“For many, yields are a welcome bonus”
Private investors can now finance start-up firms via online platforms. LMU economist Lars Hornuf discusses crowd investing, a subclass of crowdfunding specifically for start-up firms, which has rapidly established itself in Germany.
How widespread is crowd investing in Germany?
Hornuf: There is quite of lot of hype, but it started in 2011, and there are now 14 active internet portals that facilitate crowdfunding of fledgling business ventures. In the meantime, more than 150 start-ups have been financed by this route. A total of 60,000 investments have been made, but the number of investors involved is smaller than that, as any single investor can hold shares in different companies. In all, 31 million euros has gone to new firms via this channel. The number of flotations peaked in 2013 and 2014. The market is still growing but growth rates are falling off.
You are building a database on crowd investing. What do you hope to learn?
Our dataset is uniquely comprehensive, and contains details of all issues that have ever been launched on equity crowdfunding sites in Germany, including all funding contracts. These data enable us to observe and scientifically investigate the development of a new type of capital market from its earliest beginnings. There is no precedent for this, because we lack the systematic data that could tell us, for example, how capital markets actually developed in the US in the 18th century. We can, among other things, study how the drafting of contracts changes, we can measure the survival rates of the firms financed by crowd investing, and determine which of them succeed in the long term. We can also analyze the distribution of the capital sums made available by investors, and ascertain whether these investors tend to focus on local businesses.
What sorts of people make capital investments via crowd investing sites?
No two crowds are alike. Different portals attract different investors. On the Innovestment site, the minimal investment accepted is 1000 euros. Many investors who use this site are familiar with the IT and financial industries; most of them have already invested money on conventional exchanges, and one-third of them claim to have engaged in speculation on the commodities market. On the Companisto portal, in contrast, investors can buy a share in a company for as little as 5 euros. Conditions like that, of course, appeal to a very different crowd. Some investors here admit to using the site as an occasional alternative to buying a lottery ticket. It is certainly not the case that those who participate in crowd investing constitute a clearly definable group of people who reject the traditional mode of financing via merchant banks. They are in no way comparable to, say, the Occupy movement.
And what sorts of companies obtain their capital via crowd investing sites?
Most of them are no more than 2 years old and require capital funding for the initial start-up phase, to get the venture off the ground. But they don’t conform to any specific pattern. The spectrum extends from a flower delivery service that offers a flat rate to a helicopter manufacturer. The business plans are extremely diverse. As a rule, these are enterprises that are too risky for the banks and too small to have any hope of attracting the attention of institutional providers of risk capital or commercial venture capital funds.
How do you rate the chances of hitting on another Facebook?
Crowd investing is very transparent. Anyone can access any company’s business idea and, in some cases, the ideas may be easy to copy. This prompts one to ask what sorts of firms would be willing to take that kind of risk? Are their ideas intrinsically difficult to copy, or just not very innovative and therefore unlikely to be copied? Have the most promising young firms already been identified by state-sponsored innovation programs and large investors, so that those who turn to CI portals are by definition those who have no other access to capital? Studies suggest that business models that have been rejected by investment companies but serendipitously manage to tap other sources of capital - an unexpected legacy, for example – tend to be less successful in the long term than firms that secure funding from venture capital companies. Such companies have a good record in picking out potential winners among start-ups. Whether that holds for crowdfunders remains to be seen.
Crowd investing as such is not subject to any specific form of regulation in Germany at the moment. Do you think such regulation is necessary?
Only systematic market failure would justify such a move. A draft text for a Small Investor Protection Act has been proposed, which could provide legal certainty and mandate transparency. But regulatory measures must be applied in a rational manner. Crowd investing makes use of different types of securities, and the draft text proposes that different funding limits should apply to some of them. That could lead to firms being forced to issue a security that complies with the law but is not necessarily the most appropriate for the particular situation. We will have to wait for the results of our empirical research before we can really answer your question. For even when investors end up losing money, they may have profited in other ways.
What kind of incentive other than the expectation of a positive return could motivate people to invest?
The desire to contribute to the growth of the national economy, for instance. Investment in a start-up can lead to the creation of new jobs. There are lots of reasons why investors participate in CI. Many do so because they find a firm’s business concept convincing, and the yield on the investment is a just a welcome bonus. Many admire the enterprise shown by those who start their own companies, and would like to do the same but are deterred by the risks and the uncertainty involved. Crowd investing enables them, as shareholders, to vicariously realize their dream without having the risk the whole farm. People who are only interested in the financial returns might be better advised to try a different form of investment product.
How high are the returns from crowd investing?
There will always be start-ups that fall by the wayside, because the founders were poor managers or because the idea could not be realized as planned. Whether it is actually possible with an ideally diversified portfolio to earn a high enough return from CI to compensate for such failures will only become clear in three or four years. It is quite possible that other financial products offer a higher return for the same level of risk. With derivatives, for example, the credit risk may be comparable, but they sometimes have far greater potential to generate rising returns because few start-ups offer the same scalability.
Are there any instance of bankruptcy among companies that were dependent on financing via crowd investing?
There have been several instances of insolvency, and in some cases their applications to open insolvency proceedings were rejected owing to lack of assets. One firm actually went bankrupt during the capital acquisition phase. There will definitely be further bankruptcies in CI markets. Investors will then become more cautious and put up less money.
How can the investor dispose of his shares if he feels the situation warrants it?
CI investors can trade their shares only on the Bergfürst portal, because it is share-based. On all other German portals, investors buy rights to a share in the firm’s profits, in the form of dormant equity shares, participatory certificates or profit-participating loans with maturities of 3 to 7 years. These are loans that cannot be recovered before they mature. In other words, there is no liquidity in these markets. At the end of the agreed period, investors may receive a share in the firm’s profits. But very few start-ups will be making a profit at that stage – for tax reasons, among other things. Alternatively, investors may purchase a claim to a share in the firm’s turnover. Whether or not that claim can be honored will then depend on the size of the turnover and the liquidity of the company. There are as yet no data that allow us to assess how this will work out. In the most favorable scenario, the firm will have been bought by a venture capital fund and investors can look forward to a share in the profits realized upon its disposal.
Interview: Nicola Holzapfel
Junior Professor Dr. Lars Hornuf is currently engaged on a DFG-funded project devoted to crowd investing. The project was initiated in collaboration with Prof. Dr. Lars Klöhn, Chair of Civil and Commercial Law at LMU, where Hornuf previously worked. In November 2014, he became a Junior Professor in Law and Economics at the Economics Department at the University of Trier