VC investment slowdown: an important test for equity crowdfunding

In 2015, venture capitalists invested $58.8 billion in the United States, topping the figures for the previous two years by a substantial margin. In 2016 investors have been substantially more cautious, and if the current slowdown is a course correction rather than a blip, it will also be an important test for the nascent equity crowdfunding market.

Many equity crowdfunding platforms have sprung up, including AngelList, FundersClub, Wefunder, OurCrowd and SyndicateRoom.

To succeed, these two-sided markets need enough good investors to be attractive for entrepreneurs to post their ventures, and enough high-quality ventures to be worthwhile for investors to spend time and capital on them. If early-stage capital becomes tougher to obtain, only platforms that are surfacing high-quality deals and matching them efficiently will be able to keep growing.

Lead-Crowd Syndication

A particularly interesting feature within the equity-crowdfunding world involves syndication between the crowd and a lead investor. Platforms that have introduced syndication, like AngelList and SyndicateRoom, have done it to address the problem of information asymmetry.

Traditionally, evaluating a startup online is difficult. First-time entrepreneurs, unlike Uber drivers or Amazon products, do not come with ratings or reviews. Moreover, investors seeking to invest $1,000 per deal have little incentive to spend time and effort to conduct due diligence on each startup they select online.

Syndication solves this issue by relying on professional investors who act as leaders for smaller investors to follow.

Christian Catalini
Christian Catalini

These lead investors have established reputations and investment track records. In the United States, accredited investors can back these leads by investing in one or more of their online deals.

Leads have an incentive to curate good deals, conduct due diligence and monitor progress for the crowd since they receive a percentage of the upside if the startups are acquired or go public.

Investors benefit by gaining access to early-stage opportunities that they would not otherwise have been able to discover. Entrepreneurs are motivated to deliver good returns because their reputations are on the line with the leads and with the crowd. And good returns motivate backers to reinvest with the same leads over time.

Attractive Alternative

This type of model has the potential to increase competition among low- and mid-tier VC firms because it presents an attractive alternative for startups and investors. It also seems to be enticing some top VC firms to co-invest with the crowd when a high-potential deal is identified.

According to a recent study, my colleagues and I found that as of February 2015, AngelList had about 120 active syndicates, some of which had co-invested with top-tier VC firms, such as Andreessen Horowitz, Sequoia Capital and Khosla Ventures.

But the data so far seems to be skewed in a few directions. The top five lead investors in our study focused on consumer-facing ventures. Those investors all had easily interpretable reputations from prior investments in high-profile ventures, like PayPal and Facebook. And all five lived in the San Francisco Bay Area.

This leaves us with some unanswered questions: Will syndicates be able to affect startups in other fields? Will lead investors from other geographies also be able to attract capital? Will syndicated deals perform well in subsequent funding rounds if funding becomes scarcer?

Syndicates could become the killer app of equity crowdfunding, but it’s too early to tell. What we do know is that their characteristics significantly improve the matching between startups and investors online by reducing the information-asymmetry problem. If the current slowdown in investing is a real trend, it will also be a test to discover which equity crowdfunding models are here to stay.

Christian Catalini is 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. He also is the co-author of “Are Syndicates the Killer App of Equity Crowdfunding?” published in the California Management Review.

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