Crowdfunding Signals

• Publication year: 2018

Crowdfunding Signals

Darian M. Ibrahim
William & Mary, dmibrahim@wm.edu

CROWDFUNDING SIGNALS

Darian M. Ibrahim^*

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Entrepreneurs can now "crowdfund," or sell securities to unaccredited investors over the Internet, to raise capital. But will these companies be able to attract the follow-on investors (angels and venture capitalists) that are necessary for long-term success? Angels and VCs face extreme levels of information asymmetry when deciding whether to fund a company. Signals can reduce this asymmetry. Early commentary argues a company only crowdfunds as a last resort for fear of sending a negative signal about the company's quality to follow-on investors. This Article argues the inverse. This Article argues a successful crowdfunding campaign can send a positive signal of a company's quality to angels and VCs.
As this Article explains, crowdfunding can be a savvy move for entrepreneurs for both social and financial reasons. Crowdfunding, perhaps more than any other strategy, shows real-world demand for a company's product or service. For this and other reasons explored in the Article, crowdfunding sends a positive signal of firm quality, and thus should not disadvantage entrepreneurs without wealth or connections who depend on crowdfunding to raise funds. The Article also posits that crowdfunding signals may reduce the need for crowdfunding disclosures, thus making the process more affordable to entrepreneurs.

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Table of Contents

I. Introduction..........................................................................199

II. Signaling Theory.................................................................203

a. why do market participants need signals, and what makes a signal effective?.......................................204
b. information asymmetry in entrepreneurial finance .....................................................................................206
c. signals used in entrepreneurial finance pre-crowdfunding...........................................................209

III. Crowdfunding as a New Signal of High Quality..........212

a. successful vs. unsuccessful crowdfunding campaigns...................................................................213
b. crowdfunding as a negative signal........................ 214
c. crowdfunding as a positive signal..........................218

1. Crowdfunding can show real-world demand for a company's product or service.................................219
2. Can "Professionalize" the Company........................222
3. In Defense of SAFEs................................................223
4. Crowdfunding Can Reveal a Savvy Entrepreneur.. 225

IV. Normative and Legal Implications.................................227

a. normative implications: opening opportunities to more entrepreneurs................................................227
b. normative implications: crowdfunding can reduce informational lock-in.............................................229
c. legal implications: crowdfunding signals can reduce need for disclosure...................................230

V. Conclusion............................................................................232

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I. Introduction

Crowdfunding is the hot new method by which new companies can raise their first capital.¹ Selling unregistered securities over the Internet was prohibited in the past because it constituted a "general solicitation" of investors.² In short, entrepreneurs could only solicit investments from those previously known to them. Then came the Jumpstart Our Business Startups Act of 2012 (JOBS Act), which allowed general solicitation of "accredited" (i.e., wealthy) investors in so-called Title II offerings.³ It was not until October 2015 that the Securities and Exchange Commission (SEC) passed the final rules implementing Title III of the JOBS Act, dubbed "Regulation Crowdfunding" (Regulation CF), which allowed general solicitation—and thus Internet sales—to unaccredited investors.⁴

While companies primarily crowdfund to raise capital, this Article reveals that a crowdfunding campaign serves important, ancillary purposes. Just as patents primarily allocate rights and rents while secondarily sending "signals" about firm quality and productivity,⁵ crowdfunding campaigns serve the same dual

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functions for new companies. Signals serve to inform potential investors about a company's quality when that quality is otherwise difficult to observe.⁶ Thus, despite early commentary predicting that crowdfunding will be an option of last resort for entrepreneurs,⁷ a successful crowdfunding campaign can actually send a positive signal about firm quality to follow-on investors, namely angels and venture capitalists (VCs).⁸

Some companies that crowdfund may not seek follow-on investors, instead being content to exist as so-called "lifestyle" companies run for the benefit of the entrepreneur and the entrepreneur's family.⁹ Early companies who have conducted crowdfunding campaigns have been in the food, beverage, and other consumer products industries and do not fit the technically-innovative mold of Apple or Tesla.¹⁰ However, rapid-growth companies that go on to seek angel or VC investment¹¹ have also

