Financial Contracting in Crowdinvesting: Lessons from the German Market
Much has been written about the regulation of crowdinvesting, and what determines funding success. However, relatively little is known about the contracts that form the basis of crowdinvesting. This is a gap in the scholarly literature because the extent to which crowdinvesting needs to be regulated depends on the conditions under which investors commit their money. In our article, ‘Financial Contracting in Crowdinvesting: Lessons from the German Market’, we analyze on what contractual basis crowdinvesting is taking place in Germany, and how these contracts have evolved over time. We focus on Germany for two reasons: first, we have hand-collected contract data on 81% of the entire German crowdinvesting market since its start; second, unlike in any other crowdinvesting market, German portals have been brokering and developing investment contracts for almost six years now.
The German crowdinvesting market is unique in many respects. Unlike in the UK or the US, crowdinvesting portals in Germany do not broker equity shares to investors, which is why their business is referred to as crowdinvesting and not equity crowdfunding. Instead, German crowd investors usually obtain subordinated profit-participating loans (partiarische Nachrangdarlehen), which mimic aspects of equity shares on a contractual basis.
In our study, we find that, when crowdinvesting first started, issuers almost exclusively used silent partnerships, but, by the end of the observation period, these had been completely replaced by subordinated profit-participating loans. Significantly, more capital was raised following the change to this new type of contract, mostly because of thresholds stipulated under the German Investment Act (Vermögensanlagengesetz) exempting issuers from the prospectus requirement. Furthermore, over the course of time, the minimum duration of contracts increased from four years to between six and eight years. Currently, crowd investors can be entitled to four different kinds of participation rights. (1) Fixed interest payments: originally no contract contained a fixed interest component, yet today almost all platforms grant such participation rights to their investors. (2) Variable interest payments: most investors also participate in the company’s annual profits through variable interest payments. In the early days, investors also participated in the company’s losses, but this contract feature has been abolished. (3) Share in enterprise value: investors are entitled to a share in the value of the company at the time of the regular termination of the contract. (4) Exit rights: the number of contracts that have given investors the right to participate in exit proceeds has increased over time.
We also find that, while at the beginning of crowdinvesting crowd investors had some collective veto rights with respect to some of management’s decisions, such powers no longer exist today. Nearly all contracts require companies to provide both annual and quarterly reports containing various kinds of qualitative and/or quantitative information. The first crowdinvesting contracts did not allow dilution of the investment ratio of crowd investors. Today, all contracts include an adjustment of the investment ratio when companies secure follow-up financing from third parties. Crowd investors are, however, generally protected from the dilution of their investment ratio, when the valuation of the company is determined lower in a follow-up round than in the preceding round (down round protection). Summing up, crowd investors have over time received increased options to participate in the future profits of the start-up, as they have lost their veto rights and accepted longer durations of contracts.
There is ample scope for further research in the rapidly expanding crowdinvesting industry. Researchers might examine how profit-participating loans develop in competition with traditional financing through company shares, as well as the effects of burgeoning legislation. In addition, there is increasing need for comparative analyses of crowdinvesting markets in international contexts. The fact that this is still a young and rapidly changing industry makes it both a challenging and necessary area of study for economists and legal scholars.
Lars Klöhn is Professor of Law at the Humboldt University of Berlin, Lars Hornuf is Associate Professor at Trier University and Affiliated Research Fellow at the Max Planck Institute for Innovation and Competition, and Tobias Schilling is a researcher at the Humboldt University of Berlin.
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