1. Home
  2. Equity crowdfunding: Seeing through the hard sell

Equity crowdfunding: Seeing through the hard sell

A controversial form of crowdfunding takes the platform to a new level – but shrewd investors are seeing through the hype

Crowdfunding has transformed the way entrepreneurs raise capital and the way investors get involved in start-up businesses.

Over 12 million backers have flocked to support projects on Kickstarter, a popular crowdfunding website, pledging over $US2 billion in funding for over 100,000 projects, ranging from the Pebble Smartwatch to the movie Veronica Mars.

Platforms like these provide a form of reward crowdfunding, where project owners pre-sell their products to early customers.

Crowdfunding is becoming big business but the lack of regulation creates higher risks. Credit: Shutterstock

But crowdfunding is now big business. And it now extends to investment-based activities including equity offerings and peer-to-peer lending.

Among alternative crowdfunding models, equity crowdfunding, or ECF, is the most controversial.

In the ECF market, firms promote their equity offerings to potential investors via the Internet and receive cash when someone decides to invest.

Due to lower costs of complying with regulations related to more formal company listings via traditional stock markets, ECF has gained popularity among early stage firms. Many crowdfunded firms have moved up the ‘funding escalator’ and are succeeding in the business arena.

Preshafood, for example, raised millions of dollars through the Australian Small Scale Offerings Board (ASSOB), which is an equity crowdfunding platform in Australia that is one of the largest in the world. Today its bestselling products, Preshafruit juices, are available nationwide at major supermarkets.

However, holding stakes in these emerging unlisted companies comes with risk.

Not only are investments in these firms significantly less liquid, according to the Australian Bureau of Statistics, younger firms typically have low survival rates, putting investments at additional risk. The U.K. Financial Conduct Authority have gone so far as to warn investors: “it is very likely you will lose all your money.”

Although pressure to allow ECF has increased over the past few years, it is available in only a few countries.

Australia is at the forefront of the ECF movement, where it has been available to all investors since the launch of ASSOB in 2006.

As part of the plan for Advancing Australia as a Digital Economy, the Australian government continues promoting the environment for crowdfunding. The latest development is the Corporations Amendment (crowd-sourced funding) Bill 2016 which is currently under consideration and expected to ease certain requirements for small firms.

Unlike in traditional equity markets, in the crowdfunding setting regulators attempt to balance investor protection against easing disclosure requirements and compliance costs for these young firms.

Since managers of firms have more discretion to shape their disclosure in the ECF market, they may use biased language to boost their potential prospects.

Academic researchers in accounting and finance have provided important insights about how investors in other markets react to the use of positive or negative words. This research indicates that investors react positively to use of optimistic tones by firms.

However, if investors understand that the less-regulated environment permits such strategic disclosure, they interpret and react to the use of biased language in disclosure differently than in the other more regulated markets.

My research, the first such empirical evidence, found that ECF investors react negatively to the use of positive words like ‘achieve’, ‘progress’, ‘spectacular’, and ‘successful’, in offer documents.

Investors’ responses also differs across investor types. Although retail and sophisticated investors see through the use of different tones, the negative response appears to be stronger for sophisticated investors. Use of biased language in offer documents is also associated with poor future outcomes.

ECF continues to gain traction as an alternative or complementary means of financing. In the less-regulated ECF environment, managers enjoy more freedom in shaping their disclosure to attract potential investors.

Managers appear to use their disclosure opportunistically to bias the potential prospects of their firms. But strategies like these, don’t seem to work out well, as sophisticated investors see through the language and discount it.

Banner image: Shutterstock/SFC

Recommended for you