Reading: Alternative Going Public Strategies

At its very core, "digitalization" takes out intermediaries and reorganizes markets into platforms where buyers and sellers meet to allocate scarce resources. Financial intermediaries are core targets of such digital transformations, which is not very surprising in light of the attractive margins that these intermediaries earn. 

In the process, numerous Peer-to-Peer (P2P) financing and Crowd Funding Platforms have emerged. Oftentimes, the logic is fairly simple: Entrepreneurs showcase their business idea on the platform and interested investors can then invest directly through the platform. 

While is straightforward to see that such platforms can connect entrepreneurs with investors instantaneously, it is less clear how to filter out scams and secure trust between the investors and the entrepreneurs. Put differently, there could be significant counterparty risk. This is a problem that affects platforms in general, but it is often easier to address for businesses that exchange goods and services whose quality is comparatively easily verifiable.

Take the case of Airbnb. The idea of short-term P2P apartment rentals over the internet might not seem particularly innovative. And it was not new when the firm came into existence in 2008. Craigslist, for example, offered that service long before, but renting an apartment via that platform was often rather adventurous, as it attracted a lot of fake ads from dubious "hosts" and it was impossible for guests to verify the validity and the quality of the offer before stepping through the door of the (hopefully existing) apartment. Airbnb solved these issues with professional pictures of the apartment, host due diligence, guest rating systems, a centralized payment system that allowed clawbacks, insurance contracts, etc. Today, the counterparty risk on Airbnb is minimal and the platform has become a mainstream provider of housing for people who travel.

The quality of an apartment can be determined more or less reliably and client ratings are typically available from the onset, as the rental period is often only a few days. Therefore, it would seem to be comparatively easy to dismantle the information asymmetry between "buyers" and "sellers" on platform markets such as Airbnb.

In the case of equity financing, the situation is strikingly different. Several factors make it particularly difficult to reduce counterparty risk:

• First, a capital raise is often a one-time event. There are no preceding experiences with the firm and no track record it could show (no past "client ratings").
   
• Ex ante, the quality of the business idea is very hard to ascertain. There are few, if any, objective standard quality measures and investors mostly buy in the future prospects of the idea, not the firm's current assets (no maps and pictures that provide reliable information about the offering). 
   
• Investors invest at the same time, so there is no learning during the investment process. Put differently, the investment does not take place sequentially so that the first investors could rely their experiences with respect to the quality of the investment to potential later investors.
   
• It can take a long time, often years, to learn about the actual quality of the investment (whether it was good or bad). And even when we know the outcome, it's not clear whether that outcome was due to (lack of) skill or (lack of) luck. So even ex post (that is, several years down the road), quality is very hard to measure.
   
• Last but not least, investors do not have a very strong claim, as they buy minority stakes in a privately held firm. They are at the bottom of the priority latter in the case of a dissolution of the company, and they have little say in strategic decisions (including dividend payments and liquidity events). So even if the firm is successful, it is not clear that investors will fully participate in that success.

There are various ways how crowd financing platforms attempt to tackle these challenges. As in the case of Airbnb, it is conceivable that those platforms who manage to minimize counterparty risk will be the ones leading the digital disruption of public equity financing:

• Crowdcube, is the largest U.K.-based crowd financing platform with more than GBP 500 million raised for more than 700 companies, as of mid-2018. Their pursue a highly personalized fund raising process, where the entrepreneur herself is in the spotlight. Also, they put great emphasis on the firms' existing stakeholders, and attempt to "turn your friends, family, fans and customers into investors." Finally, they conduct their own due diligence to avoid misleading presentations.
   
• SyndicateRoom, another large U.K-based crowd financing platform. has raised more than GPB 100 million for over 125 companies as of mid-2018. Their verification process is very simple yet quite convincing: Their platform only features companies that have managed to secure the backing of professional investors (venture capitalists). By participating on their platform, investors can therefore co-invest with professionals who have carried out their own due diligence.

Clearly, such platforms make a very important contribution towards the democratization of investment, as they give "ordinary" investors access to venture-capital types of investments. Yet is important to note that these financing channels are not particularly cheap. In the case of Crowdcube, for example, the platform charges a completion fee of approximately 1% as well as a success fee of 7% on the amount successfully raised. Therefore, this source of equity financing is actually not cheaper than a traditional underwriting structure in an IPO, but it is open to much smaller firms, and much earlier in their lifecycle.