Exploring agency dynamics of crowdfunding in start-up capital financing.

Ley, Andy ; Weaven, Scott

INTRODUCTION

The venture capital industry is a key stakeholder in the market for providing equity finance for new business ventures (Cumming 2006). The provision of equity financing is necessary for new start-up ventures to form, operate and develop their relative contribution to the business innovation process (Cassar 2004). Over the last decade, the market for venture capital in Australia and throughout the world has experienced rapid growth both in terms of capital under management and the number of venture capital firms providing finance (Bivell 2008). Whilst this growth has been substantial, there is growing evidence that the focus and interest of venture capital is moving beyond early stage innovative start-up firms to later-stage investments (Bivell 2008; Osnabrugge 2000). This shift in focus has created a significant 'funding gap' for early stage start-up ventures and has renewed both academic and practitioner interest in possible methods of promoting the aggregated pool of available capital to early stage start-up enterprises that are pre-revenue and yet to reach commercialisation stages (Cassar 2004; Cumming 2007).

Crowdfunding is an emerging online trend representing a new potential pool of capital as a source of start-up equity financing. A central tenant of crowdfunding is that the crowd funds what the crowd wants. In this context the crowd represents members of online virtual communities and users of social media and social networking sites (SNS). Crowdfunding is derived from another social media phenomenon termed crowdsourcing. Crowdsourcing is defined as the act of taking a job traditionally performed by a designated agent (usually an employee) and outsourcing it to an undefined, generally large group of people in the form of an open call (Howe 2006; 2009). Although crowdsourcing (and thus crowdfunding) has not been the subject of prior academic research, previous research in the information technology literature has investigated the development of open source software and distributed computing (Anne and Anurag 2005; Hippel 2001) and the increasing popularity of online virtual communities and SNS (Boyd and Ellison 2008; de Souza and Preece 2004; Ellison et al. 2007; Gerard et al. 2004; Jenny and Diane 2005; Utz 2009). Overall, prior research suggests that SNS may provide access to embedded resources within the online community (Boyd and Ellison 2008) and may actually facilitate in bridging current social capital limitations (Ellison et al. 2007; Utz 2009).

Within the context of start-up capital, there is some suggestion that social networking methods may provide a solution to early stage equity financing gaps resulting from market failure (Shane and Cable 2002; Shane and Stuart 2002; Zhang and Wong 2008). Therefore, crowdfunding, as a vehicle for accessing resources embedded within online social networks, may provide access to a new source of capitalisation for entrepreneurs. We define crowdfunding in the venture capital context as a source of start-up equity capital pooled via small contributions from supporting individuals collaborating through social media. However, to date, the factors influencing crowdfunding adoption in the venture capitalist industry have not been examined. Moreover, venture capitalist perceptions of this equity-financing model have not received attention in the entrepreneurship literature.

Hence, the purpose of this research is to investigate the emergence of crowdfunding and how it might be appropriately adopted within the start-up equity financing context. Given the relational character of start-up venture financing (Dushnitsky and Lenox 2006), venture capitalist's perceptions of agency dynamics in the investor-investee relationship provides an appropriate lens for analysing the likely acceptance of crowdfunding in start-up financing. Thus, this research aims to investigate the agency dynamics relevant to the adoption of crowdfunding investment models in start-up financing from the venture capitalist's perspective.

BACKGROUND

As a major contributor to innovation, start-up firms have been the subject of significant academic interest (McDaniel 2000; Osnabrugge 2000; Timmons and Bygrave 1986). Moreover, the growth of economies around the world has shown to largely depend upon the contribution of small firms to employment and national Gross Domestic Product (GDP) (Cumming 2007; Gans et al. 2002; Osnabrugge 2000). Given this, the survivability of innovative start-up firms and thus the provision of start-up capital represent an important issue, one which has received considerable attention from academics and practitioners alike.

