Letter number 78 of November 2013


News : Crowdfunding

Crowdfunding means financing by collecting funds from a large number of people.  Funds, which may be provided in the form of equity, loans or gifts, are raised using internet platforms which offer investors a multitude of projects.

The idea of financing certain projects through a large number of investors is not new.  It is the basis of the creation of stock markets.  But crowdfunding, as it is being practised today, is closer to financial subscription for large projects (the Panama Canal, the Statue of Liberty) or the financing of companies that cater to a very large public which are held in great affection (newspapers, museums, etc.).

The recent and massive take-off of crowdfunding is closely linked to that of the Internet, and in particular, of social networks.  This type of funding is not only made possible by technological developments but also driven by the participatory logic behind Internet 2.0.  By definition, funding means putting agents who need funding into contact with other agents who have excess funds.  Crowdfunding developed on the Internet which is nothing if not the largest platform for putting people into contact with each other that has ever been invented.

Crowdfunding is in the process of being structured into a real industry.  From around $500m raised in 2009, crowdfunding has grown to $2.7bn raised in 2012 (1 million projects financed).  Forecasts for 2013 are $5.1bn. Even though this growth may be impressive, funds raised through crowdfunding still accounts for only 1% of funds raised in the world. 

Given the financial stakes (platforms generally take a cut of between 5 and 10% of the funds raised), the players have multiplied (600 platforms in 2012). Like any young industry, crowdfunding will no doubt become more structured and consolidate very rapidly.  Given that platforms need to reach a very large number of people and be credible, only a relatively small number of them will survive over the long term.

Crowdfunding initially developed outside the field of finance, mainly in the arts and humanitarian sectors.  We have seen fundraising via the Internet and social networks for the production of albums or films, but also appeals for donations by humanitarian organisations when natural catastrophes occur (and also political parties!).  Next, young entrepreneurs started using this method of fundraising to launch their activities.

The aim of crowdfunding is simple for the person behind the project or the company – raise funds that the traditional financial market cannot provide.  This is especially the case when the lack of maturity of projects presented explains why the traditional banking market may not be interested, as in the case start-ups, and/or when amounts to be raised are too low for traditional lenders to be interested (the time invested in analysing the project may outweigh the possible return in absolute value).  Finally, projects presented require the raising of funds that runs from a few hundred euros to a maximum of a few million. 

Over and above the financing aspect, the entrepreneur takes advantage of crowdfunding in order to validate its concept with a wide public and to rapidly raise and increase awareness of its project.

When it comes to the individual who is going to invest, things get a little more complicated.  The rationale depends on the type of products that are being backed by crowdfunding.  They may be:

  • Donations: subscription is then used in the regular functioning of cultural or non-profit organisations, or can be used on a one-off occasion for a special event.   For example, 1,536 donors enabled the Fine Art Museum of Lyon to top up public funds and acquire a painting by Ingres.

  • Donations in exchange for products: the newly formed company will thank those who have provided funds by giving them products.  The value of the products is most often way below the amounts contributed.  These gifts aim at creating a strong link between the company and subscribers and at raising awareness of the products.

  • Interest-free loans: this is where we find microfinance[1]. The loan is used to finance a small business, in a mature or in an emerging country. 

  • Interest-bearing loans: either directly to firms (but this raises the issue of getting around the banking monopoly if there is one as this occurs in some countries) or via funds which in turn lend to a pool of firms.

  • Equity: the investment can take the stake of a real stake in the share capital of the company being financed.

The 3 first types of investment fall under the domain of philanthropy, social funding or solidarity.  It should be noted however that interest-free loans rely on the mechanisms underlying finance.  This is in fact essential in order to rationalise and optimise the efficiency of the humanitarian action, as players in the field of microfinance often remind us.

