The Equity Crowdfunding Paradox

By Jorge Sanchez III Partner, Nouvantage.com, Crowdfund Beat Guest Contributor,

Crowdfunding is a broad classification used to categorize a variety of modern digital funding activities aimed at engaging wide networks of people. In this article I will refer to the equity crowdfunding of venture capital.

Investing is a risk-taking endeavor where return on investment is the premium harvested by investors for allocating funds to a venture executing a business plan and confronting the risk of failure and loss of capital. The uncertainty of the outcome that the business pursues gives rise to the primary barrier to investment, information asymmetry. Investment decisions are information driven and based heavily on knowledge that investors can derive from their analysis of the team, the business plan, and the market. Investors commit a great deal of time, effort, and money on conducting due diligence to determine to the best of their understanding the likelihood of a venture being a success and them harvesting the return on their investment.

Crowdfunding is designed to increase the access to capital for small businesses and startups by allowing for them to solicit and raise a smaller dollar amount per investment from a larger pool of investors, which is the inverse of traditional private placement where a small number of investors provide a greater share of the funding. This is where the paradox of equity crowdfunding arises; Because the average ticket is greatly reduced in size, the cost of due diligence is no longer economically feasible and must be reduced if equity crowdfunding for new ventures is to achieve wide adoption as an asset class. By implementing the economic principle of specialization throughout the investment process, the necessary efficiencies for the economic feasibility of equity crowdfunded venture capital can be realized.

There are three major costs that are associated with the information asymmetry problem as it pertains to crowdfunding: awareness, due diligence, and transactional. Minimizing these costs through the economic principle of specialization will greatly reduce the amount of friction currently involved in conducting private placement activities. This can permit a wider adoption of private placement of venture capital via equity crowdfunding by investors in the general public. This specialization has three major actors: the portal, the lead investor, and the syndicate.

Awareness

The issue of minimizing the cost of the awareness is solved by both the platform and the lead investor, each specializing in different activities, that ultimately allow for members of a wider audience to become aware of potential investments. By providing a platform for deals to be posted and having registration requirements, portals conduct an initial screening that makes it easier for people to locate potential ventures to invest in. Because lead investors have a transparent investment record, they allow for deal seekers to quickly sort through the noise created by the wave of new opportunities, and follow or join syndicates that bring to their attention preselected opportunities that meet their often value-based investment criteria.

Due Diligence

Since the due diligence process contributes tremendously to the decision to invest in an opportunity, it is a paramount part of the process that is considerably costly, timely, and burdensome. It is because of this that it may be the greatest source of friction and cost to overcome for the successful adoption of equity crowdfunding for venture capital. Crowdfunding is designed for each of many contributors to invest a relatively small amount into the venture. However, the cost, knowledge, and experience necessary to conduct accurate due diligence is beyond both what can be expected from the investor and what is economically justifiable for the size and expected value of the investment. This creates a paradox that excludes the target demographic of crowdfunding from easily adopting or being successful in equity crowdfunding for venture capital. By utilizing a syndicate with a lead investor, that is ideally and most likely local to the venture’s management team, the costs of conducting due diligence can be absorbed by the lead investor and repaid to them in the form of carried interest from the syndicate. This enables a specialist to efficiently conduct due diligence, provide validation for promising opportunities, and promote them through their syndicate. With this cost greatly reduced for the people equity crowdfunding is intended to serve, the biggest non regulatory challenge facing this new industry is overcome as people can now focus on providing capital to projects that resonate with them while a professional investor works to only provide them the best opportunities.

Transaction

The introduction of funding portals has been a great innovation that has created the possibility of crowdfunding as we imagine it. It is also a great contributor to the reduction of transaction costs that were previously a critical obstacle for the wider investor base to participate in the private placement market. By providing a platform to find and conduct the trade, the costs for investors to participate in this market has been dramatically reduced by the innovation of funding portals.

The costs associated with investing is generally informational and often driven by the gathering and analysis of information.   If equity crowdfunding for new venture development is to achieve success, the costs of doing so needs to be reduced. Because information asymmetry is a fundamental problem that is critical to investing and crowdfunding, reducing it through the use of platforms and syndicated lead investors lowers the friction to participate and reduces the failure rate of investments. Both of which are necessary to have a significant adoption of crowdfunding and having the market survive as a whole.

 

Tags: , , , , , , , , , , , , , , , , , , , , ,

HEADLINE NEWS

Yahoo FinanceCan Equity Crowdfunding Be Fixed?Yahoo FinanceWith the adoption last year of the Regulation Crowdfunding (Reg CF) exemptions by the Securities and Exchange Commissionprivate companies can now raise capital from all 230 million American adults. Until now, businesses have b [...]

Phys.OrgCrowdfunding expands innovation financing to underserved regionsPhys.OrgThe study found that crowdfunding in a region, and in particular successful technology campaigns, appeared to cause an increase in venture capital funding in the region. This occurs as venture capitalists [...]

Telegraph.co.ukWellesley to freeze crowdfunding campaign as it courts City investorsTelegraph.co.ukPeer-to-peer property lender Wellesley is suspending its crowd-funding efforts as it courts City investors to help fund its expansion. Wellesley is set to pause its campaign that asked s [...]

Mountain XpressFaces in the crowd: WNC crowdfunding initiatives | Mountain XpressMountain XpressEach week, Xpress highlights notable WNC crowdsourcing initiatives that may inspire readers to become new faces in the crowd. This week features an album ...and more » [...]

Amanda Todd's mom nears crowdfunding goal to attend Netherlands trialCTV NewsThe mother of a B.C. teen who died by suicide after being sexually exploited online is raising money to travel to the Netherlands for the trial of a Dutch citizen who will eventually be extradited to Can [...]

Crowdfunding Helps Little Red Feather Buy Horse ShareBloodHorse.com (press release) (registration) (blog)"We have the budget for one or more additional purchases under this current Crowdfunding initiative," said LRF's founder and managing partner, Billy Koch. "We n [...]

EntrepreneurHow Will Donald Trump's Presidency Affect Crowdfunding?EntrepreneurDonald Trump will soon be inaugurated as the country's 45th president and will potentially impact the burgeoning crowdfunding industry in a "yuge" way. Before I share my thoughts as one [...]

VentureBeatHere's how regulation crowdfunding performed in 2016VentureBeatIn May, the third and final part of the 2012 JOBS Act, Regulation Crowdfunding, went into effect and 2016 ended with much promise for entrepreneurs seeking funding and our government seeking jobs. Regulatio [...]

STV NewsCouple launch crowdfunding campaign to start own energy firmSTV NewsA couple fed up with the performance of energy suppliers are launching a crowdfunding campaign to start their own company. David Pike and Karin Sode said their firm Our Energy will be "completely transpar [...]

Forbes'Star Citizen' Lumbers Into 2017 With $141 Million In CrowdfundingForbesWhile HL3 is more a question if Valve ever feels like making video games again, Star Citizen is another animal entirely, a game that's very publicly in development with a practically unlimited [...]

CFB Finance

Marketwired

  • Crowdfunding
  • Crowdfund
  • Peer to Peer Lending
  • FinTech
  • Reg A+
  • Reg CF
  • Crowdfunding USA

Press Release

Live Crowdfunding .tv

What's Next Step in Regulation A+ JOBS ACTS Title IIII :L Interview : Steve Cinelli with Brian Korn Securities and Crowdfunding/Peer-to-Peer Lending Lawyer, Watch more video library | Conference | Interview | Campaign Showcase | Research | Education |