CROWDINVESTING / ALTERNATIVE FINANCING FOR GERMAN MID-SIZED COMPANIES

Abstract

This paper analyses and evaluates Crowdinvesting as an alternative financing method besides the known financing methods such as bank financing and venture capital financing. Since the developing speed of the Internet outpaces the scientific literature analysing quickly emerging new markets, a widely accepted definition of the term Crowdinvesting is yet to be stated. There are various types of Crowdinvesting, one of them is the equity-based Crowdinvesting which is to be seen as a promising alternative financing method for start-up companies and entrepreneurs. The goal of financing a project through many investors providing small scale investments fits the risk evaluation of rather uncertain projects such as start-ups and prototype/innovation developing, particularly for German mid-sized companies seeking financing for more risky and specialized projects. As more positive results are made public, Crowdinvesting can play an important role in generating a momentum in the German economy.

1. INTRODUCTION AND EXPLANATION OF TERMS

Scientific literature is not keeping up with the development speed of the Internet because of which a widely accepted scientific definition of the term Crowdinvesting is still missing. The term Crowdinvesting itself can be traced back to Jeff Howe, who introduced the so-called Crowdsourcing Howe, 2006) first. Howe defines Crowdsourcing as the effect that can be derived from the knowledge of a variety of people in order to optimize output results of a particular process (Moritz and Block, 2013). For example this approach is commonly used in product development of Internet games (Hornuf and Schwienbacher, 2014).
Crowdinvesting is to be seen as a variation from Crowdfunding, representing an increase of the financing level. Literature differentiates the two terms by the definition of Belleflamme P./Lambert T. /Schwienbacher A.: »Crowdfunding involves an open call, essentially through the Internet, for the provision of financial resources either in form of donation or in exchange for some form of reward and / or voting rights.« (Belleflamme et al., 2010). With reference to Moritz and Block the following definition is used for the term Crowdfunding: »Crowdfunding ist eine Finanzierungsform, die über einen öffentlichen Aufruf im Internet erfolgt (mit oder ohne Intermediär) und zum Ziel hat, finanzielle Mittel für ein Projekt oder Unternehmen mit oder ohne Gegenleistung zu erhalten. Beim Crowdfunding beteiligen sich in der Regel eine größere Zahl von individuellen Investoren.« (Moritz and Block, 2013) Crowdfunding can occur in the following forms (Moritz and Block, 2013):
⊲ Reward- vs. Donation-based Crowdfunding: represents the donation form of Crowdfunding. It is supposed to enable the realization of cultural and creative projects, whereby no funds are transferred back to the donors. The donors either participate in form of the result or the transaction is a pure donation. The difference and modification to the already known and existing donation structures is the use of the Internet.
⊲ Lending-based Crowdfunding: This form includes the allocation of micro financing. Investors provide capital through platforms to selected projects and expect interest payments as well as the repayment of the invested capital within the agreed up on time period.
⊲ Equity-based Crowdfunding (Sixt, 2014): represents a form of equity financing and is also called Crowd-financing.
This type of Crowdfunding gives investors (»Crowd«) shares of a company, thereby accepting the possibility of a total loss in case of project / company failure. Investors directly participate from profits in proportion to the capital invested. Equity-based Crowdfunding reflects Crowdinvesting and is the focus of this paper.

2. Crowdinvesting process

Process and structure of a Crowdinvesting process is based on a simple idea. The goal is to generate small amounts of capital through a large number of people (»Crowd«) in order to enable the realization and successful implementation of projects. The Internet is used as a facilitator in order to attract the highest number of potential investors possible. Usually start-up companies and entrepreneurs are looking for this type of financing. Even though the risk of total loss is high, it is easier to cope with due to providing only small investments per investor. The Crowdfunding process can be shown as follows:

Involved parties in a crowdinvesting process include the project initiators, the intermediaries and the investors (»Crowd«). Usually, project initiators are legal entities or private persons presenting their projects and investment opportunities on platforms provided by the intermediaries. First, the capital seeking initiator sends information about the project and the financing need to the intermediary. Second, registered investors receive all relevant data and information through the intermediary’s platform. Moreover, the intermediary can assist the contractual closing of an arrangement. While the project details are discussed, a trustee handles the provided capital and transfers the funds to the initiator as soon as the contracts are signed (Moritz and Block, 2013).
Considering the substantial uncertainties involved in Crowdinvesting, it is seen as a rather risky investment from the investor’s point of view. With reference to Anglo-American sources, Meschkowski A. Wilhelm K.A. (2013) analyzes the risks of Crowdinvesting investments. However, the mentioned results¹ – even without presenting detailed scientific analysis – are not to be valuated negatively. The involved parties always need to take the risk and return valuation into account. This corresponds to the framework of the portfolio theory, which is mainly supported by findings in the US regarding the realization of Crowdinvesting projects. The approximate loss rate appears too high, however, relative to the level of M&A transaction (Meschkowski and Wilhelmi, 2013) losses (52 % show a negative rate of return)². This fact can be seen as rather positive
for a new financing source.

