Are Syndicates the Killer App of Equity Crowdfunding?
Ajay Agrawal, Christian Catalini, and Avi Goldfarb
Information asymmetry is a primary barrier to the financing of early-stage ventures. Investors will hesitate to invest in a promising new project if they don’t have enough information to assess its true value. This is because most information that is predictive of success is tacit and unspoken -- the personalities and relationships of founders, for instance, is of critical importance. But information about founders is difficult to codify and credibly communicate. Markets for early-stage capital use a variety of mechanisms to overcome these hurdles. Venture capitalists invest heavily in due diligence and monitoring for the firms in their portfolios. They structure financing in stages, so that they can cut off new financing from unsuccessful firms. In addition, they “syndicate” by making investments together with other VC firms. Syndication enables a VC firm to diversity its portfolio while providing incentives for due diligence and sufficient financing.
Equity-based crowdfunding is a relatively new tool for investors to finance early-stage ventures. Often “the crowd” is limited to accredited angel investors only. Equity crowdfunding has enabled angel investors to pursue a wider portfolio of investments than those available in their specific location. But information problems still persist. Relying exclusively on online information makes it difficult to assess the founding team in terms of their grit, determination, interpersonal dynamics, and trustworthiness.
Equity crowdfunding syndicates can overcome many of these challenges. Like venture capital syndicates, crowdfunding syndicates enable a diversified portfolio while ensuring that due diligence is performed. But they differ from VC syndicates in that they serve primarily as a way for well-informed lead investors to leverage their knowledge and bring in substantial funds from a less well-informed “crowd.”
“Equity crowdfunding syndicates serve primarily as a way for well-informed lead investors to leverage their knowledge and bring in substantial funds from a less well-informed crowd.”
Equity Crowdfunding Syndicates
There are many equity crowdfunding platforms, but only a handful (like AngelList) allow syndicate-like investing. On AngelList, individuals, angel groups, and venture capital funds can form syndicates. Individual investors create a syndicate profile online, providing basic information for potential backers such as size. As a syndicate “lead,” the investor commits to providing a written investment thesis for each investment. Other accredited investors who apply to participate in a syndicate are called “backers.” These backers follow the syndicate lead by agreeing to invest in each of the lead’s future deals. As of February 2015, AngelList had approximately 120 active syndicates.
Solving the Information Asymmetry Problem
Syndicates employ a market design feature that enables a division of labor among investors. Lead investors conduct due diligence and monitor progress on behalf of other investors. Syndicates are designed such that lead investors endure a reputational and financial penalty for poor performance (and rewards for good performance). This setup addresses three primary difficulties presented by the information asymmetry problem.
The first problem is general awareness. It’s difficult for many investors to learn about early-stage deals. The second problem is transaction costs. The overhead associated with small, ad hoc equity investment increases with added communication and delivery costs. The third problem is due diligence. Monitoring and assessing companies often requires face-to-face interaction. Costs increase with distance between the investor and the venture.
Syndicates amplify the impact of high-performing angel investors by providing them with a more explicit reputation and online tools, both of which can be leveraged to attract capital from a global rather than local community of investors. Equity-based crowdfunding platforms enable new and better ways for investors, entrepreneurs, and policymakers to address issues of information asymmetry inherent in early-stage ventures.
Christian Catalini is the Fred Kayne (1960) Career Development Professor of Entrepreneurship and Assistant Professor of Technological Innovation, Entrepreneurship, and Strategic Management at the MIT Sloan School of Management. (firstname.lastname@example.org)
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