Recently, two London School of Economics professors published this fascinating paper on equity crowdfunding. Some industry players were quick to suggest that it provided proof that all investors make informed decisions based on objective investment criteria. I take issue with those interpretations.
Examining a few years of data from leading platform Crowdcube, Professors Saul Estrin and Susanna Khavul of the London School of Economics have published an interesting paper exploring what motivates investment into a crowdfunding campaign. A spokesperson at Crowdcube has inferred a conclusion from this study which confuses herd-like behaviour, with stampede behaviour. The study seems not to have been seeking evidence of a stampede (explosive, unstable behaviour) – but that’s not to say it doesn’t exist. Simply, the study seems to have examined average behaviour over the life of a campaign, rather than isolating behaviour right at the end of a campaign.
For anyone who has followed a lot of campaigns, anecdotal evidence is likely to confirm that the rate at which funding is committed to a campaign accelerates towards the end – a statistical examination of this would be an interesting topic for further research, as would a study of the behaviour of one pitch in particular this week, which was so popular that investor behaviour crashed the crowdfunding platform. At first sight this would appear to be either a mis-pricing of the deal – or, a stampede.
The study notes that a five-year average of only 31% of pitches actually get funded, so we suspect that the more commonly observed last-minute rush reflect investors switching their funds out of deals that risk missing their targets, and into deals that appear to be on a trajectory to close successfully. In doing so, we suggest (but would welcome research evidence) that investors are giving more consideration to other investors’ behaviour, rather than an objective examination of underlying merits of the investment proposition.
Herd behaviour is when the actions of one party cause others to follow suit. Estrin and Khavul are clear on this point: they have found that it is the investment of £1 (not other information) that causes 51p to be invested almost immediately, and 76p in the days that follow. To put it another way, every four investors who come along and invest a pound each for the “right” reasons cause three investors to come along and invest a pound each for no reason other than seeing others do it.
Before even beginning to consider whether the first four investors were really doing so for the “right” reasons (“friends and family” investors, for example, who are much less driven by objective investment criteria), this finding can’t be good.
This creates a problem for both public policy and for an individual’s return on investments made. Here’s why, in an example/analogy that we’re all familiar with.
We’ve all walked past side-by-side restaurants, one busy and the other empty. So let’s imagine how this could come about. Luigi and Dave both open their new restaurants on the same day. Luigi is a master Pizza chef, and he’s inside toiling away at the wood-fired stove. Dave’s more of a chancer: he picked up a batch of frozen pizza bases at the cash-and-carry. Their costs are the same and the prices displayed on their menus outside (let’s call this the valuation), are identical too. But Luigi’s home-made pizzas are much more delicious (let’s call this the quality of the business or investment).
They both hang out their “open” sign at 6pm. Just then, a family of four stroll by. Dave, not working at his pizza oven, smoothly ushers them in. (Alternatively, he could have pre-arranged some friends to come along and make the place look busy – let’s call that the “friends and family” round). At 6.01, while Dave is seating his customers, a couple walk past and quickly opt for Dave’s restaurant, rather than Luigi’s empty one. At 6.05, a sole diner makes the same choice. So the scores now are Luigi 0, Dave 7.
At 6:10pm, Dave spots a group of six outside and doesn’t leave it to chance – he’s outside promptly, for another quick stint of marketing/promotion. Estrin and Khavul’s multiplier effect kicks in again, and in comes a party of three then a party of two: Luigi 0, Dave 15. And so it continues until closing time, with a new stint of promotion from time to time plus a multiplier effect, leaving Luigi and his business to fail while Dave’s inferior offering at the same price point results in him filling all the covers that evening (let’s call this the funding target).
The problem is, none of the diners liked Dave’s frozen pizzas (let’s call this, zero return on their investment) and won’t go back. Dave goes bust, and any investment subsidy he received (like SEIS) becomes a cost to the public purse. Too many such instances, and the public purse-holder decides that subsidising such businesses is bad policy, and withdraws the subsidy; and meanwhile Luigi (whose superior pizzas would have underpinned a great business) never gets off the ground – another public policy failure.
Crowdcube believes that the LSE study shows that investors are “smart”. It does indeed seem like smart behaviour, to try to reach a good decision in the shortest possible time. We are all time-poor so the temptation is strong to use proxy information such as “this restaurant is popular so it must be good”. But danger lurks when we use proxy information to short-cut our own enquiries, because we are making the assumption that somebody else has looked into the matter in detail before us. In the words of Benjamin Franklin: When everyone is thinking alike, no one is thinking. In our example, all parties lose out – investors, tax payers, and the businesses that should have got funded if assessed properly and objectively, but didn’t.
Equity crowdfunding is not just a great innovation, whose broad adoption is attributable to the great work of the leading platforms; it is also arguably on track to become the standard means by which capital formation takes place for early-stage businesses – the new AIM, if you will. But its mechanics are still open to improvement, particularly in the area of communication, transparency, and investment dynamics. All three will need to be addressed if equity crowd funding to achieve mass adoption.
Shane Smith was previously founder and Chairman of an AIM–listed independent equity research boutique, providing research to institutional investors and London Stock Exchange. Subsequently he founded and runs investor communications businesses including Intelligent Crowd TV which hosts a weekly TV format providing investors with enhanced information and insight on early-stage investments, supporting objective and independently formed investment decisions.