Two’s a Company, Three’s a Crowd: Contractual Deal Breakers in Securities-based Crowdfunding for Later-stage Venture Capital

Abstract

Crowd-based means of funding are emerging as a valid novel way of providing scarce seed-finance for entre-preneurial ventures. In recent years, securities-based variants such as equity crowdfunding or initial coin offer-ings (ICOs) are increasingly attracting higher funding amounts than reward-based models, in particular for commercially oriented ventures. However, securities-based crowdfundings also come along with the more com-plex contracts, since they introduce a large set of new shareholders in the firm, possibly with voting, information and cash-flow rights. This might have implications for the ownership structure and future governance of a com-pany, and in turn influence the evaluations by prospective investors. This paper is concerned with exploring potential knock-out criteria in securities-based crowdfunding contracts and to what degree they serve as a deal breaker for the investment decision of subsequent professional venture investors. Using an explorative mixed methods approach, we find empirical evidence that, e.g., an inflated capitalization table owing to crowd inves-tors holding direct securities in a company, redemption and voting rights by the crowd, as well as the non-existence of a drag-along clause, lead venture capitalists and business angels to refrain from an investment in an otherwise attractive but such-funded start-up firm. We conclude that contractual frictions play a decisive role in whether entrepreneurs can combine crowd-based means of funding with traditional forms of venture financing. Theoretical and managerial implications are discussed.