Cohesion among crowd investors in the presence of moral hazard

Abstract

ABSTRACTThis article studies cohesion among crowd investors when investments in innovative start-ups are staged. The presented model determines both, optimal entrepreneurial effort and the equilibrium degree of cohesion among crowd investors taking into account that there is single-sided moral hazard. Cohesion measures the probability that a sufficiently large number of crowd investors decides to provide capital. Thus, cohesion also captures the probability of successful crowdfunding. The model demonstrates that entrepreneurial effort is strong when cost benefits are substantial. Thus, cost benefits related to crowdfunding help overcome moral hazard frictions. This translates into greater cohesion among crowd investors because they can force the entrepreneur to share profits. Greater profit share simply increases the crowd’s expected profits, thus encourages cohesion, and eventually facilitates crowdfunding success. However, it simultaneously weakens the entrepreneur’s incentive to exert effort, and exacerbates moral hazard, which reduces expected profits. We demonstrate that the net effect of profit sharing on cohesion is positive below a certain threshold, and turns negative when the crowd’s share of profits becomes too large.