
Supervisor: Dr. Rafael Perez Ribas
The Role of Information Disclosure in Attracting Large and
Small Investors in Equity Crowdfunding
An empirical examination of the company quality signals on crowdfunding
campaign success
ABSTRACT This thesis presents an empirical examination of the effect of company’s quality signals on the
decision of investing in equity crowdfunding projects. Using a sample of 250 projects listed on Crowdcube in 2011-2016, I estimate the impact of ownership offered to investors, debt outstanding, capital contribution by the founders, disclosing financial statements, and information disclosure regulations on the likelihood of being funded. My findings show that only the offered ownership fraction to investors affect a project’s likelihood of being funded, whereas other company information changes the composition of small and large investors in a project. Small investors are mostly attracted by signals, which do not require complex and costly due diligence such as the offered ownership percentage to the investors. Similarly, the supply of company financials brings small investors to the projects, but their assessment of the content of disclosure information is limited. Unlike large investors, small investors do not consider leverage or founders’ equity investment to post-asset-value ratios in their decision process. Finally, after information disclosure is enforced by regulation, large investors penalize projects without financial statements. Findings imply that small investors’ opportunity evaluation lacks the sophistication present in traditional investment processes. This creates concerns on the way equity crowdfunding market operates currently.
Statement of Originality
This thesis is written by Gülçin Altınok who declares to take the full responsibility for the contents of this document.
I declare that the text and work presented in this document is original. No sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business Administration is responsible solely for the supervision of completion of the work, not for the content1.
1 I would like to thank Dr. Rafael Perez Ribas for his time and feedback on the paper in its different phases of development.
Table of Contents
1. Introduction ... 1
2. Theoretical Framework ... 5
2.1 Signaling ... 5
2.1.1 Elements and Characteristics of Signaling ... 6
2.1.2 Moral Hazard and Principal Agency Theory ... 8
2.1.3 Adverse Selection and Market of Lemons ... 9
2.2 Equity Crowdfunding ... 10
2.2.1 Rationale of Equity Crowdfunding ... 10
2.2.2 Process of Equity Crowdfunding ... 12
2.3 Signaling in Equity Crowdfunding Context ... 13
2.3.1 Moral Hazard and Principal Agency Theory in Equity Crowdfunding ... 14
2.3.2 Adverse Selection and Market of Lemons in Equity Crowdfunding ... 15
2.4 Signals in Equity Crowdfunding ... 17
2.4.1 Risk ... 17
2.4.2 Disclosure and Market Regulations ... 20
2.5 Conceptual Model ... 22
3. Data Source – Crowdcube.com ... 23
3.1 Platform ... 23
3.2 Regulation ... 24
3.3 Project Information on Crowdcube ... 26
3.4 Sample ... 27
3.5 Variables ... 28
3.5.1 Project Performance ... 28
3.5.2 Risk ... 29
3.5.3 Disclosure and Market Regulations ... 30
3.5.4 Control Variables ... 30
3.6 Descriptive Statistics ... 31
4. Analytical Approach ... 34
5. Results ... 36
5.1Baseline Model ... 36
5.1.1 Risk ... 36
5.1.2 Disclosure ... 38
5.2 Effect of Regulation ... 39
6. Discussion ... 42
7. Conclusions ... 46
Bibliography ... 50
1. Introduction
Information asymmetries take place “when different people know different things” (Stiglitz, 2002, p. 469). Equity crowdfunding is a financial market where information asymmetries are present, since entrepreneurs who want to raise capital know the true quality of their venture, whereas the potential investors lack the information on the quality of the ventures that offer equity. In fact, due to the characteristics of investors investing in these ventures, information asymmetries are more pronounced in equity crowdfunding markets compared to traditional seed stage financing processes. The majority of the investors on equity crowdfunding platforms are small investors who invest small amounts and expect small returns, especially in comparison to business angels (BA) and venture capitalists (VC). Small investors do not have enough incentives to perform due diligence on investment opportunities since the small investment and small return do not compensate for performing a costly due diligence. Furthermore, small investors have inferior capabilities and less experience in assessing investment opportunities compared to traditional investors. Investors’ unwillingness and poor competences to make a thorough assessment on the company information creates the risk of an Akerlof type market, where investors can’t distinguish high and low quality projects from each other (Tomboc, 2013). This can cause high quality projects to eventually desert the market to the low quality ones, namely to the ‘lemons’ (Akerlof, 1970). In order to distinguish themselves as high quality projects, entrepreneurs communicate about their venture on the project pages with potential investors. The information on the new venture acts as signals on company’s value and future prospects. The reaction of investors to the company signals determines which projects will reach their target amount. Consequently, the way investors assess company quality signals is crucial for the separation of the high and low quality projects on the platforms and for the future of equity crowdfunding market.
To investigate the investors’ company assessment on equity crowdfunding platforms, this thesis attempts to answer the following question: ‘what is the role of company quality information on the equity crowdfunding platforms in attracting small and large investors?’. To do so, I exploit 250 projects from Crowdcube, which took place between September 2011 and May 2016. In an effort to understand the effect of different company quality signals, data is examined on project results, which is adopted as the average investment per investor and the final investment amount in relation to the targeted, namely the likelihood of a project being funded. Regarding the company quality signals inducing investors to commit financial resources, the effect of offered ownership fraction to investors, leverage level, equity investment by the entrepreneur and/or the founding team, supply of financial disclosure
documents, and the changing regulations in the market is explored.
In this thesis, the investment decisions of small and large investors are investigated under two different scenarios: one in which companies on the platform voluntarily provide their financial statements and another in which they are required to do so. In the first case, a few companies try to differentiate themselves from the lemons and expect to be compensated by investors. In the latter, only firms that really are low in quality are expected to avoid providing financial details. The changes in the legal setting of the equity crowdfunding market in United Kingdom, in which Crowdcube operates, provide the setting that I use to examine how large and small investors react to those two scenarios. One recent regulation change is underwent in April 1st 2014, which was a call for project owners to disclose more and healthier company information2 (FCA, Policy Statement PS14/4, 2014). After the regulation change, projects that were not providing financials would start to do so due to their unwillingness to reveal low quality. Therefore projects without financial disclosure listed after FCA’s new regulation are expected to be penalized by potential investors and have lower probability of reaching their target amount.
