Investing in startups is no longer limited to the wealthy in the U.S. The New York Times reports, “Starting Monday, new rules will permit anyone, not just the moneyed, to risk $2,000 a year or more investing in small companies in exchange for a stake in the business. Companies can raise up to $1 million a year this way.”
As a result, lots of people are going to lose money.
But what effect will the rules have on startups? After all, the legislation, passed in 2012 but stuck in SEC rule making until now, was intended to boost America’s entrepreneurial economy. I’m skeptical that it will succeed.
Allocating more resources to the startup economy probably is a good thing. New, growth-hungry businesses are disproportionately likely to innovate and to create jobs. More of these productive, young firms would mean faster economic growth. The question is whether the extra seed capital provided by crowdfunding will help.
My read of the evidence suggests this isn’t the case. The biggest barrier for most startups isn’t raising that first round of capital — it’s scaling, which in some ways is getting even harder.
If the limiting factor for the startup economy is capital, you’d expect newly founded venture funds to generate solid returns. But if the limiting factor is the number of promising startups, you’d expect more capital to have little impact because investors are either competing to get into the same deals or funding second-rate startups with little chance of success.
In fact, venture capital hasn’t performed well compared to other asset classes, with the big wins clustered among the top dozen or so firms. And research has shown that VC performance is inversely correlated with the amount of money invested. That suggests more capital just ends up chasing the same handful of promising companies, rather than finding new winners.
Further evidence that early-stage funding is not the limiting factor in the startup economy comes from a recent report at MIT. Previous research has identified a decline in U.S. startups, a worrisome sign. But the MIT study, by Jorge Guzman and Scott Stern, used a more-precise measure to distinguish between new businesses that aspire to grow like startups and new small businesses that are unlikely to make a large economic dent. They found that the number of high-potential growth startups is actually ticking upward. The U.S. is generating plenty of high-potential startups, they argued, yet there is a problem: These companies don’t seem to be scaling or reaching an exit, such as an IPO or an acquisition. Companies that on paper look likely to grow are not growing as quickly as they have in the past. As Guzman and Stern wrote in a companion policy paper with Catherine Fazio and Fiona Murray, “To the extent that the current state of American entrepreneurship is facing a crisis, it is not in the rate of creation of high-growth-potential startups or even in the initial funding of those firms, but, instead, in the potential of those firms to scale in a meaningful way over time.”
None of this is to say that more capital will hurt the startup ecosystem. In theory, more financing should mean better terms for startups, though it’s not clear that that’s how it always works in practice.
And there are two cases to be made for crowdfunding. The first is that while high-growth startups are more likely to create jobs and fuel growth, other small businesses matter too — and financing might be a bigger constraint for them. The second is that VCs have a terrible record when it comes to diversity. They disproportionately fund white male entrepreneurs, mostly clustered in tech hubs such as the Bay Area, Boston, or New York. If crowdfunding could diversify startup investments, that would be a major improvement. Steve Case and others have emphasized crowdfunding’s potential to support startups outside the main tech cities, furthering what Case calls the “rise of the rest.” And there is research suggesting that women excel on nonequity crowdfunding sites, such as Indiegogo. If equity crowdfunding continues that pattern, perhaps it could help diversify seed investing.
Still, startup finance is something the American economy does comparatively well. Getting better at it can’t hurt, but really boosting innovation and entrepreneurship will take more than a little extra seed funding.
via HBR.org http://ift.tt/1TkkkY4