Only the last 2 types of crowdfunding (interest-bearing loans and acquisition of a stake in the capital) are really based on financial logic, i.e. investing with the hope of a return[2]. But the very high risk of the projects, with the low level of the initial investment for the investor, and generally the lack of an in-depth analysis of the project (impossible and not economic) lead us to wonder whether the investor’s logic is not closer to that of a lottery player (who in addition gets to feel good about helping to boost the economy).

The development of crowdfunding is coming up against legislation that is most often not adapted to this new approach to funding.  Accordingly, crowdfunding platforms have to keep in line with anti-money laundering regulations, payment services regulations, the banking monopoly if any, rules for making offers of financial products to the public.  Remember that the main aim of these regulations, for the most part, is to protect the financial investor.

We note, however, that those seeking to promote crowdfunding have argued for the simplification of regulations by claiming that the risk is low in view of the small amounts at stake for the investor.  This is one way of looking at things, but in our view does not reflect economic reality.  Investing in projects that have not yet been tested, very far upstream, means that the investor is taking the highest possible risk in finance and it matters little whether he or she is investing €100 or €10,000.  Nevertheless it is true that the impact on his or her overall assets will be minimal if the investment is only €100.

The characteristics of this type of investment (very high risk, lack of solid financial criteria for supporting the investment thesis), are reason enough for it to account for only a very marginal amount of any investment portfolio. 

We believe, fundamentally, that crowdfunding, regardless of the form it takes, can only be based on financial motivations.  It should also correspond to motivations that are moral or fun-based (for example guessing which project is going to work).  Paradoxically, while crowdfunding is on the margin of finance, the new force that is driving it, seems to be giving a meaning to finance within the wider public and making it appear “cool”, which is not a bad thing in the current economic context.  . .



[1] For more see the Vernimmen.com newsletter  n°22, dated  January 2007.

[2] Supported in some cases by tax incentives.


Statistics : Net debt to EBITDA ratios for European LBOs

Statistics for the first 9 months of 2013 show a surge in the appetite of lenders for LBOs:

  • Senior loans granted to European LBOs have reached €36bn which is their highest level since 2008, the double the level of 2012 and roughly the same amount as in 2004;

  • The share of equity financing has kept on decreasing since the beginning of 2013 from 50% in January to 35% in September;

  • Mezzanine finance has all but completely disappeared and has been replaced by high yield bonds.

Research : Say on Pay: what are the consequences for firms?

Edith Ginglinger, University Paris-Dauphine


Say on Pay can be either non binding (as in the USA, UK, France, Spain, Switzerland) or bidding (as in the Netherlands, Sweden or Germany). In the first case, shareholders are asked about their view on compensation of top managers; in the second case, they have to approve it. In case of a non binding vote, the presentation of information on compensation due or allocated to each corporate officer for the past financial year must be followed by a consultative vote of shareholders.  Accordingly, this is a vote after the fact and a negative vote by shareholders at the meeting will not call into question the compensation.  In most countries having implemented a non binding version of the Say on Pay, the Board of Directors will have to discuss the issue at a future meeting and publish a notice setting out its intentions on the basis of the expectations expressed by shareholders on the company's website.  

Can such a consultative vote have an impact on management’s compensation and on the value of firms? The existence of Say on Pay will strengthen the voice of shareholders and in this way, enable Boards to negotiate better compensation packages with managers, who will be keen to avoid a negative vote which could be taken up in the press.  Critical voices claim that since Say on Pay is not binding, it is unlikely that it will have an observable effect and that at worst, it could result in sub-optimal compensation packages if directors follow the wishes of shareholders who are poorly informed.

Say on Pay was introduced in other countries earlier on in the century - United Kingdom (2002), USA (2010, Dodd-Frank Act), Australia (2005), Germany (2009).  What lessons can be learnt from the studies[1] that have been carried out in these countries?