Due to the 2008 financial crisis in the U.S. and its repercussions in the world, BAs and VCs have moved their investment activities to upstream, later-stage companies where the existing risk of investing is considerably less (Block & Sandner, 2009). This caused a funding gap, which obstructs the access to financial resources for new ventures (Dawson & Bynghall, 2012). Currently crowdfunding appears to be a common remedy to this problem. Particularly, equity crowdfunding is increasing in popularity as an alternative source of capital for start-ups (Nesta, 2016), where an entrepreneur makes an open call on the Internet to raise capital from a large group of individuals in exchange for equity from his/her company (Bradford, 2012). Equity crowdfunding has doubled its volume every year since 2009 and currently accounts for a $2.5 billion investment volume in the world (Massolution, 2015). According to The World Bank (2015), equity crowdfunding is expected to reach a volume of $36 billion worldwide at the end of 2020, surpassing other sources of traditional financing for start-ups (Barnett, 2015). As equity crowdfunding becomes more widespread, countries change their regulations to permit equity crowdfunding to unaccredited investors3. This triggers an
2 Crowdcube operates under the Financial Conduct Authority (FCA), which regulates financial markets in UK. In their Policy Statement 14/4, FCA introduced the project pages as the main source of information for the potential investors on equity crowdfunding platforms, hence encouraged project owners to disclose all relevant company information on the project pages. Rather than a new law, this was a call for tightened requirements in equity crowdfunding platforms.
3 Approved by SEC on October 2015, the Title III of the JOBS Act brings non-accredited investors to equity crowdfunding markets in the United States. Here unaccredited refers to citizens who are not specialists in investing like BAs and VCs, or are not high worth individuals (Barnett, Non-Accrediteds, 2015)
increasing amount of small investors to invest in equity crowdfunding projects. Since the small investors commit the majority of the investment on equity crowdfunding platforms, the equity crowdfunding market is being shaped by the investment decisions of the small investors. This strengthens the significance of understanding the evaluation investors make before investing in equity crowdfunding platforms.
Crowd investors’ investment decisions are determined by the way they assess the company quality signals, which are sent by the entrepreneur (Vismara, 2016). Originally proposed by Spence (1973), signaling theory is typically used to understand what kind of information provided by the entrepreneur leads the potential investor to invest (Spence, 193; Stiglitz, 2002; Akerlof, 1970; Bertoni, Meoli, Vismara, 2014; Carter & Manaster, 1990; Connelly, Certo, Ireland, Reutzel, 2011; Leland & Pyle, 1977). The current literature on the signaling has primarily focused on the application of this theory to the traditional entrepreneurial finance context, where the investment processes of the traditional investors such as BAs and VCs is the main focus (Busenitz, Fiet, & Moesel, 2005; Osnabrugge, 2010; Prasad, Bruton, & Vozikis, 2000; Hölmstrom, 1979), thereby overlooking whether these relationships still hold for investors who invest smaller amounts, expect lower returns and are less sophisticated in assessing investment opportunities.
To the best of my knowledge, the research for the effect of signals on investment decisions of equity crowdfunding investors is limited to two notable studies. This first one is by Ahlers, Cumming, Gunther, & Schweizer (2012), in which a sample of 104 offerings from an Australian equity crowdfunding platform is examined on final investment amount and final number of investors. Authors reported that the fraction of retained equity by the founders is the strongest positive signal affecting the final investment amount. Furthermore they’ve found that companies with more board members, higher levels of education, and better networks attract higher numbers of investors. In a similar study, Vismara (2016) examined 271 projects from a combined sample of Crowdcube and Seedrs, where social capital and retained ownership fraction is found to have a positive impact on the success probability of the campaigns.
My findings can be considered as a step towards filling the literature gap on the crowd investors’ investment process, where signals effecting small and large investors’ investment decisions are identified. Drawing from a sample, which covers offerings from the establishment of the platform to date, the present study provides one of the largest samples examined in equity crowdfunding literature. Furthermore, this research tests the effect of several company quality signals on the equity crowdfunding context for the first time, such as the leverage and founders’ equity investment to post-asset-value ratios. Findings indicate that,
when these ratios are high, large investors are drawn to these projects, whereas the investment decisions of small investors are not necessarily influenced by these signals. Since the majority of investors are small in equity crowdfunding platforms, the probability of a campaign’s success is not affected by the outstanding debt and capital contribution of founders. Furthermore, the supply of financial statements doesn’t affect the success probability of a campaign, however it pulls small investors to invest in these projects, rather than large ones. Another initial attempt of this research is to incorporate the effect of market rules and regulations on the behavior of crowd investors. Regarding this, small investors’ investment decisions are found to be indifferent for entrepreneurs not conforming to the changing regulations and the success probability of projects listed without financial disclosure after FCA’s encouragement for not to do so doesn’t decrease. However larger investors penalize projects without financial statements, which are listed after changed regulations towards transparency. Finally, results imply that the high offered ownership percentage to investors discourages small investors from investing and decreases the probability of a campaign’s success.
According to Mollick (2014), if small investors on equity crowdfunding platforms are sophisticated enough to make thorough assessments of investment opportunities, considered to be salient quality signals for the investment decisions of traditional investors should be significant for small investors as well. Drawing from this rationalization, small investors are expected to assess investment opportunities in a similar manner to traditional investors. However, findings imply that, small investors are induced to invest through signals that do not require complex and costly due diligence such as offered equity fraction to investors. Unlike large investors on the platform, they do not perform a thorough assessment on the company financials such as leverage or equity investment by founder ratios. Furthermore, even though larger investors on the platform pay attention to entrepreneurs’ conformity to the legal framework imposed on the market, small investors remain unreactive to the projects that lack financial documents after the new regulation by FCA.
The difference between small and large investors’ response to company quality signals indicate their varying level of sophistication in the evaluation of investment opportunities (Mollick, 2014). This difference points to the variation in the receiver attention (Connelly et al., 2011) and signal interpretation (Srivastava, 2001) between two investor types. Namely, while large investors on the platforms pay attention to signals on company financials and interpret these signals in a similar way with BAs and VCs, the signal attention and interpretation of small investors is limited to obvious project information. The varying signal attention and interpretation of small investors stem from their lack of experience and
capability in performing due diligence (Larralde & Schwienbacher, 2011) along with poor incentives to make a through opportunity assessment (Agrawal et al., 2014). The limitations of small investors’ signal attention and interpretation raises concerns on their ability to eliminate less competent ventures from the market (Busenitz et al., 2005; Cable, 2010). Since the potential failure in separating low and high quality projects can trigger equity crowdfunding to become a market of lemons (Tomboc, 2013), the sophistication of small investors in assessing investment opportunities raises concerns for the rationale in which the market operates currently. Results indicate that enforcing new regulations is not sufficient to inform small investors on project quality. This insight can be useful from the point of view of platforms and policymakers. One remedy to this problem can be education of small investors in investment opportunity assessment. Finally, the entrepreneurs on the platforms can put the important quality signals found in this thesis forward, in order to take the attention of small investors, and differentiate themselves from the lemons.