Previous research suggests that the financing life cycle of a start-up venture closely follows stages of firm development (Cassar 2004). Pre-seed capital and seed capital are types of funding relevant for innovative ideas that have not yet been commercialised. Funding at this early stage tends to be characterised by greater levels of information asymmetries and risk, leading to higher probability of failure and difficulties in liquidating investments (Cumming 2007). Early stage start-up firms have limited options for capitalisation due to high uncertainty and the liability associated with 'newness' and 'smallness' (Cassar 2004; Cumming 2007; Harrison et al. 2004; Zhang and Wong 2008). Widely reported options for early stage start-up capital financing include bootstrapping; friends, families and fools; business angels and pre-seed and seed venture capitalists. Bootstrapping denotes a creative means to resourcing the start-up without engaging in traditional methods of accessing externally sourced capital (Sohl 2003). The next potential source of funds comes from 'friends, family and foolhardy investors' (referred to as the FFF) (O'Gorman and Terjesen 2006, p. 70) who invest in a start-up venture due to their supportive connection with the entrepreneur. Generally, FFF have no grounded perception of liquidity and return (De Noble 2001). Next, 'business angels' represent the informal market for access to start-up capital. By definition, business angels are high net worth individuals that are largely motivated by potential returns attached to their risky investments (Osnabrugge 2000).

Pre-seed and seed venture capital firms represent the final and most structured source of early stage start-up capital. As formal capital, the venture capital market represents experienced investors who often invest institutional money with the goal of receiving the highest possible internal rate of return (Huggins 2008; Mason and Harrison 2002; Osnabrugge 2000). Venture capital is widely considered as 'informed capital' focuses upon screening, monitoring and advising start-up company operations (Kanniainen and Keuschnigg 2004). Therefore, the venture capitalists' perspective offers a more inclusive perspective than those centred upon friends, families and foolhardy investors, or business angels.

The nature of the close working relationship that exists between the venture capitalist and entrepreneurs within their portfolio of companies has been well researched (Arthurs and Busenitz 2003; Bottazzi et al. 2008). Prior research in this field informs some preliminary assumptions regarding likely relationship dynamics within crowdfunding models. For instance, previous research has applied agency theory in investigating and examining the nature of relationships between venture capitalists and entrepreneurs (see Arthurs and Busenitz 2003; Bolton and Scharfstein 1990; Douglas J. Cumming 2005; Norton 1995). In the context of venture capital, the principal-agent relationship develops when an entrepreneur seeks funding from a venture capital firm for their start-up venture (Arthurs and Busenitz 2003; Sahlman 1990). The venture capitalist (acting as the 'principal'), provides resources to the start-up entrepreneur (acting as an 'agent') with the view that "the agent will be able to successfully develop, produce, and market a product that will lead to an attractive return on the principals' investment," (Norton 1995, p. 23). Therefore, the relationship between the venture capitalist and the entrepreneur may be understood in terms of separation of ownership and control (Jensen and Meckling 1976; Osnabrugge 2000). This perspective suggests that agency theory is a useful lens through which to better understand the relationship aspects between the venture capitalist and entrepreneur (Sohl 1999).

In analysing the characteristics of relationship design, a dual 'ex-ante and ex-post' approach can incorporate mechanisms for controlling agency problems and costs throughout the entire investment process (Fried and Hisrich 1994; Osnabrugge 2000; Sohl 1999). Mitigation strategies used by venture capitalists throughout the investment process include deal flow and initial screening; due diligence; contractual control; post investment monitoring; and exiting (Osnabrugge 2000).

