Crowdfunding Under Market Feedback, Asymmetric Information And Overconfident Entrepreneur

Anton Miglo

doi:10.1515/erj-2019-0018

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Crowdfunding Under Market Feedback, Asymmetric Information And Overconfident Entrepreneur

Anton Miglo

Published/Copyright: February 28, 2020

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From the journal Entrepreneurship Research Journal Volume 11 Issue 4

Abstract

This article is the first one that considers a model of the choice between the different types of crowdfunding, which contains elements of the asymmetric information approach and behavioral finance (overconfident entrepreneurs). The model provides several implications, most of which have not yet been tested. Our model predicts that equity-based crowdfunding is more profitable than reward-based crowdfunding when an entrepreneur is overconfident. This is because the entrepreneur learns from the sale of shares before making production decisions. The model also predicts that an equilibrium can exist where some firms use equity-based crowdfunding, which contrasts the results of traditional theories (which have rational managers), for example, the pecking-order theory. It also contrasts traditional behavioral finance literature (e. g. Fairchild, R. 2005. “The Effect of Managerial Overconfidence, Asymmetric Information, and Moral Hazard on Capital Structure Decisions.” ICFAI Journal of Behavioral Finance 2 (4).) where equity is not issued in equilibrium.

Keywords: entrepreneurial finance; crowdfunding; asymmetric information; overconfidence; equity-based crowdfunding; reward-based crowdfunding; entrepreneurship and learning

JEL Classification: D82; G32; L11; L26; M13

Acknowledgements

I am grateful to Vincent Crawford, Gary Dushnitsky, Todd Kaplan, Peter Klein, Claire Leitch, Victor Miglo, Simon C Parker, Deborah Trask, the seminar participants at University of Lincoln, Coventry University London, De Montfort University, London South Bank University and two anonymous referees for their helpful comments.

Appendix

Proof of Proposition 2. Consider a situation where l selects reward-based crowdfunding and h selects equity-based crowdfunding. If a separating equilibrium exists, the market beliefs about the firm’s type are unbiased for each type of firm. Therefore we have (all calculations are based on the symmetric information case for each type described in Section 3):

(28)Πh=(ah−c)24,

(29)Πl=(al−c)24,

where Π_j is the equilibrium profit of type j. Also we have (as follows from Lemma 1):

αh=2cah+c,

Mh=c(ah−c)2.

Suppose that l mimics h and chooses equity-based crowdfunding instead. l’s profit Π_lh then equals

Πlh=(1−αh)(pq+Mh−cq).

After shares are sold, the entrepreneur will select p and q that maximize the value in the second bracket: p=al+c2 and q=al−c2. Note that these are the same values as under symmetric information for type l. However, the difference here is that when l mimics h, it has to sell a smaller stake of equity in the firm compared to the symmetric information case and it also gets more money because ah>al. This means that l has a higher payoff than (29) so it will mimic h and such an equilibrium does not exist.

Now consider a situation where h selects reward-based crowdfunding and l selects equity-based crowdfunding. The payoffs again are determined according to (28) and (29). Suppose that l mimics h and chooses reward-based crowdfunding instead. Using similar reasoning one can show that l’s profit Π_lh equals

Πlh=(ah−c)24.

This is greater than (29). This means that such an equilibrium does not exist.

Proof of Proposition 3. Consider pooling with equity-based crowdfunding, which is supported by off-equilibrium market beliefs that the firm is l if the market participants observe reward-based crowdfunding. First of all, let us verify non-deviation for each type to reward-based crowdfunding. After shares are sold, the firm chooses q to maximize the entrepreneur’s expected profit.

(30)(1−α)(p(aj−p)+M−cq)=(1−α)((aj−q)q+M−cq),j=l,h

subject to:

(31)M≥cq.

Two cases are possible. Case 1.

(32)M≥c(ah−c)2.

In this case both types of the firm will be able to produce an optimal quantity of goods, i. e. each type can select the q that gives the absolute maximum for (30) and the constraint (32) holds. This optimal quantity equals q=aj−c2, j = l, h. The cost of production is cqj=c(aj−aj+c2)=c(aj−c)2≤M so the constraint (31) holds. Also, p=aj+c2.

The entrepreneur’s expected profit equals:

(33)(1−α)((aj−c)24+M).

The funders’ expected earnings should cover their investment cost or:

(34)α(x((ah−c)24+M)+(1−x)((al−c)24+M))=M.

This condition means that the market believes that the firm is h with probability x. (34) implies:

α=4Mx(ah−c)2+(1−x)(al−c)2+4M,

(35)M=α(x(ah−c)2+(1−x)(al−c)2)4−4α.

Substituting this into (32), we find that:

α(x(ah−c)2+(1−x)(al−c)2)4−4α≥c(ah−c)2,

α≥2c(ah−c)x(ah−c)2+(1−x)(al−c)2+2c(ah−c).