2. Theoretical Framework
In this section, the theory that is relevant for the scope of this research will be discussed. First signaling theory literature will be explored. Next, a brief overview of the equity crowdfunding concept will be provided. Based on the theoretical background regarding the signaling theory, I will explicate the equity crowdfunding concept as a function of signaling. Lastly, the hypotheses on the signals influencing the performance of equity crowdfunding projects will be proposed. The chapter will conclude with an illustration of the conceptual model.
2.1 Signaling
Financial markets are characterized by the information asymmetries, where sellers know the quality of the goods they are offering, but buyers do not (Akerlof, 1970). ”In the absence of perfect information, decision-makers often look to various indicators to signal what future outcomes are likely to be” (Busenitz et al., 2005, p. 2). Hence asymmetric information is considered to be a fundamental assumption of signaling theory (Spence, 1973; Levy & Lazaraovich-Porat, 1995; Certo, 2003). Through “addressing the problems of information asymmetry in markets, signaling theory proposes that this asymmetry can be reduced by the party with more information through signaling it to others” (Morris, 1987, p. 47).
Similar to other markets, in the context of entrepreneurial financing signaling theory is a central issue (Busenitz et al., 2005; Bertoni et al., 2014; Carter & Manaster, 1990; Mogliorati & Vismara; 2014; Megginson & Weiss, 1991). The reason is the presence of information
asymmetries between investors and entrepreneurs (Connelly et al., 2011). In the context of entrepreneurial financing the entrepreneur has better knowledge of the true quality of the company and future potential of the business compared to the potential investors (Backes-Gellner & Werner, 2007). Therefore unless the new ventures communicate the superiority of their business concept or their high competences they undergo the risk of being under-funded or not being funded at all (Busenitz et al., 2005). According to Wright & Robbie (1998), sending signals that can diminish the influence of asymmetric information is one of the greatest challenges for new ventures in early stage financing. Especially venture capitalists are highly concerned with pre-investment processes such as screening, valuation and due-diligence where they evaluate the signals of new venture competences and decide whether to invest or not (Osnabrugge, 2000). The more positive the signals are on venture quality the higher the probability to receive investment (Davila, Foster, Guptab, 2003). Hence, new ventures aiming to raise money from investors should be convincingly signaling the quality of their company (Prasad et al., 2000).
2.1.1 Elements and Characteristics of Signaling
In order to better comprehend the concept of signaling Connelly et al. (2011) proposed a framework where the signaling action is represented as a dyadic relationship. According to this framework this relationship has three elements: the signaler, the signal and the receiver. To begin with, the signaler is defined as the insider, who has access to information where the same information is not available for outsiders. In the context of entrepreneurial financing, this information is usually about either a product (Ross, 1977), a firm (Kirmani & Rao, 2000) or a firm leader (Zimmerman, 2008). According to Connelly et al. (2011) one of the most important characteristics of signalers is their partially conflicting interest with the signal receivers. This may cause some of the signalers to send false signals in order not the reveal the true quality of product, firm or leader and therefore persuade the receivers to select them (Campbell & Kracaw, 1980). Referred as signal honesty, the term stands for whether the signaler truly has the signaled quality or not (Connelly et al., 2011). According to Lee, Ang, Dubelaar (2005) signal honesty creates concern especially if there is no cost for cheating, namely when the market is indifferent between the high and low quality signalers.
The second element of the signaling theory, the signal stands for the communication of information held by the insider to the outsiders with the purpose of creating a positive image on the organizational attributes. Therefore signals aim to resolve the underlying information asymmetries about the latent, imperceptible or unobservable qualities of the insider (Spence, 1973). However not all the signals sent by the insider ultimately help to overcome the problems created by the information asymmetries (Ahler et al., 2012). According to Connelly
et al. (2011), effective signals have two characteristics: observability and signal cost. Observability refers to the extent that the sent signals are noticed or understood by the receivers. If the receiver does not perceive the signal sent by signaler, then the communication initiated with the purpose of reducing the information asymmetry fails. Gulati & Higgins (2003) differentiate the signals as ‘weak’ and ‘strong’, which refers to the degree of their detectability by the receivers. Ramaswami, Bretz & Wiethoff (2010) goes one step further and adds the concept of signal strength on top of the signal observability. Here signal strength refers to how salient is the signal is for evaluating a given signaler.
The second characteristic of an efficient signal; signal cost stems from the fact that signaling certain attributes is more costly for some signalers (Bird & Smith, 2005). For instance, obtaining patents is less costly for high quality companies with novel products than it is for low quality companies with mediocre innovations (Hsu & Ziedonis, 2006). After all, low quality companies would require implementing costly transformations, and dedicating time and money in their products to obtain patents. Therefore the costs of certain signals facilitate the differentiation between very competent and less competent new ventures, hence contribute to the efficiency of markets (Busenitz et al., 2005). In addition, if a signaler with low quality product believes that signaling a certain attribute outweighs the cost of actually having that quality, he/she may send false signals (Connelly et al., 2011). False signals can dominate a market until the receivers learn to distinguish true and false signals. Therefore signaling theory requires the pre-condition that signaling costs should be positively related to the ambiguous nature of the signals.
The third element of the signaling framework is the receiver, which refers to outsiders who lack the information about the organization in question and are willing to obtain it. Depending on the information provided by the signaler, the receiver aims to make a selection, from which he/she can benefit. In the context of entrepreneurial finance the selection of a signaler by the receiver refers to the investment decision (Connelly et al., 2011). Therefore receivers in this context stand for potential or existing investors where they can be either public (Burke et al., 2014) or private investors (Busenitz et al., 2005; Ehrilich, Noble, Moore & Weaver 2005; Cumming, Pandes, Robinson, 2015). In this context the investors may profit from buying shares of a new venture which signals high returns in future.
According to Connelly et al. (2011), the effectiveness of the signals is restricted by the receivers’ ability to perceive them. In other words, the signaling will not take place if receiver does not know which signal to search for or if does not search for signals at all. The extent of receiver’s search of his/her environment is defined as the receiver attention. Especially when the sent signals are weak, which complicates the observation of them, it can
be challenging for the receivers to find and evaluate these signals unless they put a conscious effort in searching for them (Kuusi & Ilmola, 2006). Even when the receiver attention is high and signals are strong, effectiveness of the signals differ depending on the perception of the receiver (Leland & Pyle, 1977; Srivastava, 2001). Defined as receiver interpretation, this concept refers to the process of extracting a meaning from the signal. The presence of receivers’ existing biases, beliefs and notions can lead to different inferences of the same signal by different receivers. The difference in these inferences can be both in the extrapolation of meaning and in the significance attached to the signal (Ehrhart & Zieger, 2005).