Deal flow refers to the quantity and quality of investment opportunities. Venture capitalists may use an initial screening criterion to identify potential projects for funding resulting in a stronger deal flow that is of higher quality than achievable by a typical informal investor (Osnabrugge 2000). Deal screening may be achieved through structural barriers in the funding application process (Hall and Hofer 1993), limiting funding to a specific domain of interest or expertise (Bygrave 1987; Norton and Tenenbaum 1993), or investing in fewer cold deals by leveraging referral networks (Fried and Hisrich 1994). Next, venture capitalists undertake due diligence measures to ensure the investability of any given venture opportunity. Normally, this process involves comprehensive analysis of a start-up's management team, technology, products and business plan (Davila et al. 2003; Fried and Hisrich 1995; Gorman and Sahlman 1989). A critical element of any investment decision-making is the design of optimal contracts (Casamatta 2003; Kaplan and Stromberg 2003; Trester 1998). Optimal contracts share particular characteristics, including the staging of capital and exiting options, the use of compensation linked to value creation and the controls for the distribution of investment proceeds (Sahlman 1990). Kaplan and Stromberg (2003) suggest descriptive elements of contracts between venture capital firms and the start-up enterprise. These include securities, residual cash flow rights, board and voting rights, liquidation cash flow rights, redemption rights, and other rights including automatic conversions of securities, anti-dilution protections and vesting and non-compete clauses for founders; and finally, contingency clauses for resuming control.

Involvement of the venture capitalist beyond the initial decision to invest includes managerial roles such as providing help to obtain additional capital; strategic planning, recruitment of management; operational planning; providing access to a network of suppliers and customers; and resolving compensation issues (Gorman and Sahlman 1989). Much of this involvement occurs through the contractual right of maintaining a position on the start-up company's board (Forbes et al. 2009; Kaplan and Stromberg 2003). Venture capitalists consider their strategic ex-post involvement to be an important factor in the overall success of the enterprise (Sapienza et al. 1996).

Exiting is the final stage of the investment process. Researchers have documented that there are a limited number of exits available at the end of an investment period and these potentially include buy backs, secondary sales, trade purchases and Initial Public Offerings (IPO's) (Bascha and Walz 2001). Whilst many of the securities options will be determined within the contract, the venture capitalist needs to liaise with the entrepreneur and the potential new owners to ensure that the most successful exit outcome is achieved (Amit et al. 1998; Douglas J. Cumming and MacIntosh 2003). This includes determining the time of exit, and the determination of an acceptable exit price.

Crowdfunding as a source of capital

Crowdfunding, as an emerging source of capital, differs from traditional venture capital investments in a number of aspects. Theoretical differences between these two sources are apparent when assessing the characteristics of the fund and the characteristics of the investors. Further investigation is warranted given that these apparent theoretical differences are likely to result in a set of agency dynamics unique to crowdfunding situations. That is, crowdfunding models may require a unique set of agency cost control mechanisms. Therefore, this research contributes to the body of knowledge of start-up financing and is the first exploratory investigation of crowdfunding. In addition, this research contributes to the under-researched field of venture capital in Australia, highlighting venture capitalist's perceptions of agency-related cost controls throughout the investment process, the complexities of the principal-agent relationship before (ex-ante) and following (ex-post) the beginning of the investment relationship.

RESEARCH DESIGN

Early stage venture capitalists were interviewed to identify the different agency dynamics throughout the investment process. To minimize extraneous variation in data, this research was limited to a single country (Australia). A venture capitalists' perspective may prove to be more reliable and valid (Patton 1990) given that as investors, they are more active and experienced than alternative early stage start-up capital providers (Gompers et al. 1998; Macmillan et al. 1989). In addition, previous research has shown that venture capitalists may be more accessible to researchers than alternative informal capital providers who may be unknown or unknowable (Wetzel 1983).

A worldview or realism paradigmatic approach was adopted in this research to gain meaningful and holistic insight into real life events through tracking down patterns and consistencies in respondent data (Mintzberg 1979; Perry 1998; Yin 2003). Although research examining the agency dynamics of venture capital has some theoretical and empirical grounding, the realism paradigm was deemed the most appropriate approach given the lack of research into crowdfunding as a source of start-up equity finance. Thus, a series of convergent interviews was conducted to identify interviewee behaviours and attitudes that are not directly observable in an imperfect reality (Godfrey and Hill 1995; Healy and Perry 2000; Patton 2002). This unstructured method of inquiry encouraged interviewees to divulge responses based upon their own interpretations, enabling greater potential for new insights and perspectives into agency rationales for crowdfunding adoption (Aaker et al. 2001).