If l deviates to reward-based crowdfunding, its payoff equals (al−c)24 which is smaller than its equilibrium payoff. Indeed, if we substitute (35) into (33) we have that l’s equilibrium payoff equals

(36)(1−α)((al−c)24+α(x(ah−c)2+(1−x)(al−c)2)4−4α).

It equals (al−c)24 if x = 0 and it is larger if x > 0. So l does not deviate. Now consider the potential deviation of type h. If h deviates its payoff also equals (al−c)24. This is smaller than its equilibrium payoff since its equilibrium payoff is higher than that of type l and the latter is greater than (al−c)24 as was shown previously. Let us now verify that off-equilibrium beliefs survive the intuitive criterion of Cho and Kreps (1987). To show this, let us calculate the maximal payoff of type l in the case that it chooses equity-based crowdfunding. Its payoff is evidently maximized if the market places the probability 1 on type h observing equity and it equals (ah−c)24. If off-equilibrium beliefs survive the intuitive criterion, this expression must be not less than the payoff of l in equilibrium.^[18] Indeed (36) is equal to (ah−c)24 if x = 1 and it is smaller if x < 1. So off-equilibrium beliefs survive the intuitive criterion of Cho and Kreps (1987). The proof is omitted for brevity.

Case 2. M<c(ah−c)2. In this case only type l will be able to produce an optimal quantity of goods, or both types will not be able to produce an optimal quantity of goods. The payoff of the entrepreneur is smaller than in the first case so we omit calculations for brevity.

Now suppose that a pooling equilibrium exists where both types select reward-based crowdfunding, which is supported by off-equilibrium market beliefs that the firm is l if the market participants observe equity-based crowdfunding. The firm’s payoff in equilibrium is:

(37)Πj=(am−c)24,

where am=xah+(1−x)al.^[19]

Let us analyze the mispricing for each equilibrium. In the case of equity-based crowdfunding, h’s profit Π_h equals (1−α)((ah−c)24+α(x(ah−c)2+(1−x)(al−c)2)4−4α). This is greater than (1−α)((am−c)24+α(x(ah−c)2+(1−x)(al−c)2)4−4α)=(am−c)24+α(x(ah−c)2+(1−x)(al−c)2−(am−c)2)4. This is in turn greater than (am−c)24. Indeed, x(ah−c)2+(1−x)(al−c)2−(am−c)2=x(1−x)(ah−al)2≥0.

Proof of Proposition 4. First consider the case where the entrepreneur of the high-quality firm (h) is overconfident. Consider a situation where l selects reward-based crowdfunding and h selects equity-based crowdfunding. We have (all calculations are based on the symmetric information case for each type described in Section 3; for brevity we consider the case when the entrepreneur learns from the sale of shares when using equity-based crowdfunding; proofs for the other cases are similar and do not affect the results):

(38)Πl=(al−c)24,

where Π_l is the equilibrium profit of type l. Consider the potential deviation of l. Suppose l chooses α=2cah+c. Then, since the funders believe that this is type h when observing equity-based crowdfunding, as follows from the Section 3 analysis of this case:

(39)M=α(ah−c)24(1−α).

The entrepreneur of type l will then select:

(40)q=al−c2,

after selling shares and his payoff is (1−α)((al−c)24+M). Taking into account (39) and (40) his payoff then equals (1−α)(pq+M−cq)=(1−2cah+c)((al−c)24+α(ah−c)24(1−α))=(al−c)24+α4((ah−c)2−(al−c)2) that is greater than (38) so l will mimic h and this equilibrium does not exist.

Now consider a situation where h selects reward-based crowdfunding and l selects equity-based crowdfunding. We have:

(41)Πl=(al−c)24,

Πh=(ah−c)2−ε24.

The entrepreneur of firm h, however, thinks that:

Πh=(ah+ε−c)24,

h does not deviate to equity-based crowdfunding since he thinks that the price of shares is too small. Suppose that l mimics h and chooses reward-based crowdfunding instead. Since l is unbiased and since, the funders believe that the firm is h when observing reward-based crowdfunding, l chooses p=ah+c2. His payoff is:

(ah−c)24.

This is greater than (41). So this equilibrium does not exist.

Now consider the case where the entrepreneur of the low-quality firm is overconfident.

Consider a situation where l selects reward-based crowdfunding and h selects equity-based crowdfunding. We have:

Πh=(ah−c)24,

(42)Πl=(al−c)2−ε24.