2.1.2 Moral Hazard and Principal Agency Theory
“The problem of moral hazard arises when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome” (Hölmstrom, 1979, p. 74). In these instances there are no compelling incentives to take correct actions therefore the Pareto optimality of the risk sharing is generally truncated. A root cause of moral hazard is information asymmetries since neither of the parties is expected to be completely transparent with their qualities in this context (Leland & Pyle, 1977). This leads to a situation where decision maker decides on how much risk to take, while the costs of this decision is underwent by someone else than the decision maker when things go badly (Krugman, 2009). Therefore the moral hazard can be defined as the problem of inducing agents to supply proper amounts of productive inputs when their actions cannot be observed and contracted for directly (Hölmstrom, 1982).
According to Eisenhardt‘s agency theory (1989) the unobservability of agent’s (entrepreneur’s) actions causes two problems: First one is the nonalignment of the goals between the principal and the agent. Due to the impossibility of verifying what the entrepreneur is doing it’s difficult to ensure that the principal and the agent have same motivations. This is particularly important in the entrepreneurial finance context where incentives of the entrepreneurs dictate the structure of organizations and set the limits of its performance potential to a large degree (Arrow, 1974). Furthermore as mentioned in section 2.1.1. the partially conflicting interests of entrepreneur (signaler) and the investor (the receiver) can lead to fraud (false signal) where the entrepreneur benefits at the expense of the investor (Bird & Smith, 2005).
The second problem is the agents’ tendency to make risky decisions since their attitudes towards risk are different from the principals’ (Eisenhardt, 1989). These actions cannot be foreseen and therefore cannot be controlled if they are not monitored. Thus, Hölmstrom (1979) argues that the remedy to the principal-agency problems lies in investing resources to
monitor the actions of the agents and use this information in contracts. Indeed venture capitalists actively get involved in monitoring activities (Klonowski, 2010) such as pre-investment screening, sophisticated contracting, post-pre-investment monitoring and advising (Kaplan & Stromberg, 2011). Furthermore Eisenhardtt (1989) shows that monitoring of actions of the agent is highly crucial especially when an entrepreneur is overfunded relative to the amount he/she asked for. The reason is overfund’s reflection as a decrease in entrepreneur’s incentives to work and as an increase of overly risky business decisions.
2.1.3 Adverse Selection and Market of Lemons
According to Kirmani & Rao (2000), signals can send by two types of entities: good quality firms and bad quality firms. In order to illustrate the dynamics of the signaling game between the two entities authors propose an example. First they assume an environment where these firms know their true quality but the outsiders do not (e.g. investors), so information asymmetries are present. Second, both of these firms have a choice of signaling or not signaling the true quality of the firm. Third, the high quality firm benefits by Payoff A when it signals, and Payoff B when it does not signal whereas low quality firm benefits by Payoff C when it signals and by Payoff D when it does not signal. In this situation it is viable for high quality firm to signal its true quality only if A>B and D>C. In other words, when the high quality firm has enough incentives to signal their true quality and the low quality firm does not. In this state of signaling, which is referred to as separating equilibrium, outsiders receive the opportunity to distinguish between high and low quality firms (Cadsby, Frank, & Maksimovic, 1990). Conversely, when A>B and C>D, namely when both entities benefit from signaling the result is a pooling equilibrium. Here, the cost for dishonest signaling is low and outsiders are not able to detect the difference between the good and the bad quality firms. In an environment where asymmetric information is present between the buyers and the sellers and where buyers are aware that the market consists of both high and low quality products (‘lemons’) but cannot differentiate between the two, the problem of adverse
selection arises (Akerlof, 1970; Nayyar, 1990). Hence, buyers become unwilling to pay high
prices for the good quality products since they don’t know whether the product they are interested in is of high or low quality (Tomboc, 2013). For buyers in this market it’s viable to buy a product only when the price is a measure of the average quality of all products in the market (Kwoka, 2005). While the average price rationalization of the buyers rewards the seller’s with low quality products, it penalizes the high quality product sellers. Unable to receive a fair return for their product, sellers of high quality products will start to exit the market (McDonald & Slawson, 2002). As more high quality sellers exit the market, the average price buyers are willing to pay decreases as well. In the end, all of the high quality
product sellers abandon the market, until the market is deserted to low quality products, namely to ‘lemons’ (Goshen & Parchomovsky, 2006). According to Akerlof (1970) the lemons problem can lead to a complete failure of a market since “it is quite possible to have the bad driving out the not-so-bad driving out the medium driving out the not-so-good driving out the good in such a sequence of events that no market exists at all” (p.490).
Spence (1973) argues that the harm caused by lemons in a market can only be reduced through signaling. According to Busenitz et al. (2005), “the extent that a venture’s financial success is an informational problem, signals provide a mean for outsiders to make judgments and predictions about actions, in this case the future of a venture” (p. 3). For new ventures this points out to the prominence of signaling the financial potential of their ventures to outside investors as much as possible in order to reveal their higher quality and distinguish themselves from low quality ventures (Leland & Pyle, 1977).
2.2 Equity Crowdfunding
Equity crowdfunding refers to “a method of financing whereby an entrepreneur sells equity or equity-like shares in a company to a group of (small) investors through an open call for funding on Internet-based platform” (Ahlers et al., 2012, p. 8). There are two crucial parts in this definition that should be underlined. The first one is the refer to the characteristics of the investors as small. This is due to relatively smaller amounts of investments by equity crowdfunding investors compared to the investments by BAs and VCs (Hemer, 2011). The second one relates to the structure of the offer, which is defined as an open call. The open-call in the context of equity crowdfunding refers to the immutability of the offer (Crowdfunding Industry Report, 2013). In contrast to traditional sources of entrepreneurial financing, the terms of an offer on an equity crowdfunding platform is not open to negotiation or to further evaluation.
2.2.1 Rationale of Equity Crowdfunding 2.2.1.1 Reduced Transaction Costs
Before the Web 2.0 development it was difficult to match entrepreneurs and investors even if funding was available due to the informational inefficiencies (Bradford, 2012). Contacting twenty investors would at least take four months (Barnett, 2013). However the advent of Web 2.0 and interactive platforms on Internet facilitated access to networks of investors (Belleflamme, Lambert, & Schwienbacher, 2013). Through Web 2.0 an entrepreneur has the opportunity to reach literally millions of potential investors with zero marginal costs, all around the world (Stuart & Yadley, 2007). The latter is especially important for the context of entrepreneurial financing since geography has long been a barrier in access to capital
(Agrawal et al., 2014).
