Crowdfunding: Information Broker for Early-Stage Venture Capital Funds

In this post we extend the analysis to the second, major source of startup capital to date: early-stage Venture Capital (VC) funds. The VC decision-making process is usually more complex and systematic compared to that of BAs. Such procedure is composed of several steps that cream off the enterprises up to the final investment. The main obstacle in such sort of investment is indeed the information asymmetry, which reverts into adverse selection (Fried and Hisrich, 1994). As pointed out by the authors, a seed or early-stage investment is highly illiquid and its success relies on a small group of managers/entrepreneurs. Sahlman (1988), shows that the transaction is featured by significant information asymmetries, which allows managers to engage in opportunistic behavior. As a consequence, the initial screening of candidates takes a crucial role.

Fried and Hisrich (1994) were among the first to empirically analyze the decision making process of VC funds. Their results indicate that the procedures is composed of 6 different steps and on that it takes on average 97 days before it reaches the (the or a?) conclusion. This process is time-consuming and labor-intensive and it is featured by a high rate of refusals. The question is: can crowdfunding speed up the process? Or alternatively, can crowdfunding help VC funds to increase the final pass rate by supplying a, on average higher ,quality of startups?

As pointed out before, active BAs and potential investors would indeed benefit from the digitalization of crowdfunding, given its online structure and the immediacy of investment. VC funds on the other hand usually invest larger bulks of capital compared to BAs and the mere online due diligence may not be sufficient for them. Crowdfunding platforms may however work as their information broker for the initial part of the screening. In the following paragraph I analyze the individual steps of the investment process, trying to outline the synergies with crowdfunding.

According to Fried and Hisrich (1994), the selection starts with the origination – that is, the first contact. There is no standardized way for startups to get in touch with a VC other than an application form on the fund website, if at all. Nevertheless, most of the market agents find difficulties in spotting promising startups with outstanding potential according to the authors. Also for this reason, VC funds tend to create a network of trusted contacts that can redirect to the fund referred investment opportunities (Fried and Hisrich, 1994). Among the contacts, there are usually investment bankers, investors who committed capital to the VC fund itself, commercial bankers, management of  firms  in  the  VCs’ portfolio, consultants who had worked for the VC in the past, and family friends . The interesting aspect of such referrals is that the deals provided through the network are more likely to pass through the generic screening since these opportunities were already selected by the personal judgment of the referring contacts.

The second step in the selection process refers to the VC-specific requirements, especially in terms of investment size, industries, geographic  location  and  stage  of development. After this screen, a generic analysis of the business idea is carried out. This consists of just a cursory glance at the business plan combined with any existing relevant knowledge the VC may have.

After this initial screening, the business case is further investigated in ist details. This phase usually takes more time and requires more direct interaction between entrepreneurs and investors. Among the key aspects determined by the authors in their research on the field, the strengths and weaknesses of the founders are of  utmost importance. Then a second valuation stage follows, where VC’s interest is clear. This stage is aimed at finding an agreement among the parties. Finally, the deal is closed by defining the details of the partnership.

We will master how the collaboration between VC funds and crowdfunding platforms can be established and what the main unique advantages compared to the current network of contacts are in  our next article The Unique Advantages Of Crowdfunding Portals As Information Brokerage.