Equity Crowdfunding and Governance Cumming Johan 2019 Chapter

Equity Crowdfunding and Governance • Cumming & Johan (2019, Chapter 9) Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights

Equity Crowdfunding Governance Valuation Ownership Success Cases / Failed Cases Summary Governance in Equity Crowdfunding (ECF) • Governance is an important topic for ECF, since there is scant “voice” or “exit” as with publicly traded firms – No analysts for ECF firms, unlike publicly listed companies on exchanges – Minimal liquidity of ECF firms, unlike publicly listed companies, which limits capital market disipline • Governance is an important topic for ECF relative to venture capital – venture capital investees and are subject to due diligence, extensive contracts, and monitoring – ECF firms, however, raise funding from small so-called ‘amateur’ investors that may lack the knowledge, incentives, and power to conduct a due diligence, write extensive contracts and monitor entrepreneurs • Possibly adverse selection problems with ECF (Chapter 2) 2 Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights

Equity Crowdfunding Platforms Governance Mechanisms in ECF Institutional Governance Mechanisms Shareholder Structures Issues Governance Mechanisms in ECG • Governance mechanisms in ECF come possibly from – Investors – Entrepreneurs – Platforms 3 Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights

GOVERNANCE MECHANISM: Crowdinvestors Wisdom of the Crowd Entrepreneurs Signaling ADVERSE SELECTION MORAL HAZARD ++ When markets are wise, this mechanism might be very effective in reducing adverse selection problems. 0 The wisdom of crowds mechanism may reveal moral hazard issues. However, the diversity in backgrounds, goals and time horizons of equity crowdinvestors may provide more discretion to entrepreneurs, thereby fostering moral hazard problems. Ultimately, other governance mechanisms will be required to control moral hazard issues. + 0 to + Entrepreneurial signaling may decrease adverse selection Signaling is unlikely to be effective to reduce moral hazard; and minimize the need formal regulations that increase unless it is combined with other governance mechanisms, information availability. such as active secondary markets or strong investor protection laws. Platforms Due diligence Shareholder structure Secondary markets + If the wisdom of crowds mechanism functions, probably most important to reduce fraud cases and assure that information provided on platform represents the facts. 0 to + Both direct and nominee shareholder structures do not directly address adverse selection issues. In the coinvestment structure, however, crowdinvestors may benefit from the due diligence efforts of others. 0 Should be ineffective. 0 to + The direct shareholder structure might be more problematic in dealing with moral hazard problems but the nominee structure and co-investment structure might be more effective because of shareholder concentration. + May be effective through creating a form of market discipline. Notes. ++ = potentially very effective, + = potentially somewhat effective, and 0 = likely ineffective. 4 0 Should be ineffective. Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights

Equity Crowdfunding Platforms Governance Mechanisms in ECF Institutional Governance Mechanisms Shareholder Structures Issues Governance in Equity Crowdfunding (ECF) • Governance mechanisms in ECF may also come possibly from – Institutional conditions • Formal (legal) • Informal (culture) – Recall Chapter 3 5 Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights

GOVERNANCE MECHANISM: ADVERSE SELECTION MORAL HAZARD + + to ++ Country Institutions Formal Laws that increase information availability may be Strong investor protection laws may be important but can also be problematic as they to curtail self-dealing and other moral hazard raise the cost of firms that search for equity problems. The effectiveness of these laws may crowdfunding. dependent on how elaborate shareholder agreements are between crowdinvestors and the ECF firm. + + Informal institutions such as country-level trust may be efficient to reduce both adverse selection and moral hazard problems. Informal and formal institutions may have complementary or substitutive effects. Notes. ++ = potentially very effective, + = potentially somewhat effective, and 0 = likely ineffective. 6 Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights

Equity Crowdfunding Platforms Governance Mechanisms in ECF Institutional Governance Mechanisms Shareholder Structures Issues Shareholder Structures in Equity Crowdfunding • Different platforms offer different shareholder structures that can improve governance – Direct Model – Nominee Model – Co-Investment Model 7 Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights

Direct model Nominee model Co-investment model Definition: Equity crowdinvestors become Equity crowdinvestors invest in a direct shareholders in the ECF 'Special Purpose Vehicle' and firm thus are not direct shareholders in the ECF firm. A 'nominee' manages the shares of all equity crowdinvestors. Advantages: Fosters a sense of belonging by Limits coordination problems Detailed due diligence and the crowd. between crowdinvestors. monitoring by the professional Increases the power and investor. incentives to monitor entrepreneurs. Disadvantages: Limited power and incentives for individual crowdinvestors to monitor and influence entrepreneurs. May hamper the sense of Potential principal-principal belonging by crowdinvestors. problems between the crowd and Potential differences in goals professional investors between the nominee and the crowd may create new agency issues. Example: Crowdcube Seedrs 8 Cumming & Johan (2019) The equity crowdfunding platform requires that next to a commitment by the crowd, a professional investor (venture capitalist or business angel) also commits funding. Syndicate. Room Crowdfunding: Fundamental Cases, Facts, & Insights

Equity Crowdfunding Platforms Governance Mechanisms in ECF Institutional Governance Mechanisms Shareholder Structures Issues • What governance model works best in equity crowdfunding? • Recall Chapter 2: Agency problems mitigated, not eliminated • Role for government intervention? • Role for legal standards? • Need for empirical evidence? 9 Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights

Equity Crowdfunding Platforms Governance Mechanisms in ECF Institutional Governance Mechanisms Shareholder Structures Issues • Governance is important for not only the equity crowdfunders, but also for the growth of the entrepreneurial firm • Which governance model best facilitates the transition to the next set of investors? – Direct? – Nominee? – Co-investment? 10 Cumming & Johan (2019) Crowdfunding: Fundamental Cases, Facts, & Insights