Crowdfunding: Why Business Angel Networks are Inefficient

In the previous article I have discussed some empirical research that proved the existence of a limited exposure of Business Angels to promising projects. I used this fact to support my thesis about the need of a centralized online marketplace that will benefit not only entrepreneurs but investors as well. An opportunity to build such online marketplace is represented by equity-based crowdfunding. The last article concludes by challenging the effectiveness of crowdfunding compared to other online portals as those run by Business Angels Networks (BANs).

BANs have indeed their websites to collect applications of candidates. Indeed Harrison and Mason (2002) argue that, thanks to the public intervention aimed at supporting the creation of channels of communication, the conclusions by Wetzel (1986, 1987) can no longer be regarded as complete explanation. According to the authors, this communication channels are identified in business angel networks. In a previous research, Harrison and Mason (1999) observed that a significant numbers of business angel networks (BANs) have been formed in the UK and also in various other countries over the past 10 years. The authors however conclude that for a significant proportion of UK investors, membership of one or more BAN has had little or no impact on increasing the volume of potentially investable opportunities that they receive.

Business Angel Network Inefficiencies

This analysis suggests that there may be some inherent features in the crowdfunding system that make it superior to previous forms of interactions. Harrison and Mason (2002) support this conclusion. In their later paper Harrison and Mason (2002) extended their previous empirical evidence by observing that another inefficiency in the BAN organization is not causing reluctant potential investors to enter the market, nor increasing entrepreneurs’ willingness to use equity financing.
As a matter of fact, the scarcity of investment can be related to entrepreneurs preferring debt financing, or on the other hand by the limited number of investors. For example, assuming that the active investors are very selective and thus limiting their investments despite their total wealth, by increasing their effective number the inefficiency of the market can be offset. In other words, increasing the agents in the market can supply additional liquidity, although such increase may not be reflected in a similar increase in the total amount ready to invest. This would for example happen when less high-net-worth people were involved. This hypothesis is supported by Freear et al. (1994), that determined that the US potential investors outnumber actual investors by a ratio of 3:1. In short, there is a substantial pool of informal venture capital available for investment but it is not being mobilized effectively though.

Harrison and Mason (2002) conclude that time has come to fundamentally redesign the concept of business angel networks and thus develop a “second generation” of BANs whose role is much wider than simply being an information broker, extending to educational tasks. The main conclusion of this paper is therefore that the communication channels mentioned by Wetzel (1986,1987) have been developed but are ineffective because the market failure stems for other factors that can be offset only by an educational effort.

This is exactly what Harrison and Mason (2002) refer to when claiming the birth of a “second generation” of BANs. Since the paper dates back to 2002, the authors could not foresee such a massive digitalization of everyday life and were thus referring to offline system of networks. However, this concept can be applied today to the current level of technological development. Crowdfunding can be seen as the second generation of BANs and the authors as the pioneers of the crowdfunding concept. This model indeed is successful in attracting not only member of existing networks but also addressing reluctant investors’ and entrepreneurs’ propensity toward equity financing. Compared to online BANs, crowdfunding allows immediate investments that start with very little amounts. It allows a better diversification of the investment portfolio regardless of the budget. This sort of system is indeed superior to BANs and should just be able to attract a substantial portion of informal investors. This will additionally give them an overview over a broader range of investment opportunities, once the critical mass on a certain platform is reached. This is indeed the main challenge for such websites.

With regard to the educational role, the crowdfunding system has the crucial advantage of being an online model thus with a wider scope of reach. In addition, knowledge can be transferred immediately and remains available to everybody. According to Harrison and Mason (2002), there are three main arguments of interest: the advantages of equity financing, the mentoring and coaching of entrepreneurs in order to transform them in attractive investments and finally the teaching of investment competences to virgin and less experienced investors in general. Especially for the latter two points, this supposes crowdfunding platforms to optimize their supply of information, although the impersonal and standardized approach of online interaction may constitute a hurdle. This is why such portals should invest most of their efforts in improving the functionalities aimed at educating their audiences.

After having extensively mastered the advantages to Business Angels, in my next article I will focus on later-stage capital sources to entrepreneurs: Venture Capital Funds.