cutting out the middleman: crowdinvesting, efficiency, and...

Cutting out the Middleman:Crowdinvesting, Efficiency, and Inequality

Hans Peter Grüner (Mannheim) & Christoph Siemroth (Essex)

Christoph Siemroth (Essex) Crowdinvesting 1 / 10

Introduction

Crowdfunding and crowdinvesting

Crowd-financing: money directly from savers toborrowers/entrepreneurs (“many to one”)

Similar to market-finance except via web-platforms and not marketsCrowdfunding: either as donation/pre-sale (kickstarter) ordebt-contractCrowdinvesting (also ‘equity crowdfunding’): buy part of a venture(companisto, crowdcube)

Financial innovation made possible by the internetPossibly cheaper than bank-financeIPOs (market-finance) not affordable for small projects

⇒ May help alleviate credit market imperfections, macroeconomicimplications/growthDownsides: moral hazard, fraud, adverse selection?


Introduction

Example from crowdcube (UK)


Paper overview

Question and motivation

We investigate the consequences of a wealth and incomedistribution mismatch on the functioning of crowdinvesting

Wealth and income distribution mismatch: wealth distributionis more concentrated than income distribution

Saez & Zucman (2014): bottom 90% of American householdsowned about 23% of wealth, but received about 60% of income in2012

Consequence: a big share of consumers is not active on thecapital market (no financial wealth); capital misallocation?


Paper overview

Question and motivation

We investigate the consequences of a wealth and incomedistribution mismatch on the functioning of crowdinvestingWealth and income distribution mismatch: wealth distributionis more concentrated than income distribution

Saez & Zucman (2014): bottom 90% of American householdsowned about 23% of wealth, but received about 60% of income in2012

Consequence: a big share of consumers is not active on thecapital market (no financial wealth); capital misallocation?


Paper overview

Problem and main finding

Purpose of the capital market: channel funds from savers(consumers) to lenders (entrepreneurs with new innovativeproducts)New technology/product:

Consumer i ∈ [0, 1] likes the new product or not, θi ∈ {0, 1}Aggregate uncertainty about how many consumers like theproduct: s =

∫ 10 θidi = 1− β with prob 1/2 and s = β with prob 1/2

(with β > 1/2)

New company uses investments to produce the new productEfficient capital allocation: products that most consumers areinterested in should get most funding (for production):

X(s = 1− β) < X(s = β)


Paper overview



Paper overview


How to achieve efficient capital allocation via crowdfunding: everyinterested consumer invests in products he would like to consume(vote analogy)Problem due to wealth/income distribution mismatch: not everyinterested consumer can invest; wealthy have to invest “on behalf”of the poorMain finding: efficient capital allocation is possible if and only ifthe income and wealth distribution of potential consumersmatchesEquilibrium with sufficient wealth: consumers invest in the newcompany if and only if they like the new product (for informationalnot brand-loyalty reasons)


Paper overview

Empirical implication

Example: iPhone holder for LamborghiniPool of potential customers probably wealthy

⇒ every potential consumer can crowdinvest, hence crowdfundingcan aggregate demand information

Example: new kind of low-budget football shoesPart of potential consumers not wealthy

⇒ some interested consumers cannot participate in the investmentstage about whether the project is funded

Hence crowdfunding should work better for Lamborghini iPhoneholders than low-budget football shoes


Conclusion

Consequences of wealth inequality

In most industrialized countries, wealth is far more concentratedthan incomeHence many consumers cannot invest on the capital market dueto wealth constraintsInvestment flows on the capital market therefore reflectpreferences of the wealthy, not necessarily future demand, withnegative welfare consequences

⇒ not all socially beneficial projects are funded


Conclusion

Conclusion crowdfunding

The Internet makes it possible to match a large number ofinvestors with projects seeking funding at much lower cost thanbeforeSmall firms now have access to equity finance when they couldrely only on intermediaries beforeThus, crowdfunding and crowdinvesting may be a valuablefinancial innovation, which can improve social welfare if themismatch of wealth and income distribution is not too great


