Can platform competition support market segmentation? Network externalities versus matching efficiency in equity crowdfunding markets

• Author: Esther Gal‐Or,Nabita Penmetsa,Ronen Gal‐Or
• DOI: http://doi.org/10.1111/jems.12286
• Published date: 01 June 2019
• Date: 01 June 2019

Received: 13 February 2017

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Revised: 26 July 2018

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Accepted: 8 August 2018

DOI: 10.1111/jems.12286

ORIGINAL ARTICLE

Can platform competition support market segmentation?

Network externalities versus matching efficiency in equity

crowdfunding markets

Esther Gal‐Or

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Ronen Gal‐Or

2

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Nabita Penmetsa

3

1

Katz School of Business, Marketing and

Business Economics, University of

Pittsburgh, Pittsburgh, Pennsylvania

2

Department of Accountancy, Bentley

University, Waltham, Massachusetts

3

Department of Operations and IS, David

Eccles School of Business, University of

Utah, Salt Lake City, Utah

Correspondence

Esther Gal‐Or, Katz School of Business,

Marketing and Business Economics,

University of Pittsburgh, Pittsburgh, PA.

Email: esther@katz.pitt.edu

Abstract

We investigate whether, in spite of the existence of cross‐market network

externalities, platform competition can lead to segmentation of the two sides of

the market served by the platforms. We address this question in the context of

competition between two equity crowdfunding platforms that connect startups

looking for capital with prospective investors. Given the heterogeneity in the

populations of startups and investors in terms of the riskiness of the former

population and the degree of risk aversion of the latter population, we

investigate whether there exists an equilibrium where the two populations are

segmented to ensure an improved match between them. We find that the

segmenting equilibrium can arise only when compatibility in terms of their risk

profiles is of high importance to both populations, and compatibility is

significantly more important than the size of the network externality considered

by startups. Segmentation is likely to improve the welfare of both populations

when the basic benefit from any kind of match is relatively high.

KEYWORDS

analytical modeling, equity crowdfunding, network externalities, platform competition,

segmentation, two‐sided markets, vertical differentiation

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INTRODUCTION

Platforms are intermediaries that bring together groups of users in two‐sided networks. Platforms have emerged in

many different industries, including credit cards (cardholders and merchants), dating websites (men and women),

crowdfunding (investors and startups), peer‐to‐peer lodging (hosts and renters), peer‐to‐peer ride sharing (drivers and

passengers), and so on. One important characteristic of a platform that determines its value to each side of the market is

the size of the opposite side served by the platform. Because of these positive cross‐group external effects between the

two sides of the market served by the platforms, it has been recognized that platforms have the tendency to tip

(as shown by Caillaud & Jullien, 2003). This explains the phenomenon of market agglomeration, where all users on

both sides of the market choose one platform over the other. However, in some of the above‐mentioned examples, there

is great heterogeneity in the population of users on each side of the market. For instance, in dating platforms, men and

women greatly differ in their levels of education and income, and in crowdfunding platforms, investors differ in their

extent of risk tolerance and startups differ in their extent of riskiness. When such heterogeneity arises in traditional

one‐sided markets, firms tend to differentiate in the type of products or services they offer to segment the single

population they serve. Such differentiation allows them to successfully compete in the market, as each firm serves a

J Econ Manage Strat. 2019;28:420–435.wileyonlinelibrary.com/journal/jems420

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© 2018 Wiley Periodicals, Inc.

different segment of the population. In the present paper, we investigate whether, in spite of the existence of network

externalities, this strategy of product differentiation can also arise in the context of platform competition.

We address this question in the context of competition among equity crowdfunding platforms. By allowing startups

looking for capital to pitch their idea to the crowd of investors with access to capital, equity crowdfunding platforms

bring transparency to the secretive and exclusive high stakes world of early‐stage venture investing. Equity

crowdfunding platforms have raised more than $790 million since the regulations for Title II of the Jobs act came into

effect in September 2013. In addition to providing a website where startups can pitch their ideas and investors can learn

about startups, platforms also provide tools and services that enable investors to search for available investment

opportunities and to carry out the investment process. For example, Angellist offers features that help investors to filter

startups and to assess their quality by publishing a quality score for every startup and by allowing them to follow the

behavior of other investors. Moreover, some platforms conduct a very rigorous vetting process of the startups. This

vetting process may lead to only 1–2% of startups being approved for funding (in case of CircleUp and WeFunder,

according to Table 1), thus assuring investors about the quality of the startups listed with the platforms. Once the

investment decision is made, platforms handle the legal, accounting, and financial procedures required to complete

the investment. Such features are valued highly by investors and may drive their platform choice. Table 1 includes

information about the leading equity crowdfunding platforms in the US. As presented in Table 1, there is wide variation

in the pricing strategies used by crowdfunding platforms depending on the side of the market charged. There is also

variation in whether the payment is in the form of a membership fee or contingent on the size of the transaction. For

example, Angellist and CircleUp charge a commission or transaction fee (typically, a percentage of the funds raised or

invested). In contrast, Fundable and Crowdfunder charge a monthly subscription fee.

Equity crowdfunding platforms attract a wide spectrum of investors ranging from first‐time investors to experienced

venture capital funds. There is a high level of heterogeneity in the experience and risk attitude of such investors. For

example, an investor with no experience of either working or investing in early‐stage startups and who is trying to gain

some exposure to this asset class has a very high level of risk aversion. In contrast, an experienced and seasoned

investor like Jason Calanicus, who has gained significant experience in investing in several early‐stage startups

1

, has

greater tolerance to the risk involved in startup investing. Similarly, there is also great heterogeneity in the population

of startups active on crowdfunding platforms in terms of the expected return they offer and the risk they impose on

investors. Given the heterogeneity in the populations of investors and startups, crowdfunding platforms can offer added

value to the two sides of the market they serve by segmenting each population to ensure an improved match between

the riskiness of the startup and the risk profile of the investor who chooses to invest in it. The importance of a match

between investor risk profile and investment characteristics is well established in the finance literature (Hsu 2004;

Sorensen, 2007).

In this paper, we investigate whether such segmentation can arise in equilibrium when two platforms compete in

attracting both investors and startups. At the segmenting equilibrium, one platform acts as a matchmaker between

more risky startups and experienced investors who tend to be more tolerant to risk and the second platform matches the

opposite profiles of startups and investors, namely less risky startups with more highly risk‐averse investors. We model

the competition between the two crowdfunding platforms as a two‐stage game where in the first stage each platform

chooses its level of investment in the quality of service it offers to investors, and in the second stage, it chooses its fees.

We find that the segmenting equilibrium can arise only when compatibility in terms of their risk profiles is of high

importance to both investors and startups. Moreover, the importance of compatibility should be significantly higher

than the size of the network externality considered by startups in order for segmentation to arise as equilibrium. If such

TABLE 1 Leading equity crowdfunding platforms

a

Platform Amount raised No of deals Revenue model Deal flow

Angellist 710M+ 1,880+ Investors Vetted through syndicates

Fundable 411M+ 108+ Investors Open

CircleUp 390M+ 256+ Startups Vetted (2%)

FundersClub 100M+ 270+ Investors Vetted (2%)

WeFunder 55M+ 174+ Startups and Investors Open for listing, vetted (1%) for funding

a

Source: Data aggregated from individual web pages as of January 2018. https://angel.co/done‐deals, https://www.fundable.com/, https://circleup.com/,

https://fundersclub.com/, and https://wefunder.com/

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