The role of lead investors in equity crowdfunding campaigns with a secondary market

Abstract

We explore two recent phenomena in equity crowdfunding platforms: the development of dedicated secondary markets and the crucial role of institutional investors (lead investors in terms of pledge). First, we propose a theoretical model in which crowd and lead investors choose to finance campaigns posted by entrepreneurial firms that are heterogeneous with respect to their target and long-term return. We suppose that lead investors make huge pledges in the highest return campaigns but bear the cost of illiquidity whereas the crowd invests in all campaigns. The platform sets up a secondary market to enhance asset liquidity, but all entrepreneurial firms with successful campaign are not automatically listed. If they are listed, second-hand transactions send signals on the chance of success of the funded campaigns. Theoretical results show that increasing the number of lead investors or their pledge improves fundraising but always reduces access to the secondary market for some entrepreneurial firms. If the lead investors’ cost of illiquidity is particularly low, it may even decrease the share of entrepreneurial firms that have access to the secondary market. We then test these predictions using data scraped from one of the most important ECF platforms that covers the period November 2018–October 2020. We empirically show that the number of lead investors and their pledge are positively correlated with the success of the fundraising campaign and negatively correlated with the access the entrepreneurial firms have to the secondary market. These results suggest that the illiquidity of shares is not of first importance for lead investors, who tend to make long-term commitments to crowdfunding campaigns. The implementation of secondary market is thus a useful tool to attract crowd investors but should be finely monitored by the platform to retain lead investors.

Plain English Summary

The development of secondary markets and the increasing role of institutional investors (lead investors in terms of pledge) are recent phenomena in the world of equity crowdfunding platforms. We question why all funded entrepreneurial firms are not automatically listed when secondary markets open. Second-hand transactions offer a valuable exit option for investors but may send perturbing signals through too much price share volatility and possible loss of confidence from entrepreneurs and investors. The role of the platform is then to select funded campaigns authorized to be listed on its secondary market. We show both theoretically and empirically that increasing the number of lead investors or their pledge improves fundraising but surprisingly reduces access to the secondary market for some entrepreneurial firms. This suggests that the illiquidity of shares does not really matter for lead investors, who tend to make long-term commitments. In conclusion, our study provides practical implications for equity crowdfunding platforms that seek to organize the opening of secondary markets.

Appendix A

1.1 A.1: The optimal minimum level of long-term return needed to access to the secondary market in Cases A and B

In Case A, ${R^{sec}_\textbf{A}}^*$ is given by the following:

$$\begin{aligned}{} & {} {R}_{\textbf{A}}^{sec*}=\\{} & {} \!\!\frac{\frac{\sqrt{\left( {\delta }_{1}\!+\!{\delta }_{2}\right) {Hm}^{l}\left( {c\overline{R} }^{3}{\left( \overline{p }\!-\!b\left( 1\!-\!\overline{p }\right) \right) }^{2}\right) \left( cH\overline{R }\left( {\delta }_{1}\!+\!{\delta }_{2}\right) {m}^{l}\!+\!{\delta }_{2}\left( 1\!-\!\overline{p }\right) {n}^{c}\right) }}{cH\overline{R }\left( {\delta }_{1}\!+\!{\delta }_{2}\right) {m}^{l}\!+\!{\delta }_{2}\left( 1\!-\!\overline{p }\right) {n}^{c}}\!-\!\overline{R }\left( \overline{p }\!-\!b\left( 1\!-\!\overline{p }\right) \right) }{1\!-\!\overline{p} } \end{aligned}$$

The same variable in Case B, denoted ${R^{sec}_\textbf{B}}^*$, is given by the following:

$$\begin{aligned}{} & {} {R}_{\textbf{B}}^{sec*}=\\{} & {} \frac{\frac{\sqrt{{\delta }_{1}{Hm}^{l}\left( {c\overline{R} }^{3}{\left( \overline{p }\!-\!b\left( 1\!-\!\overline{p }\right) \right) }^{2}\right) \left( cH\overline{R}{\delta }_{1}{m}^{l}\!+\!{\delta }_{2}\left( 1\!-\!\overline{p }\right) \left( {n}^{c}\!+\!{Hm}^{l}\right) \right) }}{cH\overline{R}{{\delta }_{1}m}^{l}\!+\!{\delta }_{2}\left( 1\!-\!\overline{p }\right) \left( {n}^{c}\!+\!{Hm}^{l}\right) }\!-\!\overline{R }\left( \overline{p }\!-\!b\left( 1\!-\!\overline{p }\right) \right) }{1\!-\!\overline{p} } \end{aligned}$$