Appendix Description of the model

Timing and consumers

Period 1 (Investment): use wealth to invest either at riskless rateR ≥ 1 or in firm producing product x

Period 2 (Consumption): use income and investment returns toconsume product c or x

Consumers have exogenous financial wealth wi ∈ R+0 in period 1

and exogenous income yi > 0 in period 2Income yi > 0 is sufficiently large, but wi may be small/zeroθi ∈ {0, 1}: Consumers are interested in the new product x or not;private information



Consumers and preference distribution

Two groups of consumers, wealthy i ∈ [0, 0.5] and poor i ∈ (0.5, 1]

Preferences within the same group are correlated, share ofconsumers 1/2 < β < 1 or share 1− β are interested in product x

Preferences between groups are independent (wealthy learnnothing about preferences of poor from their own preferences)Aggregate demand uncertainty as realization(s1, s2) ∈ {1− β, β}2

⇒ either few (1− β), half, or many (β) consumers are interested innew product x



Investment in innovative firm

Innovative firm needs capital for production of xFirm sells shares, modeled as “crowdinvesting” compaign or directpublic offeringProduction technology: Aggregate investment in firm linearlytranslates into supplyFirm distributes all later earnings (from selling x) among allinvestors



Goods market equilibrium

Investment determines production: If firm raises little capital, thenonly few units of x can be produced (low supply)If many consumers are interested in x, then there will be highdemand for x

Price p clears the market; higher price with more demand or lowersupplyp determines revenues of the firm, thus p is also per unitinvestment return


Appendix Results

Efficiency and welfare

Efficient aggregate investment: linearly increasing in the shareof interested consumers in x

Hence, the more consumers want to consume the good, the morehas to be produced (requires larger investment in firm)Efficiency implies a state independent market clearing price p = R


Appendix Results

The consequences of unequal wealth distributions

Simple case: wealth among all consumers in same group isconstant

PropositionThere exists an efficient equilibrium if and only if consumers in eachgroup hold enough wealth to finance production of their own efficientconsumption in case of θi = 1, wi ≥ (α/R)1/(1−α).

If all consumers have enough wealth, then all interestedconsumers can invest, and aggregate investment increases withthe share of interested consumers (efficient)If the poor do not have enough wealth, but do have income forconsumption, then only inefficient equilibria existThe wealthy have to invest “on behalf” of the poor, but have noinformation about preferences of the poor


Extensions Financial intermediaries

Adding financial intermediaries to the model

Perhaps investment banks or venture capital firms could correctthe inefficiency due to wealth inequalityTo investigate, we add a “financial sector” to the model with N ≥ 1investment fundsFunds have no information about the preference distribution ofconsumers, but can acquire it from “market research” firms at acostFunds have a big exogenous budgetFunds can also invest at riskless rate R or in the innovative firm,and compete with crowdinvestors on the market



The impossibility of efficient investment with activefunds

Proposition

There exists no equilibrium with an efficient state-dependent capitalallocation in which investment funds invest.

Intuition: funds can fix inefficient investment only if they areinformed, since efficient investment depends on the preferencedistributionBut becoming informed is costly, which pays in equilibrium only ifthere is mispricing (implying excess returns)



The consequences of unequal wealth distributions

Corollary

There exists no equilibrium with an efficient state-dependent capitalallocation if consumers of one group do not have enough wealth(wi < (α/R)1/(1−α)).

Thus, even professional financial intermediaries do not fix theinefficiency due to wealth inequalityReasons are informational frictions or market power of funds


Extensions Further extensions and alternatives

Extensions

The inefficiency due to wealth constraints is robust to. . .Introduction of forward markets / pre-order crowdfundingDynamic investments / learning from investmentsOther utility functions


cutting out the middleman: crowdinvesting, efficiency, and...

Documents