"Investors lack expertise"

Crowdinvesting sounds appealing to some start-ups, but many who try it fail. Finance professor Markus Petry explains why.

Investing a small sum in a start-up and perhaps profiting from the next Google or Facebook: This is what users of crowdinvesting platforms dream of. 100 million euros have flowed into this form of financing by 2019 in Germany alone. But the success is moderate: every third of the corresponding start-ups goes bankrupt, as Markus Petry from the Wiesbaden Business School found out in a study. In an interview, he talks about the reasons for the high failure rate, the risks for investors and what the platforms can do better.

Mr. Petry, according to your survey, a third of all crowdinvesting start-ups go bust. Is that because of the companies or because of the financing instrument?

There is actually nothing to be said against crowdinvesting per se. The largest market is real estate financing, which has developed very positively and has seen a pleasingly low number of defaults, which is partly due to the positive economic conditions of real estate. But with startups, what I call adverse selection kicks in.

You have to explain that.

What I mean by that is that the founders who resort to crowd money have usually already been rebuffed by all other capital providers. When banks and venture capitalists say a startup isn't promising, they rely on their expertise. An expertise that investors on crowdinvesting platforms usually don't have.

But couldn't founders consciously rely on this grassroots form of financing?

It's possible, but not reasonable. After all, business angels and VC funds not only bring money, but also know-how that can help start-ups. They can accompany the development process and establish contacts. Crowdinvesting does away with all that.

So investors are unlikely to find the next Google on crowdfunding platforms?

There are very few unicorns that have relied on crowdinvesting. Recently, for example, it was Revolut, the British fintech. But they used that as a complement to their venture capitalists. In my opinion, it was mainly about marketing, so they could engage customers and raise their own profile.

There are no such outstanding cases in Germany?

Not on this scale, and that is also the problem. VC funds work according to the principle: I support ten start-ups, and if only one of them does exceptionally well, it makes up for the losses of the others. Theoretically, investors on such platforms could also proceed in this way and invest in several start-ups. But they won't even find the one runaway winner that makes up for nine losing deals. I've done the math on this: All crowdinvesting start-ups in Germany have lost 26 million euros in investment money since 2011, and in return only ten million euros have flowed back to the investors. So even if you had invested extremely diversified, they would have lost a lot of money.

Even if crowdinvestors had invested extremely diversified, they would have lost a lot of money.

Markus Petry

So should investors stay away from it completely?

They should at least be aware that crowdinvesting is extremely risky. Studies have shown that most investors are aware of the risks and take them sight unseen. Most are what we now casually call "old white men" who have significant financial resources. For them, it's a form of play money, they view crowdinvesting a bit like a casino.

Would the platforms have to do a better job of filtering to keep the failure rate down?

The platforms are in a quandary: on the one hand, they want to attract as many companies as possible to their sites, because they earn from the transaction fees. On the other hand, they can't afford too many failures either, because then customers will stay away. However, they probably accept some failures, otherwise the rate cannot be explained. But at least the most serious cases could be dealt with by the providers through better contract conditions.

You mean fraudsters?

Not only. Fraud was involved in Unyte Yoga, for example, where the crowd platform had already transferred the investors' money to the start-up, but then nothing happened with it. The platform can hardly prevent misappropriation of funds.

What I mean here shows the example of Protonet, which wanted to offer a cloud for everyone. Assets were shifted from one company to another, and the investors were left holding the bag. But according to the terms of the platform, it was legal. Maybe if you start there, it could drive down the odds.

Thank you very much for the interview.

Personal details: Markus Petry is Professor of Financial Services Controlling at the Wiesbaden Business School. Among other things, he conducts research on crowdinvesting, robo-advisor offerings and digital investment. Previously, he worked at Deutsche Pfandbriefbank, Aareal Bank and the management consultancy McKinsey. He studied business administration at the University of Frankfurt, the College of New Jersey and the Sorbonne and holds a PhD in economics.