While equity crowdfunding is often associated with ordinary investors who either invest purely for diversification (casual investors) or for pro-social factors (crowd investors), limited research has been conducted concerning the sharks in the pool: sophisticated investors with sizable checks and relatively more experience. A recent workpaper by researchers at the Universities of Jena and Bremen in Germany sheds light on these investors with respect to the country’s Small Investor Protection Act (SIPA), which instituted standards similar to the United States’ accreditation policy.
The paper analyzes SIPA through two tests. The first area of inquiry concerns the actual impact of the new policy on investing activity, ultimately concluding that the requirement that one sets up a corporate entity for investments over 10,000 EUR led to a decline in large investments and a loss of sophisticated investors. This piece will focus on the second test, which concerns the signaling power of sophisticated investors.
In Daniel Kahneman’s seminal work on attention, he notes that attention is a limited resource and often relies on proxies – when provided with incomplete information, we are inclined to look for and trust signals in order to minimize effort. Within the realm of investing, Kahneman acolyte Nassim Nicholas Taleb posited in his book Skin in the Game that the actions of large investors serve as signals for smaller investors, which research by Hornuf and Schweibacher (2018) has since confirmed. Casual and crowd investors assume that, because these sophisticated investors have more skin in the game, they have more reason to conduct thorough diligence on a given opportunity.
Using data from Companisto and Green Rocket, two of the largest crowdfunding sites in Germany, Goethner et al. looked to see if sophisticated investors leaving the market following SIPA would result in other investors “no longer [basing] their investment decisions on these signals.” In confirming this hypothesis, they note that it is due to a loss of sophisticated investors, but not necessarily a loss of signaling. Perhaps more interestingly, they note that, prior to SIPA, large investments (10K+ EUR) were positively and significantly correlated with more subsequent funding, while medium investments (1-10K EUR) were negatively correlated with subsequent funding.
There are a couple interesting observations here worth consideration for both investors and investment platforms. Chief among them is the outsized impact of large investors, who, despite accounting for only 0.4% of all investments, significantly influenced the financing activity of all other classes of investors. In the face of supposed democratization of opportunity, many decisions are dependent on a select cadre of investors.
Additionally, the paper indicates that sophisticated investors prefer higher-tier offerings, such as Companisto’s club deals, that exclude or limit regular investors. Given the abundance of similar offerings on accredited-only platforms in the U.S. – examples being AngelList, OurCrowd, and Agfunder – certain non-accredited equity crowdfunding sites may be lacking key vehicles for driving investing activity.
Bifurcated offerings within a single platform fail to bridge this gap. It may be the case, then, that a top-down growth model like AngelList’s spin-out of Republic –starting with accredited investors then pivoting to Reg CF or applying the Reg CF model on a new site – trumps the bottom-up accumulation of small investors in order to attract larger ones down the road.
Protecting Investors in Equity Crowdfunding: An Empirical Analysis of the Small Investor Protection Act
Market Mechanisms and Funding Dynamics in Equity Crowdfunding