Signaling in Equity Crowdfunding


 

Crowdfunding practices can present benefits and risks for both project founders and funders. For funders, in particular, risks can arise from the uncertainty on the founder’s (in)competence and/or (dis)honesty in effectively carrying out a project as specified in the crowdsourcing platform, and give back resources to funders also as specified in the platform. If the founder happens to be a well-established company, funders may tend to be less worried about these risks, trust the company and commit financial resources to the founder’s project. Trust is thus paramount in online crowdfunding contexts. If trust is absent, founders may well receive no funds from the crowd for their projects. Instilling trust is thus of vital importance for a founder who wishes to carry out a project successfully. How then, can trust be inspired in crowdfunders, who may include people who have never seen or heard of the project founder?

Signaling in Equity Crowdfunding

Proper signaling has been identified as being one of the most effective strategies for inspiring trust in crowdfunders and thus increase the chance of funding success for  projects. Potential funders can infer unobservable venture features (e.g. future returns on investment) by individuating observable features that “signal” the likelihood of positive outcomes in a project. One seminal paper in this field (Ahlers et al., 2015) examines signaling in equity crowdfunding. Equity crowdfunding is chosen based on the usually small (monetary) size of investors and on the pressure for return on investments. These two characteristics make equity crowdfunding particularly suitable for measuring the effects of signaling on investors’ trust in projects and founders. In fact, Angel investors/venture capitalists, contrary to small investors, usually have all the resources and capabilities to quickly and relatively inexpensively evaluate a project, without the need of signals; and other types of crowdfunding, such as donations-based ones, typically do not require the same level of trust as for equity crowdfunding.

 

Findings

By analyzing 104 projects and their funding success within 1 year, the authors find that three reported aspects of a venture provide significantly important signals to small investors, so as to spur these latter to invest in a certain project. The first aspect is the human capital of the firm. In line with what logic would suggest, the authors find that better venture’s human resources’ knowledge, competences and educational level provide positive signals, inspire trust and spur small investors to commit financial resources to the venture. Two more interesting findings relate to the perceived level of uncertainty of a venture. More specifically, the authors find that a founder retaining a significant amount of equity in his/her project represents a potent positive signal for investors. Retaining large equity shares as a founder is costly and is thus undertaken only if the founder expects with a high degree of certainty future positive cash flows on the project. Its costly nature makes retaining equity an observable potent signal to small investors. The authors also find that reporting a project’s financial projections and potential risks in venture information can reduce the level of uncertainty and allow investors to better evaluate a project. A founder reporting such information shows his honesty and full awareness and understanding of his project risks and potentials. This information can also signal investors a founder’s will to reduce information asymmetries. Thus these founders’ behaviors, by making a project evaluation easier, more precise and oftentimes more reliable, provide a potent signal to small investors, who would thus be more spurred to commit financial resources to the venture.

 

Limitations

The study is the first-ever empirical examination of signals’ effectiveness in equity crowdfunding practices. As it is in all academic papers, this one’s findings and methodology also presents limitations. First of all, the authors choose to evaluate signals’ effectiveness only in equity crowdfunding practices. This aspect inevitably limits the scope of their findings. In other crowdfunding practices, like donations-based ones, other non-monetary rewards are likely to be important to funders, and thus other venture aspects may be reported to signal venture reliability and assure potential investors. Another limitation lies in the authors’ only data source: ASSOB, an Australian equity crowdfunding platform. A platform fully regulated by Australian laws, ASSOB also presents inherently unique policies and norms, such as data sharing policies and offering periods’ rules. This entails a low generalizability issue, potentially binding the authors’ (non)findings to the specific platform’s policies and regulatory standards.

 

 

Conclusion

The paper by Ahlers et al. (2015) contributes to show how important it is to instill trusts in potential funders in crowdfunding contexts. In accomplishing this, sending proper signals can be very effective. Indicating appropriate venture information can signal a venture’s realistic potential of positive outcomes. If done properly, signaling can be very helpful to founders to increase their funding success, and provide potential funders with what matters most to them in crowdfunding contexts: trust and assurances.

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Sources

Ahlers, G. K., Cumming, D., Günther, C., & Schweizer, D. (2015). Signaling in equity crowdfunding. Entrepreneurship Theory and Practice39(4), 955-980.

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