For traditional seed stage investors, being located closely to the venture being funded is crucial (Sohl, 2003), as this facilitates the access to information about the venture and then monitoring and mentoring the entrepreneurs (Zook, 2002). Indeed Sorenson and Stuart (2005) demonstrated that “venture capitalists invest in companies 10 miles from their offices at twice the rate of ones situated 100 miles away” (p. 1580). In contrast Agrawal, Catalini, and Goldfarb (2011) reported that in crowdfunding projects more than 86% of the funds come from individuals who are 60 miles away from the creator where average distance between the fundraisers and investors is 3,000 miles. Clearly, equity crowdfunding platforms mitigate the geographical restrictions in access to capital for new ventures. In addition, equity crowdfunding platforms take on the responsibility of handling the contracting and post-investment transactions between the investors and entrepreneurs, hence eliminating one of the most costly parts of a traditional investment procedure both for entrepreneurs and investors (Herman, 2013). Consequently it can be argued that through leveraging Web 2.0 technologies, equity crowdfunding platforms reduce transaction costs and increase the effectiveness of the relationship between the investors and the founders in seed stage financing (Bakos, 1998).
2.2.1.2 Riskiness of Investments
Pecking order theory states that the priority to issue funds is issue cash and internal funds, issue debt and issue equity respectively (Myers, 1984). In the equity crowdfunding context this implies that firms that are raising funds from crowdfunding platforms are the ones with insufficient internal funds, with no option to issue debt and are the ones, which are not funded by BAs or VCs. Therefore equity crowdfunding investors might be investing in projects that are found too risky or poorly presented by traditional investors (Hemer, 2011). Namely, equity crowdfunding provides an opportunity for new ventures to raise seed stage financing, which otherwise might not be the case with other methods.
This creates a new outlet for capital of ardent consumer-investors (Heminway & Hoffman, 2011), where investors are investing in start-up companies with high levels of risk (Dorff, 2013; Belleflamme, Lambert & Schwienbacher, 2013). According to Ahlers et al. (2012), equity crowdfunding is the most risky type of crowdfunding, where the return on investment is highly uncertain. Due to the expectation of monetary returns by the investors, and the riskiness of the investing in these ventures, equity crowdfunding requires a complex legal environment for the protection of small investors (see Appendix 1: Figure 1).
2.2.2 Process of Equity Crowdfunding
Equity crowdfunding process essentially involves three parties: fundraisers, investors and intermediaries (Tomczak & Brem, 2013). First, the term fundraiser, which refers to both entrepreneurs and others, is defined as people who “use crowdfunding to get direct access to the market and to gather financial support from truly interested supporters” (Ordanini et al., 2010, p. 5). In return of the financial support, fundraiser offer equity on their company. Second, the investors; namely the ‘crowd’ is the group of people “who decide to financially support projects, bearing a risk and expecting a certain payoff” (ibid). The investors on equity crowdfunding platforms are categorized as accredited and unaccredited according to their net worth, hence according to their resilience in bearing the loss of their investments when the invested companies fail (FCA, 2015). While each country has its own regulation for this categorization, usually accredited investors who are net worth individuals constitute 3-5% of the country’s population (Osnabrugge & Robinson, 2000). The remainder of the investors is categorized as unaccredited and usually their investments are capped with an upper limit (British Business Bank, 2015).
Finally the intermediaries stand for the crowdfunding platforms and defined as “the matchmakers between promoters and funders” (Burkett, 2011,p. 68). The intermediaries are the online platforms where communication between the fundraisers and investors are facilitated, where legal framework for the transactions is supplied, where to become projects on the platform are selected and where investment documents and funds are transmitted back and forth between the two parties (Bradford, 2012).
Even though the steps in the equity crowdfunding process can show differences depending on the platform, the generic structure of the process can be represented as in Figure 1.
Figure 1: Equity Crowdfunding Process
2.3 Signaling in Equity Crowdfunding Context
According to Ahlers et al. (2012), the concern for information asymmetries between investors and entrepreneurs also holds for equity crowdfunding platforms. Similar to BA and VC financing, entrepreneurs listing projects on equity crowdfunding platforms have a superior knowledge of the true quality of the company compared to the potential investors (Busenitz et al., 2005; Backes-Gellner & Werner, 2007). Therefore like other entrepreneurial finance settings, the uncertainty caused by the information asymmetries characterizes the equity crowdfunding platforms as well (Vismara, 2015). In fact the information asymmetries are even more pronounced in equity crowdfunding platforms compared to traditional forms of early stage financing (Ahlers et al., 2012). This is due to the difficulty of executing crucial pre-investment activities such as information gathering and monitoring as the cost of these measures are highly sensitive to distance (Agrawal et al., 2011). Hence, even though equity crowdfunding facilitates access to early stage capital for new ventures (Agrawal et al., 2014), the increased distance between the investor and the entrepreneur widens the information asymmetry gap between the two parties. Furthermore, the small investors who constitute the majority of the investments on equity crowdfunding platforms usually lack the capability and experience to assess potential investments (Lambert & Schwienbacher, 2010). Consequently “information asymmetry problems common to seed and early-stage financing are exacerbated in equity crowdfunding” (Wilson & Testoni, 2014, p. 9).
“As in every market laden with information asymmetries, the ability to signal quality to potential investors is a critical factor in gaining finance in equity crowdfunding” (Vismara, 2016, p. 5). Similarly, Ahlers et al. (2012) argues that in order to successfully raise money via an equity crowdfunding platform, start-ups need to find ways to clearly signal their value to small investors. Furthermore they draw attention to the results of equity crowdfunding projects in these platforms where some start-ups are able to raise substantial amounts of money while some of the projects are not funded at all. This points to presence of a company quality assessment process by investors, which is realized through evaluation of signals sent by the fundraiser.
In equity crowdfunding model, investors are mainly concerned with extrinsic motivations, namely with the monetary returns (Collins & Pierrakis, 2012). Therefore investors’ evaluation of signals on the current company quality and company prospects is more significant compared to the other types of crowdfunding where motivations to crowdfund are associated mostly with intrinsic ones (Cholakova & Clarysse, 2014). This is why Ahlers et al. (2012) proposes equity crowdfunding model as the most suitable type of crowdfunding that can be assessed through signaling theory. Signaling in equity crowdfunding facilitates the
observation of unobservable qualities of the projects that is thought to co-vary with its underlying but unknown quality so that investors can evaluate the company (Stuart, Hoang, & Hybels, 1999). The observable qualities mentioned here are present on equity crowdfunding platforms in the form of provided company information by the entrepreneurs (Ahlers et al., 2012). Thus the company information on the project page is considered as the signal sent (e.g. most likely exit strategy, valuation of company, financial forecasts, board experience, risk level etc.) to the potential investors on the platform. This positions entrepreneur and potential investor as the signaler and the receiver respectively (Wang, Liang, Ge, & Xue, 2015).