Firstly, in the USA, where consultation of shareholders can occur at a frequency that varies from one to three years, firms with “abnormally” large compensation packages (compared with comparable companies) are also those for which managers recommend a consultative vote every three years only instead of an annual vote.  Regardless of the frequency, the resolution on compensation is approved and is adopted by 98% of firms and approved by less than 70% of voters in 7 to 8% of cases only.

The first issue raised by the studies is that of value creation.  The case of US firms at which shareholders requested the introduction of Say on Pay before it became mandatory under the Dodd-Frank Act in 2010, and while managers were opposed to it, is interesting.  By comparing firms for which the proposal was adopted and implemented to those where it was rejected, the authors show that consultative voting, on average, creates value.  In the United Kingdom, the stock price reaction to the unexpected announcement of the Say on Pay regulation in 2002 was positive for firms where managers were overpaid given their characteristics, and in particular in the presence of poor performances.  Accordingly, investors perceive Say on Pay as a mechanism that makes it possible to exert more pressure on the Board of Directors and on management, resulting in improved performances.  

On the other hand, the impact of the consultative vote on management compensation is insignificant.  Studies do not reveal any major change – at best, a very slight decrease in the rate of increases – following its introduction in the USA.  For the United Kingdom, Say on Pay has had a moderating effect on compensation but only in the presence of poor performances.  However, the simple fact of the existence of a substantial number of negative votes, even when the resolution is adopted, results in the most controversial aspects of compensation packages being called into question.  

Like any regulation, Say on Pay has had consequences in the USA that were unexpected.  The most important has been an increase in the influence of proxy advisory firms and in particular ISS (Institutional Shareholder Service).  Institutional investors rely on their recommendations when fulfilling their voting obligations and more than half of all firms revise their compensation policies upwards in order to comply with their criteria.  The few negative votes that were recorded were the result of a recommendation by ISS.

In conclusion, consultative voting encourages dialogue between shareholders and managers on the issue of compensation, even if its impact on the moderation of compensation packages is modest.

[1] These studies are available on the site: http://papers.ssrn.com or can be requested from the author. They are Cai and Walking (2010),  Cunat, Gine and Guadalupe (2013), Ertimur, Ferri and Oesch (2013), Ferri and Oesch (2013), Ferri and Maber (2013), Iliev and Vitanova (2013), (Kaplan, 2012), Larcker, McCall and Ormazabal (2013).


Q&A : When calculating net present value, why not capitalise intermediary flows at the rate at which they will be reinvested and not at the cost of capital?

We recall that when calculating net present value, flows are discounted at the cost of capital of the project[1].  Of the project because the company may be considering making investments that present a different risk from that of its present operating asset.  The use of its present cost of capital would accordingly not make sense as the risk would not be sufficiently remunerated (if the investment is riskier than the company's present operating asset) or excessively remunerated if this were not the case.

Rather than discounting intermediate flows, some capitalise them until the end of the project, then discount the final value that results to get the net present value of the project.  Why not? This amounts to the same thing as standard discounting since the capitalisation rate and the discount rate are identical and correspond to the cost of capital.  It’s just a little more complicated than the standard NPV. 

On the other hand, making an assumption that the intermediary flows of an investment project are reinvested at a different cost of capital from the project seems to us to be dangerous and we advise against this practice.

Either you take a lower rate than your cost of capital.  And here, there are two possibilities: Either you have placed the funds in investments that are less risky than your project, which means a lower reinvestment rate for intermediate flows.  But when you discount your final value, it will be the result of a mix of risky flows (those of the project) and other less risky flows, so you are not well-founded in discounting this final value at the cost of capital of the project.  Or you have invested the funds in projects that earn less than their cost of capital, which is not what is expected from a responsible manager...

Or you take as a rate for investing the funds, a rate that is higher than your cost of capital.  And the reader will no doubt be thinking that you have made this assumption to improve your net present value, which otherwise, would perhaps have been negative.

In short, why get complicated when you can stay simple.



[1] For more on this, see chapter 30 of the Vernimmen