New research by MIT Sloan expert identifies “killer app” of equity crowdfunding

Syndicates stand to change overall economics of crowdfunding, says Christian Catalini

CAMBRIDGE, Mass., April 30, 2015--Crowdfunding platforms such as Kickstarter and Indiegogo already enable individuals to virtually invest in new businesses or other initiatives. But with equity syndicates also turning to the Internet to connect firms seeking angel funding, the overall economics of crowdfunding are now changing in significant ways, according to research by MIT Sloan Assistant Professor Christian Catalini.

In their working paper, Catalini and his co-authors, Ajay Agrawal and Avi Goldfarb from the University of Toronto, dub syndicates “the killer app of equity crowdfunding” because they enable lead investors to inform potential backers about deals of which they might not otherwise be aware. Crowdfunding equity syndicates do this by filling a major gap in online investing, namely the desire of investors to be able to actually – not just virtually -- meet the people and ventures seeking their seed money. “When evaluating a team at such an early stage, investors want to be able to get a read on the founders,” says Catalini. “They want to be able to understand the team dynamics and get a real sense of factors such as how they react under pressure. Because that’s hard to do on the Internet, angel investing has tended to be geographically localized.”

Because of “information asymmetry,” non-local investors are left unaware of particular technologies or markets in which they might want to invest because of geography. “Many value-creating transactions that could have occurred do not simply due to the distance between investor and venture,” according to the upcoming paper. “The lack of long distance angel investing is largely due to informational problems that make non-local early-stage deals costly to evaluate and monitor.”

Syndicates help solve that information problem through a division of labor among investors. Lead investors do the on-the-ground due diligence and then share their findings with the investing crowd. Because these lead investors face reputational and financial penalties for poor performance and gain from good performance, their and the crowd’s interests are aligned. “Entrepreneurs face a reputational cost within their professional network if they fail to deliver results to the lead,” the paper notes.“Syndicates give lead investors both the ability and incentive to leverage the information they collect through theirrelationships and due diligence on behalf of distant investors. Platform tools and features enable lead investors to communicate their skills and  performance history and to put their reputation at stake.”

Equity syndicates also help to expand the universe of potential investors. In the past, says Catalini, angel investors who have located good local deals had little incentive to share them with the online crowd. But equity syndicates are changing that pattern. “Equity syndicates are able to combine the global reach capability of the online world with the face-to-face due diligence and monitoring abilities of the offline world.”

Although the introduction of syndicates in online equity crowdfunding is recent, Catalini’s research finds it growing in absolute and relative terms. “On AngelList, the leading equity crowdfunding platform, syndicated deals have not only grown but overtaken non-syndicated deals in terms of the number of ventures attempting to raise capital,  the  number  of  ventures  that  successfully  raise  a  seed  round,  and  the  total  amount  of  capital.”

While the impact of equity syndicates will likely vary by region, their overall effect is clear. “The economics of information associated with  early-stage  investing are  much  better  suited  to  crowdfunding  angels  than crowdfunding  ventures at this stage.” In other words, “Syndicates enhance economic growth by reducing market failures and allocating capital more efficiently.”

To download the paper please visit:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2569988

Christian Catalini is Asst. Prof. of Technological Innovation, Entrepreneurship, and Strategic Management at the MIT Sloan School of Management.