2.3.1 Moral Hazard and Principal Agency Theory in Equity Crowdfunding
Signori & Vismara (2016) argue that “[e]quity crowdfunding markets are less equipped to overcome information asymmetry problems than other entrepreneurial finance settings” (p. 6). Therefore the presence of asymmetric information in the equity crowdfunding markets raises concerns for the problems that are caused by information asymmetries such as moral hazard problems (Agrawal et al., 2014).
According to Tomboc (2013), the information available on the equity crowdfunding platforms at the time of investment is soft information. In other words this information is highly difficult to verify, since the true quality of the company is unobservable to the potential investors whose knowledge of the company is limited to what is provided on the project page. Furthermore, equity crowdfunding platforms do not supply any formal reports by financial analysts or guidance of intermediaries such as IPO underwriters (Vismara, 2015). This raises concerns on signal honesty since credibility of the information provided on these platforms is difficult to assess (Cable, 2010). For instance since a start-up is not expected to generate revenue immediately after investment, they have more flexibility in exaggerating the forecasted returns in order to persuade investors to invest in their projects (Burkett, 2011). In the extreme case, the equity crowdfunding project may even turn out to be a total fraud (Yamagishi, 2009). Therefore “[w]hether an entrepreneur or a project is good or bad constitutes information that is largely hidden from funders”, which points to concerns of moral hazard in equity crowdfunding context (Tomboc, 2013, p. 266). “In short, the entrepreneur holds all the cards. Investors have little information about what is to come” (Bradford, 2012, p. 107). In addition, companies in equity crowdfunding platforms may be unwilling to disclose too much information as these platforms are public and competitors can reach the confidential information they’ve revealed to attract investors (Signori & Vismara, 2016), which strengthens the moral hazard problems between investors and entrepreneur (Tomboc, 2013).
In addition to ex-ante investment problems caused by information asymmetries, equity crowdfunding market is also subject to ex-post problems, which are mainly caused by principal-agency conflicts (Ley & Weaven, 2011; Kortleben & Vollmar, 2012). The reason for the principal-agent conflicts in equity crowdfunding is the difficulty of controlling the use of funding given to the entrepreneur by the crowd (Signori & Vismara, 2016). For instance in the case where entrepreneurs extract value from the business through paying themselves unfairly high salaries and charging personal expenses to the company, investors have very little chance to be informed (Tomboc, 2013). The underlying reason for these conflicts is the lack of tools to control and monitor the post-investment activities of the entrepreneur. In traditional entrepreneurial financing the potential problems that are caused by the principal-agency problems are mitigated through staged financing (Kaplan & Stromberg, 2011), preferred stock alternatives (Klausner & Litvak, 2001), or through protective provisions controlling exit decisions (Gilson, 2003). However equity crowdfunding deals only offer standardized contracts where the above-presented measures are either only vaguely discussed or not discussed at all (Stiernblad & Skoglund, 2013). The absence of these provisions leads to concerns for control difficulties and principal-agency problems (Tysklind, 2013).
The principal-agency and moral hazard problems are difficult to mitigate for the equity crowdfunding context due to the characteristics of the small investors. According to Malmendier & Shanthikumar (2007), small investors 1) invest small amounts of money and 2) receive relatively small ownership from the company in return. In equity crowdfunding context, the high costs of performing detailed due diligence is not compensated since the investments and its returns are very small especially compared to the BA or VC investments (Dorff, 2013). In fact, performing extensive pre-investment screening for each project on a platform degrades the investing experience of the small investors (Al-Tayar, 2011). Regarding this, Pierrakis & Collins (2012) reported that, in loan-based crowdfunding business angels spend on average 20 hours on conducting due diligence while crowdfunding investors dedicated 15 minutes for the same activity. In an environment where incentives to perform due diligence is relatively low, understanding the impact of signals on equity crowdfunding projects becomes more important.
2.3.2 Adverse Selection and Market of Lemons in Equity Crowdfunding
Even in the existence of sufficient and true information on company quality and of incentives of investors to perform due diligence, the capability of small investors to fully comprehend the information on company quality may not be enough (Tomboc, 2013). According to Shwienbacher & Larralde (2010), the investors that equity crowdfunding platforms attract are usually less sophisticated than Bas and VCs, who are highly knowledgeable about evaluating
the start-up value and the team (Freear, Sohl, & Wetzel, 1994). After all, equity crowd funders are not specialists in appraisal of company value (Tomboc, 2013). “In the extreme case, one could argue that potential investors may not have the ability to determine anything concrete about the true quality of a start-up, and consequently even potentially high-performing start-ups may not receive funding” (Ahlers et al., 2012, p. 17).
The inability of investors to differentiate between high and low quality projects would lead to discounts on the average value of the new ventures, which would reflect the value of a
mediocre company in the end (Cable, 2010). According to Tomboc (2013), this situation can
lead to a potential market of lemons problem in equity crowdfunding markets, where high quality start-ups would be reluctant to stay in the market due the unfair evaluations of their companies, eventually deserting the market to the lemons. The severity of the lemons problem in equity crowdfunding may increase since low barriers to list a project on equity crowdfunding platforms can create a market with companies of all kinds of quality4 (Al-Tayar, 2011). This is in line with Leland & Pyle (1977) who points to a market failure when the asymmetric information between parties are highly pronounced and where the market includes a pool of poor projects.
The lack of experience and capability of small investors to evaluate different investment opportunities (Schwienbacher & Larralde, 2010) and the absence of enough incentives to perform due diligence activities (see section 2.31) leads to “classic collective-action problems" (Vismara, 2016, p. 4). In order to reduce their own due diligence duty, potential investors on equity crowdfunding platforms may rely on the due diligence conducted by the previous investors of the projects (Agrawal et al., 2014; Hornuf & Schwienbacher, 2014). In this situation the signal interpretation of individuals shifts from the evaluation of the signals sent by the entrepreneur on company quality to the observation of number of investors invested in a specific project (Zhang & Liu, 2002). Thus, signal attention of the investors reduces, since they rely less on their own knowledge and assessment (Bikhchandani & Sharma, 2000). Observation of backers of a project gives an understanding of other investors’ future expectations from the project, hence provides a rationalization of the project quality and expected returns (Burtch, Ghose, & Wattal, 2013). This creates concerns for a bandwagon effect, where the crowd interprets company quality signals sent by the entrepreneur in a certain manner, which may not be accurate (McNamara, Haleblian, & Dykes, 2008).
4 An example can be the Title III provision of the JOBS Act, which currently only requires the funding portals to do one type of due diligence: background checks (USC, 7d–1).
