HEC PARIS - Master Thesis Can Equity Crowdfunding Crowd-Out Other Alternative Sources of Finance? Supervised by Mr. Patrick Legland David Timothy Schneider Matriculation Nr: 54060 MSc International Finance Email: [email protected] Tel: +44 7393 179 350 Tuesday, 13 September 2016 The author would like to thank his Master Thesis supervisor, Mr. Patrick Legland, for both his availability and feedback during the writing of this paper. The author would also like to thank Ms. Angela Mashey and Ms. Ivy Wong for their help in connecting the author to entrepreneurs, investors and people with industry knowledge in the San Francisco Bay Area. Abstract Following the financial crisis of 2007, many smaller firms had no access to capital. The Obama administration tried to change that with the passage of the JOBS Act in 2012, which would allow firms to seek financing from anonymous individuals online and offer debt or equity as securities. In the vacuum left behind by the retreat of bank lending stepped a host of alternative lenders, crowdfunding in its many forms being one of them. As the industry grows and matures it is starting to compete with other alternative lenders1. It is the aim of this paper to compare equity crowdfunding to the other equity investors, those traditionally being angel investors, micro-VCs and larger VC-firms. Initially the various types of crowdfunding will be defined and how they came about, subsequently this paper will examine the various forms of private equity. Finally, the types will be compared on the global volume available to investors, the cost of financing, the median investment size made by each investor type, the role of the intermediary, the degree to which shareholders involve themselves in the company’s business affairs and the legal structure of the types. The conclusion will then determine with which other forms of finance equity crowdfunding competes the most and what the future bodes for it. 1 (Greenhalgh, 2016) Table of Contents Introduction .................................................................................................................. 1 The Cause of Bank’s Retreat from Small Business Loans .......................................... 2 What is Crowdfunding? ............................................................................................... 4 Crowdfunding Models .................................................................................................. 4 The Beginnings of Equity Crowdfunding Models ......................................................... 6 History of Financial Regulation in the U.S. .............................................................. 8 Jumpstart Our Business Startups Act .................................................................... 10 Funding Portals ...................................................................................................... 12 What is Private Equity? ............................................................................................. 14 Defining the 3Fs, Angel Investors and Micro-VCs ................................................. 15 Defining Traditional VC and Larger PE firms ......................................................... 18 Global Volume ........................................................................................................... 22 Comparing Equity Crowdfunding Portals with Other Alternative Financiers ............. 24 Survey methodology .............................................................................................. 24 Fees and Cost of Capital ....................................................................................... 25 Adzuna: A case study ............................................................................................ 31 The Entrepreneur’s Perspective ............................................................................ 33 Median Fundraising Sought and Financing Round ................................................ 34 Shareholder Fractionalization ................................................................................ 36 Legal Structure, Shareholder Involvement and Legal Enforcement .......................... 38 Unrepresented ....................................................................................................... 39 Nominee represented ............................................................................................ 39 Legal Enforcement ................................................................................................. 40 The Trend of Disintermediation and Crowdfunding ................................................... 41 Conclusion ................................................................................................................. 43 Table of Figures ........................................................................................................ 44 Bibliography ............................................................................................................... 46 Appendix: Survey Format .......................................................................................... 53 Abbreviations AUM = Assets under management BDC = Business Development Company CFP = Crowdfunding platform CFR = Code of Federal Regulations DJIA = Dow Jones Industrial Average GP = General Partner HNW = High Net-Worth LP = Limited Partner pcy = per calendar year PE = Private Equity Reg = Regulation ROE = Return on Equity S.E.C. = Securities and Exchange Commission SME = Small and Medium-Sized Enterprises UHNWI = Ultra High-Net-Worth Individuals VC = Venture Capital Introduction 1 Introduction The sources for early-stage business financing have always been sparse. However, since the credit crisis started in 2007, small and medium sized enterprises (SMEs) have struggled to secure financing from their traditional financiers, the banks. In the wake of the credit crisis, pressure grew on legislators to enable better access to capital for SMEs, and a host of alternative sources started to fill the void. Unfortunately, this group of alternative financiers has not been able to fill the vacuum left behind by the retreat of bank lending completely. However, as these alternative sources of finance grow so will the competition between them, to back promising ventures. The aim of this paper is to compare the newer types of early-stage financing, such as equity crowdfunding, with more traditional forms of financing such as private equity in order to determine what the future bodes for both the newer forms and the traditional forms. At a time when participation in equity crowdfunding opportunities has been opened up to a greater number of investors in the U.S., analyzing what the future holds for early-stage financing could not be more relevant. Both equity crowdfunding platforms and private equity investors will have to reevaluate their strategies in the future if these two forms of financing do indeed begin to compete. Cost is an obvious aspect on which different models often compete. With the advent of the internet and accompanying software, the world has become more transparent. Whether this change will do away with expensive fund managers, so valued for their ability to generate positive returns from opaque investment opportunities? Or has the deluge of information led to an even greater demand for knowledgeable intermediaries? In the following chapters I will seek to find answers to the questions above and I begin by delving into the how and why SMEs saw a shortage in the amount of financing available to them. Following the brief history of the financial crisis, I will delve into the different forms and history of crowdfunding. Subsequently, I will define the various types of private equity and the two forms of financing will be compared according to their cost of capital, the composition of their investor base and the depth of both markets amongst various other metrics. The Cause of Bank’s Retreat from Small Business Loans 2 The Cause of Bank’s Retreat from Small Business Loans The two most cited reasons for the departure of the traditional lenders from the small business loan market2 is that on the one hand banks, deemed small business loans too risky and that on the other hand regulators wanted banks, amongst other things, to improve their tier 1 capital ratio3, which meant either to reduce the amount of lower quality loans lent or increase the amount of tier 1 capital. Regarding the regulators requirement, the banks worked on both fronts but it meant that fewer lower quality loans, which were predominantly small business loans, were originated. Before the financial crisis banks would often lend smaller amounts, such as less than $100k, to businesses where the founders had exhausted their own savings and where an equity investment would be too expensive. As we can see in Figure 1, the number of smaller loans originated by Bank of America fell drastically during the financial crisis and has not recovered to pre-crisis levels. The pattern is the same for J.P. Morgan, Wells Fargo and other large U.S. lenders. Figure 1: Bank of America SME Lending by Loan Size4 U.S. SME Bank Lending by Loan Size $30bn $25bn $20bn $250 to $500k $15bn $100k to $250k ($bn) $10bn $100k or less $5bn $0bn Total Bank of America SME Lending Lending SME America of Bank Total As a result of the banks retreating from this area, a ‘funding vacuum’ appeared where entrepreneurs could not use their own resources as these had been exhausted and they could not receive funds from professional