In a recent paper, we focus on the expected agency problems in equity crowdfunding markets and the governance mechanisms that might mitigate them.

In equity crowdfunding, there are two pronounced problems that result from significant information asymmetry associated with small firms and their investors. The first involves adverse selection, which posits that the pool of firms seeking to raise capital in equity crowdfunding may not have as high expected (risk-adjusted) returns as does the pool of firms trying to raise capital outside of equity crowdfunding. In the absence of prospectus requirements, it is very hard for a large number of dispersed and diverse prospective investors to mitigate information asymmetry through equity crowdfunding. Venture capital investors, by contrast, are specialized investors that make large investments in small firms (normally over $1 million per investment round per firm), which makes the time and costs associated with due diligence worthwhile. Equity crowdfunding investors normally each invest well under $50,000, and total capital raises is typically less than $500,000. Equity crowdfunding markets are also subject to information cascades whereby investment decisions are made based on investment decisions of other investors. The second type of problem that arises from severe information asymmetry in equity crowdfunding markets is moral hazard. Moral hazard can take the form of self-dealing, for example, where entrepreneurs use money raised in equity crowdfunding in ways that benefit the entrepreneurial management team at the expense of the crowdfunders.

There are a variety of governance mechanisms that may curtail these adverse selection and moral hazard problems. First, it is often said that the wisdom of the crowd is helpful in detecting problems. For example, in the famous Kobe beef beef-jerky Kickstarter fraud (i.e., reward-based crowdfunding), it was a prospective crowdfunder who noticed that the claimed sale of Kobe beef beef-jerky exceeded the available supply of Kobe beef, and hence there could not be Kobe beef in the beef jerky produced by the entrepreneur. Thus, the crowdfunding community is able to detect fraud cases, and online marketplaces facilitate such detection. Research has noted that fraudsters in crowdfunding markets are most often  individuals who do not maintain an identity on social media (Facebook, Twitter, LinkedIn, etc.). However, to date, we lack evidence of whether equity crowd-investors are good at detecting fraud and, probably even more important, whether they can also identify business ideas with real potential to generate value.

Second, entrepreneurs can signal their ability to mitigate expected adverse selection and moral hazard problems. Higher quality entrepreneurs that take costly actions that are not easily replicated by lower quality entrepreneurs can convey their superior expected performance. Research has shown that signaling, including the formation of a skilled board of directors with advanced degrees, is effective in predicting successful equity crowdfunding capital-raising.

Third, platforms can mitigate adverse selection problems by carrying out more intensive due diligence. Research has shown that platforms that engage in site visits and background checks, among other things, have entrepreneurs that are more likely to have more success raising capital.

In our paper, we further explain that there are different shareholder structures offered through equity crowdfunding platforms that have different governance implications. These structures include the “direct model” (e.g., favored by the Crowdcube platform), the “nominee model” (e.g., used by the Seedrs platform), and the “co-investment model” (e.g., used by the SyndicateRoom platform).

In the direct model, equity crowdfunders become direct shareholders in the entrepreneurial firm. The advantage of this structure is that it fosters a sense of belonging and direct monitoring by the crowd. The disadvantage is that the ownership percentages are normally very small for any single investor, and typically amount collectively to less than 20 percent of the total equity of the equity crowdfunded company.

In the nominee model, equity crowdfunders invest in a special purpose vehicle and are not direct shareholders in the equity crowdfunded firm. The advantage of the nominee model is that it enhances coordination and incentives to monitor the entrepreneurial firm. The disadvantage is that it may be difficult for the nominee to represent the diverse and potentially inconsistent goals of the crowdfunders. Moreover, this structure can limit the extent to which a crowdinvestor feels connected to the project and lead the crowdinvestor to pay less attention to the entrepreneurial firm.

In the co-investment model, the equity crowdfunding investors invest alongside a professional investor, such as a business angel or venture capitalist. The advantage of this structure is that the professional investor normally has significant experience and thereby provides extensive due diligence prior to investing  and monitoring after  investing. The disadvantage is that there are potential conflicts of interest between individual crowdfunding investors and the professional investor.

Our paper also reviews other related issues in equity crowdfunding and suggests avenues for future research. For instance, given the opportunities and threats provided by equity crowdfunding markets, it is surprising that we have limited evidence of how some of the corporate governance mechanisms discussed above may affect the post-campaign performance of equity crowdfunded firms.

This post comes to us from Douglas J. Cumming, a professor at Florida Atlantic University; Tom R. Vanacker, a professor at the University of Exeter and associate professor at Ghent University; and Shaker A. Zahra, a professor at the University of Minnesota’s Carlson School of Management. It is based on their recent paper, “Equity Crowdfunding and Governance: Toward an Integrative Model and Research Agenda,” available here.