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.

 

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