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CEP Discussion Paper No 1498 September 2017 Equity ISSN 2042-2695 CEP Discussion Paper No 1498 September 2017 Equity Crowdfunding and Early Stage Entrepreneurial Finance: Damaging or Disruptive? Saul Estrin Daniel Gozman Susanna Khavul Abstract Equity crowdfunding (ECF) offers founders of new ventures an online social media marketplace where they can access a large number of investors who, in exchange for an ownership stake, provide finance for business opportunities that they find attractive. In this paper, we first quantify the evolution of the ECF market in the UK, the world leader, as well as the benign regulatory environment. ECF already represents more than 15% of British early stage entrepreneurial finance. We then use qualitative methods to explore three research questions. First, do these large financial flows via ECF platforms supplement or merely divert more traditional forms of funding for entrepreneurs? Second, do investors understand and appropriately evaluate the risks that they are bearing by investing in this new asset class? Finally, does ECF finance bring with it the spillovers, e.g. advice and guidance critical to entrepreneurial success, associated with other sources of funding such as Venture Capital? Our study is based on extensive interviews with investors, entrepreneurs (including some who chose not to use ECF in favour of traditional funding sources) and regulators. We conclude that ECF provides real additionality to the sources of entrepreneurial finance while not bringing major new risks for investors. This suggests other jurisdictions might consider implementing the British “principles based” regulatory framework. Keywords: equity crowdfunding, early stage entrepreneurial finance, financial regulation, investor choices JEL: G3; G21; L26; M21 This paper was produced as part of the Centre’s Growth Programme. The Centre for Economic Performance is financed by the Economic and Social Research Council. The authors gratefully acknowledge research assistance from Lolo Chen, Linde de Nie, Mary Fox, Andrea Guerini-Rocco and Ines Steimelweger. We have benefited from extensive discussions with Luca Grilli, Andrea Hermann, Lukas Held, Werner Liebregts Mark Sanders and anonymous referees. We are responsible for any remaining errors. Saul Estrin, London School of Economics and Centre for Economic Performance, LSE. Daniel Gozman, Henley business School, University of Reading. Susanna Khavul, London School of Economics, Centre for Economic Performance, LSE and San Jose State University, USA. Published by Centre for Economic Performance London School of Economics and Political Science Houghton Street London WC2A 2AE All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the publisher nor be issued to the public or circulated in any form other than that in which it is published. Requests for permission to reproduce any article or part of the Working Paper should be sent to the editor at the above address. S. Estrin, D. Gozman and S. Khavul, submitted 2017. 1. Introduction The literature has long identified the potential relevance of entrepreneurship for innovation, economic growth and employment creation (Schumpeter, 1934; Baumol, and Strom, 2007; Carree and Thurik, 2003; Braunerhjelm, Acs, Audretsch, and Carlsson, 2010). However, there are also acknowledged deficiencies in the market for early stage entrepreneurial finance (HMSO, 1971; 1991; Denis, 2004; Parker 2009), which may limit exploitation of these opportunities. Entrepreneurs have traditionally financed their new ventures in steps, often starting with personal savings, investments from friends and family, and then turning to private angel investors, before seeking professional investors (Cosh, Cumming, Hughes, 2009; Hellman, Schure and Vo, 2013). In the early stages especially, asymmetries of information between entrepreneurs and investors typically make it difficult for new ventures to raise external finance through equity (Jensen and Meckling, 1976; Gompers, 1995; Manigart and Wright, 2013). This is due to the standard information asymmetry and adverse selection problems because entrepreneurs usually have better information about their capabilities and their ventures than do external investors (Stiglitz and Weiss, 1981). Moreover,, the transactions costs of collecting accurate information are high for investors, the results are unpredictable and , true risks anyway only unfold over time, usually after the investment is made. In this paper, we explore the potential of equity crowdfunding, ECF, as a new instrument to provide finance to early stage entrepreneurs. We follow Estrin and Khavul (2016) in defining equity crowdfunding as “an open marketplace for entrepreneurial finance that takes place on a