1.2 A.2: Numerical simulation

The optimal level of access to the secondary market depends on the set of parameters chosen.

One key parameter is the level of the cost of illiquidity for lead investors. In the model, we capture the cost of illiquidity with parameter c. With Lemma 1, we can see that Case B occurs when the cost of illiquidity does not matter (otherwise, Case A applies).

Considering first Case A, since the cost of illiquidity matters, the platform can open the secondary market completely, such that $R_A^{sec*}=0$, or at least partially, such that $0<R_A^{sec*}<R^{l*}$. In these cases, increasing the number of lead investors or their pledge leads to an increase in the proportion of entrepreneurial firms that are funded. The share of listed entrepreneurial firms may increase (because those new firms become listed) but may also decrease because the platform becomes more restrictive (some other entrepreneurial firms with low long-term returns are not listed anymore).

Considering now Case B, since the cost of illiquidity does not matter, the platform can completely close the secondary market such that $R_B^{sec*}=\bar{R}$, or at least can open it partially, such that $R^{l*}<R_B^{sec*}<\bar{R}$. In this last case, increasing the number of lead investors or their pledge leads to increase the share of funded entrepreneurial firms but to decrease the share of listed ones (because the new firms funded do not become listed).

To illustrate these results and give an order of magnitude, we denote by $F^*$ the optimal share of funded entrepreneurial firms and by $S^*$ the optimal share of those having access to the secondary market (among those funded). According to Figs. 5 and 6, we have the following:

$$F_i^*=\frac{\bar{R}-R_i^{l*}}{\bar{R}} +\frac{R_i^{l*}}{\bar{R}} \frac{n-T_{min}}{T_{max}-T_{min}}$$

with $i\in [A,B]$

$$S_A^*=\frac{\bar{R}-R^{l*}}{\bar{R} F_A^*}+\frac{R^{l*}-R_A^{sec*}}{\bar{R} F_A^*} \frac{n-T_{min}}{T_{max}-T_{min}}$$

$$S_B^*=\frac{\bar{R} -R_B^{sec*}}{\bar{R} F_B^*}$$

We have calibrated the parameters to match some empirical evidence: $T_{min}=100$; $T_{max}=340$; $\bar{R} =10$; $\delta _1=6\%$; $\delta _2=1\%$; $\bar{p} =0.6$; $b=0.5$; $C=20$; $c=0.005$; $n=200$; $m_l=4$; $H=60$. These parameters are compatible with Case B. We obtain $R_B^{l*}=4.94$ and $R_B^{sec*}=5.13$ meaning that 71.35% of entrepreneurial firms are funded and 68.26% of these have access to the secondary market.

Suppose now that the pledge of lead investors increases by 25% such that $H=75$. We then obtain $R_B^{l*}=4.74$ and $R_B^{sec*}=6.00$ meaning that 72.5% of entrepreneurial firms are funded and 55.17% have access to the secondary market (among those funded). In other words, increasing the pledge of lead investors by 25% leads to a 20% decrease in the share of entrepreneurial firms listed.

Finally, suppose now a higher cost of illiquidity for lead investors such that $c=0,1$. With these parameters (with $H=60$), we switch to Case A. We then obtain $R_A^{l*}=7.024$ and $R_B^{sec*}=1.14$ meaning that only 59.26% of entrepreneurial firms are funded and 91.26% of these have access to the secondary market.

In accordance with our results, the cost of illiquidity and the level of pledges significantly matter in the degree of secondary market openness.

1.3 A.3: Correlation matrix

Table 9 Correlation matrix