The risk of adverse selection in retail equity crowdfunding
How can Australia properly set the parameters for crowdfunding? Asymmetric information often leads to a market problem known as adverse selection. Adverse selection occurs in a market when buyers or sellers are on average better off trading with a randomly selected person from the population than with those who volunteer to trade. A classic example of adverse selection occurs in used car markets.
It may happen that in equilibrium, the used cars that come onto the market are not a random selection of the used car population but just the worst.
The problem of adverse selection also applies to insurance markets. The people most likely to want insurance are the people who are at the highest risk, but these are the people insurance companies would least like to have as customers. For example, the people most willing to buy annuities are those who have reason to believe that they will live long.
Insurance companies are well aware that their customers will, on average, be at worse insurance risks than a randomly selected member of the population. Thus, instead of basing their estimates of the risks they face on statistics for the entire population, they base them on statistics of policyholders from previous years.
Investing in startups potentially works best when investors have asymmetric information – special knowledge, ideas and / or networks – that leads them to fund things that would otherwise have been overlooked or undervalued by traditional investors. .
Startups benefit directly from the network effect of these active investors, whether they are wealthy experienced or angel, accelerator / incubator or financial or corporate VC. They can leverage these networks to raise follow-on capital, identify channel partners and customers, and gain in-depth domain knowledge.
Equity crowdfunding platforms pool the capital of a relatively large number of investors, who do not necessarily enjoy the additional strategic advantages of sophisticated or institutional investors.
However, raising capital through an equity crowdfunding platform provides a complementary and attractive source of capital for startups if it: can quickly and efficiently close an already partially completed funding round, enabling founders of a startup in the Startup reduce increase and maximize the time they have to develop their business reduces administrative burdens by consolidating the crowd of investors into a single entity or trust.
It also minimizes the number of investors on the share register and increases the likelihood of a follow-on investment (from VCs, startup etc, e.g. regulatory requirements – such as converting to an unlisted company in stock Exchange.
Unfortunately, under the House of Representatives’ Crowdfunding Bill passed last week and soon to be presented to the Senate, the three points outlined above are not being met.
This will mean that if the legislation is passed in its current form, the startups that are presented to the retail crowdfunding market are not a random selection of the population of all startups, but only the worst that failed to raise capital from others the source.