two-sided online platform and operates within a social media environment”. ECF platforms provide entrepreneurs and investors access to an online social media marketplace where they can trade equity finance for ownership stakes (Cummings and Zhang, 2016; Rossi and Vismara, 2017). The platform is the market-maker, regulated by the relevant financial services authority, and each offering of shares by entrepreneurs (of fixed duration) is denoted a pitch. There is a rapidly burgeoning literature about equity crowdfunding, focused on its economic potential (Mollick, 2014; McKenny, Allion, Ketchen, Short and Ireland, 2017; Courtney, Dutta and Li, 2017), risks (Agrawal, Catalini, & Goldfarb, 2013; Ahlers, Cummings, Guenther and Schweitzer, 2015) and a variety of specific issues (e.g. Bruton, Khavul, Siegel, and Wright, 2015; Vismara, 2016; Hornuf and Neuenkirch, 2016; Mohammadi and Shafi, 2017; Hornuf and Schwienbacher, 2017; Guenther, Johan and Schweitzer, 2017). However, unlike in this paper, few researchers have had direct access to pitch process data or been able to interview actual entrepreneurs and investors. 3 We anchor our study in in the largest ECF marketplace, which is in the UK. Though many other countries including Australia, and much of the European Union have permitted ECF platforms to operate since 2010 (Kshetri, 2015), with the United States formalising its rules federally through the JOBS (Jumpstart Our Business Startups) Act in 2012, the UK market remains by far the largest.3 We argue that the main contributory factors to the UK’s success in this financial innovation are likely the depth of the British entrepreneurial finance ecosystem and the emergence of a sympathetic tax and regulatory regime (Estrin, Gozman, Khavul, 2016; Drover et al, 2017). In particular, the UK regulatory environment has been more open to ECF than have regulators in much of continental Europe and the US (Hornuf and Schwienbacher, 2017), though differences have now narrowed (Dusnitsky, Guerini, Piva, Rossi-Lamastra, 2016). Our approach is to use primarily qualitative research methods on actors in the UK equity crowdfunding to explore three research questions. First, are the significant financial flows via ECF platforms additional to more traditional forms of funding for entrepreneurs or are they merely a diversion of previous flows into a new medium? Second, do investors understand and appropriately evaluate the risks that they are bearing by investing in this new form of equity asset. Finally, does ECF finance brings with it the advice and guidance critical to entrepreneurial success which has in the past been associated with other sources of funding such as Venture Capital? Our study is based on extensive interviews over several years with investors, entrepreneurs (including some who chose not to use ECF in favour of traditional funding sources) and regulators. The paper is organised in four further sections. We first briefly summarise the architecture of equity crowdfunding platforms and the role of regulation in their rapid development in the UK market, as well as providing unique data characterising the evolution of the UK sector. We are especially interested in evidence about market broadening and deepening. We then go on to analyse the views of entrepreneurs, and investors drawing on a systematic structure of interviews. We find that ECF does provide some real additionality to the sources of entrepreneurial finance while not appearing to bring unanticipated new risks for investors. There is rather less evidence that the equity crowdfunding process provides guidance of value to the entrepreneurial ventures. We conclude with a discussion of the policy implications of these findings, in the light of alternative regulatory stances in the United States and the European Union. 3 To quote the Nesta Report (2016), “Excluding real estate crowdfunding (£87 million), equity-based crowdfunding contributed £245 million worth of venture financing in 2015, which we estimate is equivalent to 15.6% of total UK seed and venture-stage equity investment.” 4 2.The Evolution and Characteristics of Equity Crowdfunding in the UK In this section, we first briefly summarise how the literature has proposed that ECF might address the weaknesses in early stage entrepreneurial finance. We go on to analyse the UK regulatory and tax environment to specify the institutional and policy environment in which the entrepreneurs and investors, whose interviews we report below, operate. We then present the mechanics of equity crowdfunding, before providing new data to consider the key economic characteristics of the UK sector; its scale and growth, market structure, and evidence concerning its broadening and deepening. 2.1
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