A recent interview for an HBR article on crowdfunding and investment platforms made me think a bit about the democratization of VC and enterprise finance.

Friend or foe, crowdfunding or crowd (in)vesting are a logical evolution of the digital revolution and its most prominent foray into the coveted space of private sector investing. To shed some light on the issue, I have gathered a few interpretations – from a company, VC and lender perspective.

They are nowhere near complete but could be good discussion points. For the sake of the argument, I am mixing debt and equity platforms, so please forgive my inaccuracies here…

The company view on crowdfunding

• Companies should welcome crowdfunding as the missing piece towards the democratization of enterprise finance in early stages. It opens up direct participation in innovation, enabling an equal dissemination of progress and its rewards. In so far, it contributes to creating open, transparent and competitive markets for financing. This is true regardless of equity platforms (think Kickstarter or Crowdcube) or debt marketplaces (think Funding Circle).

• For SMEs in particular, it fills the gap that has been created by even tighter lending and risk assessment standards put forward by established lenders. Crisis-induced financial reform of banking regulation (Basel III and the like) has triggered a significant rebalancing of asset positions. While it was difficult to obtain (risky) debt financing before, it is almost impossible now. This becomes particularly important in a bank-based system like most continental Europeans. Unlike the US, companies and innovation have traditionally relied on bank finance and close or intertwined bank relationships, while other (non-bank) capital markets have occupied a significantly lower share of enterprise finance. Crowdinvesting makes up for some of the lost financing opportunities and could become a standard form of corporate finance in the next decades.

The VC view on crowdfunding

For a VC, the democratization of corporate finance creates an interesting new situation as it challenges – and helps – the existing model on various fronts:

• It increases access to venture finance, a traditionally rather “elite” sub-sector within finance. This holds true for both (private) investors and companies
• It makes the overall industry much more transparent – a good and to-be-welcomed development
• It thus moves VC closer to a “perfect” financing market: prevailing informational asymmetries are reduced, market liquidity is increased, measurability and competitive analysis of VC performance are greatly enhanced
• It adds credibility to venture capital as an asset class

Now what are the risks from a venture investor’s angle?

• The “dumb money” argument: Institutional venture investors are industry experts. Unguided mass crowdfunding does not have this quality and might risk to fall for subpar investments. A “mediating” level (à la AngelList syndicates) might help here.
• The company building argument: VCs provide fundamental operational assistance in the build-up of a company. This function cannot be substituted for by crowdfunding.
• The cross-fertilization argument: VCs facilitate spillover effects and cross-fertilization between companies and industries – again, this cannot be undertaken by crowdfunding. The “institutional” role of a VC should not be underrated and is the main value add to “plain” finance.

To me, and despite some obvious risks attached, crowdfunding is an important development and for a historical parallel, it largely resembles the development cycles towards public markets over the centuries.

Small clubs were broken up, access to and participation in industrial progress was enhanced, investment criteria became more transparent, performance could be measured in a clear fashion.

The asset class, in general, will greatly profit from this; particularly in Europe, where VC exists only on the margin.

Finally: The lender view on crowdfunding

The situation for debt finance providers is slightly different. As they are the object of increased regulation and supervisory scrutiny, “giving in” to crowd platforms seems like a logical consequence.

• One can expect a “flight to quality” when it comes to lending practices. In other words, large chunks of riskier SME finance might be taken over by new forms of finance providers. Banks will most likely position themselves in the larger and more secure tranches of corporate debt financing
• Likewise, a “flight to size” is highly probable, to the detriment of smaller companies. Here, the true promise of crowdinvesting platforms comes into play and all signs point towards an ongoing trend.
• Overall, the portfolio substitution towards higher quality / better risk assessment is in full force and will permanently change the nature of corporate debt finance.
• One might see an interesting return of SME debt to the banks’ balance sheets if and when investing platforms become a viable asset class for banks’ asset management divisions. If materializing, that will be an interesting turn – asset managers turning into corporate financiers, i.e. banks intermediating themselves.

The floor is yours…

What do you think about crowdfunding? Have you used it before and how did you find it? Feel free to share arguments in the comment sections below, and  feel free to follow the author on Twitter: drosskamp.

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