The entrepreneur of firm l, however, thinks that:

(43)Πl=(al+ε−c)24,

h does not deviate to reward-based crowdfunding since it results in a smaller amount of profit: (al−c)24. Suppose that l mimics h and chooses equity-based crowdfunding instead. Two cases are possible. Case 1. ε<ah−al. In this case the scenario will unfold similarly to the case described in the beginning of the proof. l thinks that h has a better quality (al+ε<ah) so it will deviate to equity-based crowdfunding. All calculations are similar to (38), (39) and (40) except that a_l is replaced with a_l + ɛ. Case 2. al+ε≥ah. If al+ε=ah, the entrepreneur thinks that both types are identical so if he deviates to equity-based crowdfunding his payoff will be the same as it is in equilibrium. Therefore, he will not deviate. Now consider al+ε>ah. Two strategies are possible for the entrepreneur. First the entrepreneur can offer α<2cah+c. In this case, as follows from (15), M=ahc−c2α. This will not cover the optimal quantity of production from the entrepreneur’s point of view. Indeed, it is smaller than c(al+ε−c)2 when ah<al+ε. In this case his payoff equals (from his point of view): (1−α)Mc(al+ε−Mc), where M=ahc−c2α. This is less than (43) so the entrepreneur will not deviate using this strategy. Second the entrepreneur can offer α≥2cah+c. In this case M=α(ah−c)24(1−α). Two situations are possible. Case 1. α(ah−c)24(1−α)≥c(al+ε−c)2 or

(44)α≥2c(al+ε−c)(ah−c)2+2c(al+ε−c).

In this case, the firm will be able to produce the optimal quantity (from the entrepreneur’s point of view). The entrepreneur thinks that he will select:

(45)q=al+ε−c2

after selling shares and his payoff would be: (1−α)((al+ε−c)24+M)=(1−α)((al+ε−c)24+α(ah−c)24(1−α)). The derivative in α equals (ah−c)2−(al+ε−c)2. Since ε>ah−al, it is negative so the entrepreneur sells a minimum amount of shares (sufficient to cover the optimal quantity to produce from his point of view) which is given by (44). The entrepreneur expects that his payoff will be (1−α)((al+ε−c)24+α(ah−c)24(1−α))=(ah−c)2(al+ε−c)(al+ε+c)4((ah−c)2+2c(al+ε−c)). The difference between this and (43) equals 2c(al+ε−c)(ah−al−ε)(ah+al+ε−2c)4((ah−c)2+2c(al+ε−c)). This is negative because al+ε>ah, therefore the entrepreneur will not deviate. Case 2. 2cah+c≤α<2c(al+ε−c)(ah−c)2+2c(al+ε−c). The entrepreneur expects that M<c(al+ε−c)2. In this case his payoff equals (from his point of view): (1−α)Mc(al+ε−Mc), where M=α(ah−c)24(1−α). This is less than (al+ε−c)24 so the entrepreneur will not deviate. Overall this equilibrium exists if ε≥ah−al.

Consider a situation where h selects reward-based crowdfunding and l selects equity-based crowdfunding. We have:

Πh=(ah−c)24.

The entrepreneur of firm l thinks that:

(46)Πl=(al+ε−c)24,

h does not deviate to equity-based crowdfunding since the price of shares is too low. Suppose that l mimics h and chooses reward-based crowdfunding instead. The price offered is ah+c2. His payoff is:

(ah−c)24.

This is less than (46) if ε>ah−al.

Comparing both equilibria note that l is undervalued compared to the case with symmetric information and an unbiased entrepreneur. In the first case the mispricing equals the difference between (al−c)24 and (42). In the second case the mispricing equals the difference between (al−c)24 and its equilibrium payoff (1−α)((al+ε−c)24+α(ah−c)24(1−α)). Based on the analysis in Section 3 the latter is not less than (al−c)2−ε24 and in some cases it is greater depending on the choice of α. So undervaluation is smaller in the second case on average so the first case is eliminated by the mispricing criterion.

Proof of Proposition 5. For brevity consider the outline of the solution for case where the entrepreneur of type l is overconfident and the entrepreneur of type h is rational. Also off-equilibrium market beliefs are that the type is l. Type h never deviates since it recognizes that in this case its payoff is (al−c)24 which is lower than its equilibrium payoff for any value of x. So a potential deviation of type l is crucial. In reality type l should not deviate since “mixing” with a high-quality type is always good for a low-quality type. However, it is not necessarily the case from an overconfident entrepreneur’s point of view. If ε is sufficiently large, l will not want to be mixed with type h since he believes that he has a higher quality and so he will deviate to another strategy. The proof for mispricing is analogous to the end of the proof of Proposition Proposition 3. Under equity-based crowdfunding the entrepreneur’s payoff for each type is higher than it is under reward-based crowdfunding. The same holds for the pooling equilibrium case so, based on the mispricing criterion, a pooling equilibrium with equity-based crowdfunding dominates a pooling equilibrium with reward-based crowdfunding.

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Published Online: 2020-02-28

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Articles in the same Issue

https://doi.org/10.1515/erj-2019-0018

Keywords for this article

entrepreneurial finance; crowdfunding; asymmetric information; overconfidence; equity-based crowdfunding; reward-based crowdfunding; entrepreneurship and learning