2.4 Signals in Equity Crowdfunding
According to Mollick (2014), in order to understand the crowd investors’ level of sophistication in opportunity assessment, the small investors’ response to salient company quality signals, which are embraced in traditional early stage investment processes, should be analyzed. In this section, I will develop hypotheses for the impact of company quality signals on project performance in equity crowdfunding platforms. In order to determine the signals and their effects on project performance, I’ll draw from literature on corporate and entrepreneurial finance, and reflect the salient quality signals of these fields on the equity crowdfunding context.
2.4.1 Risk
According to Ahlers et al. (2012) information asymmetries embedded in the nature of the investment processes can be mitigated through signals sent by the entrepreneur on the riskiness of the investment. Through sending signals on the riskiness and uncertainty of an equity crowdfunding project, entrepreneurs can communicate the current value and future prospects of company, hence effect the investment decisions of the investors on the platform.
2.4.1.1 Fraction of Retained Ownership
According to Leland & Pyle (1977) asymmetric information in the investment process can be mitigated or be reduced through evaluation of signals on the investment riskiness. In this respect, these authors present a signaling model, in which the current value of firm is a function of the fraction of ownership retained by the entrepreneur. Authors argue that retaining a high fraction of ownership translates as a high cost for the entrepreneur since this means that entrepreneur ceases the opportunity to diversity his/her portfolio by doing so. Thus, the entrepreneur will only retain a substantial stake if he/she expects that expected future cash flows are going to be high relative to the current value of the firm. For this reason, they suggest the fraction of retained ownership as a signal to assess the potential future value of the company, hence as a signal on the riskiness of an investment.
Downes & Heinkel (1982) found empirical support for the hypothesis offered by Leland & Pyle (1977) in the context of IPOs. Authors reported that firms, in which the fraction of ownership retained by entrepreneurs is high, indeed have higher values as the theory predicts. Similarly, Cornett et al. (2007) found a positive relationship between operating cash flow returns and the institutional ownership. Furthermore Connelly, Hoskisson, Tihanyi & Certo (2010) argue that the high fraction of retained ownership also ensures signal honesty as if low quality firms imitate this strategy they would undergo a decrease in personal wealth when the true value of the firm is revealed. In other words the owners who have higher fraction of ownerships in a company tend to behave less opportunistically (Eisenhardt, 1989;
Himmelberg et al., 1999). Therefore the existence of high fraction of ownership by the founders reduces the moral hazard problems. Moreover, the high fraction of retained ownership signals the intentions of the owners in carrying the company to a higher value, hence diluting the principal-agency problems (Filatotchev & Bishop, 2002; Sanders & Boivie, 2004, Jensen & Meckling, 1976). Therefore in the context of entrepreneurial financing, the choice for high fraction of retained ownership by the entrepreneur can be considered as a signal of the higher value of the new venture in the future (Busenitz et al., 2005; Johnson & Greening, 1999).
Consistent with the corporate and entrepreneurial finance literature, in equity crowdfunding context if growth is expected in the future of a new venture and if it is the primary goal of the entrepreneur, then the entrepreneur is expected to retain a high stake in the control of the venture after the offering is closed (Vismara, 2016). Therefore the unobservable qualities associated with the riskiness of the new ventures can be evaluated through the fraction of entrepreneur’s retained ownership (Leland & Pyle, 1977). This is in line with Ahlers et al. (2012) who proposed a negative relationship between the fraction of offered ownership to investors and the final investment amount in an equity crowdfunding project. Following the same line it’s hypothesized that:
Hypothesis 1. The high fraction of offered equity ownership to investors decreases the performance of projects in equity crowdfunding platforms.
2.4.1.2 Leverage
In addition to the retained ownership fraction, the capital market structure of a company can also signal riskiness of investment (Eldomiaty, Choi, & Cheng, 2005). Capital market structure here refers to a firm’s composition of debt and equity (Myers, 1984). The first attempt to understand the relationship between the capital structure and the market value of a company came from Modigliani & Miller (1966). The authors showed that there is a positive relationship between the value of the firm and the leverage due a tax shield effect. The tax shield effect refers to the tax deductibility of the fixed payments, which is one of the main characteristics of leveraging (Damodaran, 2001). According to Hillier (2011), the tax shield effect operates differently for low and high quality firms. On the one hand low quality firms with low anticipated profits would probably take low levels of debt, since a small interest deduction of debt is enough to offset the tax shield effect. On the other hand, high quality firms, with high expected future profits would leverage greater amounts, as the extra interest can be used to reduce the taxes from its greater earning. Namely, the low and high quality firms are subject to different tax shield effects therefore they obtain different levels of leverage. In this way the leverage level reflects the quality of the firm, hence signals the
market value (Kraus & Litzenberger, 1973; Chen & Kim, 1979; Robichek & Myers, 1966; Baxter, 1967; Brennan & Schwarz, 1978; Chen, 1979).
The second important characteristic of leveraging is the commitment made to make fixed payments where a failure to actualize this commitment can lead to either default or loss of control of the firm to the party whom payments are due (Damodaran, 2001). Therefore using debt to finance a firm conveys the confidence in company’s future prospects to the market (Ross, 1977; John, 1987; Noe, 1988; Nachman & Noe, 1994; Harris & Raviv, 1990; Heinkel & Zechner, 1990; Myers, 1977). According to Kim & Pukthuanthong-Le (2008) “where insiders are optimistic about the future of the firm but outsiders do not share the same optimism, they will use a great deal of debt to send signal to market that their firm is of superior quality” (p. 108). Indeed Boness, Chen & Jatusipitak (1974) and Masulis (1980) demonstrated that both stock prices and firm values are positively related to positive changes in leverage. In addition Kim & Pukthuanthong-Le (2008) argue that, managers/owners in leveraged firms have less control over the cash flows of the firm due to the constrained budgets. This reduces the potential of managers/owners to make risky business decisions, therefore reducing the problems associated with principal-agency conflicts between insiders and outsiders (Eldomiaty et al., 2005).
As presented above, the corporate finance literature positions debt as a positive influencer of firm value due to its tax deductibility and due to its sanctioning role when the interest is not returned. In these two ways, debt is associated with firm value in a positive way. Driving from the above discussion we expect to find a similar relationship between debt and performance of equity crowdfunding projects. Therefore I hypothesize that:
Hypothesis 2. The amount of leverage level of a firm increases the performance of projects in equity crowdfunding platforms.