Involved parties in a crowdinvesting process include the project initiators, the intermediaries and the investors (»Crowd«). Usually, project initiators are legal entities or private persons presenting their projects and investment opportunities on platforms provided by the intermediaries. First, the capital seeking initiator sends information about the project and the financing need to the intermediary. Second, registered investors receive all relevant data and information through the intermediary’s platform. Moreover, the intermediary can assist the contractual closing of an arrangement. While the project details are discussed, a trustee handles the provided capital and transfers the funds to the initiator as soon as the contracts are signed (Moritz and Block, 2013). Considering the substantial uncertainties involved in Crowdinvesting, it is seen as a rather risky investment from the investor’s point of view. With reference to Anglo-American sources, Meschkowski A. Wilhelm K.A. (2013) analyzes the risks of Crowdinvesting investments. However, the mentioned results¹ – even without presenting detailed scientific analysis – are not to be valuated negatively. The involved parties always need to take the risk and return valuation into account. This corresponds to the framework of the portfolio theory, which is mainly supported by findings in the US regarding the realization of Crowdinvesting projects. The approximate loss rate appears too high, however, relative to the level of M&A transaction (Meschkowski and Wilhelmi, 2013) losses (52 % show a negative rate of return)². This fact can be seen as rather positive for a new financing source.

3. INVESTOR’S MOTIVATION

The investor is motivated by the given opportunity to analyze various projects with quick access to information³ (Hornuf and Klöhn, 2013). Additionally, investors gain access to sectors, which were difficult to access in the past. Especially in the private equity sector, Crowdinvesting represents a new way of equity financing. Furthermore, Crowdinvesting can play an important role in venture capital financing in Germany, which is still behind when compared to other industrial countries. The rather small invested capital amounts enable investors to diversify their investment portfolio and thereby spread risks. The option to trade with project shares (Crowdinvesting platform Bergfürst) compensates the illiquidity of this investment alternative and even elevates it to the level of exchangetraded securities – assumed liquid trading is assured by a sufficient number of participants.

4. CROWDINVESTING AS A FINANCING OPPORTUNITY FOR MID-SIZED COMPANIES

Currently, the rather low usage of Crowdfunding as a financing method is due to the relative small capital volumes generated over the existing platforms. However, one can expect that with an increasing form of the legal structure, investment volumes rise as well. Further, Crowdinvesting still belongs to the group of rather less known financing sources which will certainly change in the near future as more positive results become public.

Mid-sized German companies can especially rely on this methodology when seeking financing of innovations and prototypes (Schenk, 2012). Here however, the issue of releasing confidential information and data on new technologies during the project assessment phase needs to be solved.
Nevertheless, numerous start-up examples show that the risks can be taken.

5. CONCLUSION

Crowdinvesting is interesting to start-up companies and needs to be seen as an alternative financing source. It fills the niche between bank financing and venture capital financing (Meschkowski and Wilhelmi, 2013). Consequently, this financing instrument provides a relevant alternative for midsized German companies, especially when it comes to specializing in niche products or innovations, for example, development of prototypes. The strong innovative drive emerges from the implementation of internally financed projects. Those, however, are limited and are subject to the cyclical economic development. At this point, the usage of Crowdinvesting can generate additional momentum for the economy.

References

Belleflamme P., Lambert T., Schwienbacher A. (2010): »Crowdfunding: An Industrial Organization Perspective«, Working Paper.
Hornuf L., Klöhn L. (2013): »Crowdinvesting und Portfoliodiversifizierung«, Venture Capital Magazin 2/2013, p. 34-35.
Hornuf, L., Schwienbacher, A. (2014): »The Emergence of Crowdinvesting in Europe«, Münchener Wirtschaftswissenschaftliche Beiträge (VWL) 2014 – 43
Howe J. (2006): »The rise of crowdsourcing«, Wired magazine, 14.06.
Meschkowski A., Wilhelmi K. A. (2013): »Investorenschutz im Crowdinvesting«, Betriebs-Berater H. 24 10.6.2013, p. 1411 – 1418.
Meyer M. (2011): »Erfolgsfaktoren bei Mergers & Acquisitions«, Uni-Wuppertal 2011.
Moritz A., Block J. (2013): »Crowdfunding und Crowdinvesting« – State-of-the-Art of scientific literature, Working Paper.
Schenk R. (2012): »Die Weiterentwicklung des Crowdfunding zur modernen und unkonventionellen Finanzierungsform für kleine und mittelständische Unternehmen«, Wissenschaftlicher Kongress.
Sixt E. (2014): »Schwarmökonomie und Crowdfunding«, Springer Fachmedien Wiesbaden, p. 129-146.

¹ The authors reference the results of an Engel-study on the Crowdinvesting sector. »Hingegen enden 52 Prozent aller Investitionen in einer negativen Rendite. Gerade einmal sieben Prozent der Investitionen übersteigen die angelegte Summe um ein zehnfaches.« (Meschkowski and Wilhelmi, 2013, p. 1412)
² Scientific studies regarding the success of M&A transactions prove a decrease of shareholder value in more than 50% of the cases (Meyer, 2011, p. 2)
³ One of the fastest Crowdinvesting projects lasted only 48 minutes and generated a financing volume of roughly 200,000 EUR