Testing-the-Waters Policy With Hypothetical Investment: Evidence From Equity Crowdfunding

Dipping toe in water

“Testing-the-waters” (TTW) is an approach in entrepreneurship practice and policy that refers to soliciting indications of investor interest prior to filing disclosure material. It allows entrepreneurs to see whether going ahead with efforts to raise capital are worthwhile. On the other hand, TTW may unfairly induce investors to invest without proper disclosure. In their article, Douglas Cumming of Florida Atlantic University, Fabrice Hervé professor of Université de Bourgogne, Elodie Manthé of Université Savoie Mont-Blanc, and Armin Schwienbacher of Université Côte d’Azur speak about this much debated approach in entrepreneurship practice and policy. Highlighting the innovation through digitization in exploring the entrepreneurial fundraising process, their paper “Testing-the-Waters Policy with Hypothetical Investment: Evidence From Equity Crowdfunding” in Entrepreneurship Theory and Practice discusses the hypothetical bias evident in nonbinding commitments. Beneath the abstract for their academic paper the authors discuss the research into the issue.

Digitization has enabled “testing-the-waters” in entrepreneurial finance whereby investors can make nonbinding commitments in equity crowdfunding prior to an actual campaign to ascertain interest in the project. We consider whether these nonbinding equity investment commitments are informative about actual investments during the campaign and, thus, ultimate startup funding success. The data indicate that only 18% of nonbinding commitments are, in fact, invested. The evidence is consistent with hypothetical bias. Hypothetical bias is significantly less pronounced among women and among investors living in higher income areas or in areas with higher levels of education. While investment intentions are only partially reliable at the individual level, the aggregate amount of collected investment intentions is a strong predictor of campaign success. We investigate alternative reasons for withdrawals, such as lying and informational motives, both of which we find implausible alternatives to hypothetical bias.

Fabrice Hervé (top left), Elodie Manthé (top right), Douglas Cumming (bottom right), and Armin Schwienbacher (bottom left).

Innovative small businesses depend significantly on external funding to grow, especially equity investors who are willing to bet on their future prospects. While fundraising is time-consuming and entails costs, entrepreneurs might be tempted to “test the water” (TTW) by simply soliciting investors’ interest before going through the lengthy process. Digitalization of finance has made it possible for small business to run equity crowdfunding campaigns, but also to initiate a TTW process online and quite easily.

Under the Jumpstart Our Business Startups (“JOBS”) Act of April 5, 2012, in the United States, the TTW rule can be used under Title IV, but not under Title III, which means startups could not rely on such a testing-the-waters rule in an equity crowdfunding context. Consequently, in the U.S., Congress and the Securities and Exchange Commission (SEC) have debated a ban on Title III issuers from “testing-the-waters” (TTW), which refers to soliciting indications of investor interest prior to filing disclosure material with the SEC. It is argued that TTW could induce investors to invest without proper disclosure. Also, there is anecdotal evidence that investors often retract so that it may mislead entrepreneurs unnecessarily. This policy debate has been going on without empirical evidence.

We test the usefulness of TTW in the equity crowdfunding setting with data from the largest and oldest French platform WiSEED, where TTW is common practice since 2011. There, current members of the platform can vote on various projects and express non-binding investment intentions. Entrepreneurs who collect enough positive votes and investment intentions are then allowed to run a campaign. In our study entitled “Testing-the-Waters Policy with Hypothetical Investment: Evidence from Equity Crowdfunding” appearing in Entrepreneurship Theory and Practice, we asked the following research questions: are the non-binding commitments collected during the TTW phase a good predictor of the fundraising outcome in equity crowdfunding? And do unaccredited investors truly invest what they said they would?

Our study shows that only 18 percent of nonbinding commitments are transformed into real investments. The evidence is consistent with hypothetical bias, a phenomenon typically observed in marketing and explained by the fact that individuals often decide predominantly based on “desirability” when confronted to a hypothetical situation, but based on “feasibility” when in a real situation. We also find that the bias is significantly less pronounced among women and among investors living in higher income areas or in areas with higher levels of education.

While investment intentions are only partially reliable at the individual level due to major retractions, the aggregate amount of collected investment intentions is a strong predictor of campaign success. We therefore conclude that at the aggregate level, TTW policy is a good predictor of fundraising outcomes and thus should also be promoted in the context of unaccredited investors. It would offer important information to entrepreneurs before investing substantial amount of time and money in their fundraising campaign.

While our work directly relates to this policy debate, we further contribute to academic research in two important ways. First, we document a new cognitive bias (the hypothetical bias) by investors. Second, more importantly, we are able to compare investor intent and action, while other, real-case (i.e., outside lab experiments) studies have focused either on investor intention or action.

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