2.4.1.3 Commitment
According to Harrison, Dibben & Mason (1997), in the assessment of the perceived risk associated with a new venture, the investor’s trust in the entrepreneur plays a significant role. Authors argue that the signals on the venture riskiness and on the trust for the entrepreneur are perceived in a closely intertwined manner by the investor. This is coherent with studies conducted on the selection criteria of business angels where trustworthiness is ranked in the top three out of 25 different criteria. (Osnabrugge & Robinson, 2000; Sudek, 2006). According to Prasad et al., (2000), one of the most effective signals that can create trust in the investor is the signal of commitment. Similarly Barney, Busenitz, Fiet & Moesel (1989) argues that, the high risk embedded in the nature of new ventures, results in investor’s desire
to see a signal of commitment to the venture by the entrepreneur. The absence of a commitment signal creates a concern for the investor that the new venture lacks appropriate control and monitoring by the entrepreneur, which leads to a belief in the greater possibility of financial loss and of principal-agency conflicts (Prasad et al., 2000).
According to Bolumolea et al. (2014), the most powerful commitment signal is the equity investment made in the new venture by the firm founders. Through a study on 745 companies, which were seeking investment for their new product development, authors demonstrated that the level of equity investment by the founding team is proved to be a strong and positive commitment signal, which helps new ventures in attracting financial capital. Similarly Hoskisson, Shi, Yi & Jin (2013) argue that when founders invest their own money in the new venture, investors’ the perception on the entrepreneur’s dedication to the firm changes in a positive way, which in return decreases the risks associated with the management of the firm in the future. Furthermore Wasserman (2012) suggests that entrepreneurs investing a lot of time and money to their ventures become emotionally attached to them. This attachment intensifies the commitment of the entrepreneur to the firm hence increases trust for the entrepreneurs by the outsiders. Indeed according to Prasad et al. (2000), the information on the equity investment of founders should be strongly advertised by the entrepreneur in the business plan.
The monetary contribution of the entrepreneur and/or the founding team to a company is a crucial signal of commitment for BAs and VCs (Busenitz et al., 2005). Ahlers et al. (2012) argues that, similar to its interpretation by traditional investors, the equity investment by the founding team can act as a signal of commitment for the crowd on the equity crowdfunding platforms as well. In line with their proposition I propose the following hypothesis:
Hypothesis 3. The amount of equity investment made in the new venture by the founding team and/or the entrepreneur has a positive impact on the performance of projects in equity crowdfunding platforms.
2.4.2 Disclosure and Market Regulations 2.4.2.1 Disclosure Information
A common proposed solution to problems arising from information asymmetries is financial signaling of the firm value. When information asymmetries are to be reduced, the insider takes an observable action such as issuing debt or equity, or payment of dividend in order to give materials for the outsider to infer company quality. Since signaling is costly and the marginal cost of false signaling outweighs its benefits these signals can be considered as
credible (Spence, 1973). Communication by direct disclosure5 (e.g. accounting reports, business plans) however is usually ignored from the discussion of signaling as moral hazard problems vitiate the quality of such signals. (Bhattacharya, 1979). However according to Hughes (1986), in the presence of a third party that verifies disclosure information, entrepreneur of the risky firm can effectively use disclosure as a direct statement about the company value. The author argues that in this context disclosure can be acknowledged as a credible signal since the dishonest information on company quality is subject to being penalized by the third party.
In the presence of credible disclosure, the unobservable characteristics of a new venture can be revealed through disclosure information (Ross, 1978). For instance, disclosure of the past cash flows of a company can reveal its ability to generate cash flows in the future. According to Michael (2009), if the insiders have high quality products and act rationally they would disclose this information to the outsiders. This is due to the low costs of signaling this information for the high quality sellers, whereas signaling the same information is more costly for low quality ones (Lee et al., 2005). Thus, outsiders will perceive the products/ventures of sellers/entrepreneurs who avoided the disclosure information as low quality (Grossman, 1981; Milgrom, 1981; Amit, Glosten, Muller, 1990). Furthermore, Hemer (2011) argues that disclosure information is a time consuming and costly procedure, prohibiting many businesses to follow this path unless revealing this information does not outweigh its costs.
As equity crowdfunding platforms perform due diligence activities on the financial disclosure (e.g. financial forecasts, business plan etc.) provided by the entrepreneur (e.g. Seedrs, Crowdcube), the disclosure information may be considered as a credible signal of the company value (Hughes, 1986). Therefore if the projects on equity crowdfunding platforms are of high quality, they don’t avoid from revealing their financial disclosure. As disclosing financials is only an action high quality firms would take, projects with financial documents are expected to perform better compared to the ones without. Hence I hypothesize that:
Hypothesis 4. The existence of disclosure information on a project page has a positive impact on the performance of projects in equity crowdfunding platforms.
5 Disclosure here refers to financial reports, including the financial statements, footnotes, management discussion and analysis, and other regulatory filings (Palepu & Healy, 2001)
2.4.2.2 Market Regulations
The significance of the role of these platforms as credibility checks is increasing with changing regulations of the equity crowdfunding markets. Being a relatively deregulated market until now (Bruegel Policy Contirbution, 2014), new rules and regulations are being introduced to the market (Griffin, 2013). The main aim of these regulations is to create a transparent market for equity crowdfunding, where investors are able to separate good investments from the lemons (Martin, 2012). As a result of the new rules imposed in the market, an increasing number of equity crowdfunding platforms encourage entrepreneurs of projects to provide disclosure information (Loss, 2004). Thus, where entrepreneurs are encouraged to provide financial disclosure, the absence of this information in the project pages points to a strengthened signal of low company quality, as an entrepreneur would not avoid presenting this information, especially after being asked to do so, if the firm is of high quality (Amit et al., 1990). Therefore it can be argued that, the signal cost of financial disclosure increases for low quality projects due to the new regulations imposed on the market, which leads to a separating equilibrium (Cadsby et al., 1990). Consequently, conformation or non-conformation of the entrepreneur to the encouragement of regulations facilitates investor’s separation of good projects from the lemons, where projects without financial disclosure is considered to be lemons and penalized. Following this reasoning I suggest the following hypothesis:
Hypothesis 5. The rules and regulations towards transparency on equity crowdfunding market, moderate the relationship between the supply of disclosure information and project success.
2.5 Conceptual Model
In the above sections the role of signaling theory on the dynamics of equity crowdfunding investments is discussed. Regarding this, five signals that communicate company value to potential investors are identified. The first one is the signal of risk level. This signal is introduced in three sub-sections, which are offered equity fraction to investors, leverage level and commitment of an entrepreneur to his/her venture. Second, the very act of presenting disclosure information is introduced as a positive signal on company quality, which affects project performance positively. Finally, it is hypothesized that the influence of this signal on project performance is moderated by the changing rules and regulations in the equity crowdfunding market. The Figure 2 illustrates how the project performance on equity crowdfunding platforms is influenced by the signals sent by the entrepreneurs on project pages.