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first looked to the crowd. Both tech¹² and non-tech companies¹³ are trying to raise money through crowdfunding. For growth companies, attracting follow-on investment is the key to success.¹⁴ Virtual-reality pioneer Oculus is a notable success.¹⁵ Oculus began with a successful crowdfunding campaign on Kickstarter,¹⁶ raised $16

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million from VCs after the crowdfunding campaign, and was sold to Facebook for $2 billion.¹⁷

In this Article, I apply the economic literature on signaling to crowdfunding and show that an entrepreneur's decision to crowdfund—if that crowdfunding campaign is successful¹⁸ —can send a better signal of firm quality to angels and VCs than pre-crowdfunding signals. Because it adds a signaling function on top of the capital-raising function, crowdfunding can send a better signal for success than "friends-and-family" money.¹⁹

In an environment rife with information asymmetry, signaling takes on added importance.²⁰ Although crowdfunding is still in its infancy, early commentators predict that it is destined for failure.²¹ Those commentators suggest that crowdfunding, to the extent it signals anything, signals a weak company.²² Companies that crowdfund, the argument goes, are being shunned by the traditional sources of entrepreneurial finance—early-stage angels, VCs, even friends and family—and opt to crowdfund only as a means of last resort.²³ In short, these companies are the lemons of the startup world that have little staying power and little chance to become household names.

Arguing the opposite, this Article contends that crowdfunding can be viewed as a positive, rather a negative signal—and, in important respects, is a better alternative than other means of early financing, most notably friends-and-family money. As explained in this Article, crowdfunding can be a savvy move for entrepreneurs for social and financial reasons.²⁴ Crowdfunding also does more than perhaps any other move an early-stage company can make to

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signal real-world demand for its product or service.²⁵ A successful crowdfunding campaign shows follow-on investors that the company has a real customer base.²⁶ Crowdfunding can help democratize entrepreneurship and make it more affordable for entrepreneurs to pursue their innovations.²⁷

This Article proceeds as follows. Part II discusses the economic literature on signaling: when signaling is important and what makes a signal effective; why signaling is especially important in entrepreneurial finance; and what signals angels and VCs relied on in choosing companies to fund pre-crowdfunding. part iii introduces crowdfunding as a new signal for angels and VCs to use in selecting their investments and argues that, despite early predictions about crowdfunding's inevitable failure, a successful crowdfunding campaign can reflect positively on a company to angels and VCs. Part IV discusses the normative and legal implications of crowdfunding properly viewed as a positive rather than a negative signal. part V concludes.

II. Signaling Theory

signaling is an important concept in the law-and-economics literature.²⁸ This Part has three objectives: to discuss (1) why signals are an important tool in helping to combat information asymmetry; (2) why extremely high levels of information asymmetry make signaling paramount in entrepreneurial finance; and (3) what signals are used in entrepreneurial finance pre-crowdfunding, as well as the shortcomings of using those signals.

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A. WHY DO MARKET PARTICIPANTS NEED SIGNALS, AND WHAT MAKES A SIGNAL EFFECTIVE?

"Insiders know more than outsiders. Both have incentives to mitigate the asymmetry."²⁹ This incentive is especially true in financial transactions when insiders attempt to sell company securities to outsiders.³⁰ Information asymmetry exists in varying degrees in financial markets. For the largest and most well-known blue-chip companies, information asymmetry is remedied in numerous ways: analysts rate the company's securities,³¹ securities law forces insiders to disclose information about the company,³² newspapers cover the company's major moves,³³ and reputational concerns influence the company's actions.³⁴

But information asymmetry persists, especially with lesser-known companies.³⁵ The cost of remedying information asymmetry can be high: investors must find, process, and verify information.³⁶ Apart from large mutual funds and hedge funds, most investors do not have the time or motivation to process all the information that

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is available on a company.³⁷ The behavioral law-and-economics literature indicates that investors exhibit bounded rationality, meaning they use shortcuts when making decisions.³⁸ Thus, investors' reliance on signals about a company's...