Convergent interviews

Convergent interviewing is a cyclical collection, analysis and interpretive technique that uses a limited number of interviews with selected experts in the field (Dick 1990). This process involves a series of in-depth interviews that allows questions to be refined and developed after each interview with the aim of converging issues in a particular area. That is, this exploratory approach encourages a "series of successive approximations" (Dick, 1990, p. 3) leading to a consensus through the development and use of probe questions about important information where interviewee agreement or disagreement is tested. The convergent interviewing approach facilitates the collection of objective information about a particular phenomenon (Carson et al. 2001). Although the unstructured nature of qualitative research may promote the misinterpretation of results (Malhotra et al. 2002), convergent interviewing minimises respondent bias through a positivistic system of analysis and development (Dick 1990). In particular, interviewer preconceptions are (ideally) removed from the information gathering process by allowing respondents to self-identify salient points that can be tested in subsequent interviews. The method follows a complete process at each stage and a series of successive approximations is used to refine and test both points of agreement and disagreement until consensus is attained (Dick 1990).

Sources of bias

The strategies employed to understand and control researcher bias were reflexivity (Johnson 1997) and negative scenario sampling (Dick 1990). During the course of this research, a process of 'critical self reflection' was embarked upon (Johnson 1997, p. 283) in order to gain clarity of vision (Douglas and Moustakas 1984). While it would be unrealistic to suggest that this process resulted in a complete suspension of personal expectations and judgement, it did nevertheless allow the researcher to actively listen and record what respondents were saying. Throughout this process the interviewer was mindful that the full range of agency dynamics relevant to crowdfunding may not have been fully explained by existing theory and the literature exploring stakeholder dynamics of venture capital (Arthurs and Busenitz 2003). During the interview process, every effort was made to find evidence inconsistent with accepted theory given the theoretical differences observed between traditional venture capital and crowdfunding models. The second method employed in this research to minimize researcher bias was negative case sampling (Johnson 1997). Convergent interviewing techniques incorporate in-built negative case analysis procedures in which the interviewer is prompted to challenge and disprove emerging explanations that are interpreted from the data. Validation becomes the process of investigating and continually checking, questioning and ensuring the defensibility of the findings and theoretical interpretations (Kvale 1989, p. 77).

Research protocol

Telephone interviewing was favoured by the researchers as it offered some of the benefits of in-depth interviewing, such as responsiveness and reflexivity, without the time and financial costs associated with setting up physical meetings with each participant (Gillham 2000). All interviewees agreed to allow the researcher to digitally record the phone conversation on the assurance that their identity and the identity of their firm remained anonymous and that the recordings would be destroyed at a pre-determined period following the completion of the research. Contacting the venture capitalists by telephone encouraged a less threatening interviewing process resulting in greater cooperation and information disclosure by participants (Zikmund 2003). Care was then taken to ensure that the participants had an accurate understanding of the emergence of crowdfunding and why and how this may be applied to early stage start-up financing. In addition, interviewees were told that they could direct discussions and should verbalise any problems that they had with the interview structure, format or content.

Sample

Experienced venture capitalists were sourced from both the Australian Venture Capital guide (Bivell 2008) and recommendations from venture capitalists and academics in the field of entrepreneurship (Riege and Nair 2004). A total of 11 interviews were conducted prior to reaching convergence in identified themes. The interviewees in this research were active venture capitalists who provided capital financing for seed or early stage start-up ventures (See Table 1). Each interview lasted between 20 minutes and one hour in duration and interviews were discontinued when no new ideas or themes emerged. Thus, interview duration was dependent on the convergence of themes and issues (RL Yin 1994). Following each successive interview the researcher summarised each of the issues raised to highlight convergence of identified themes.

FINDINGS

The research findings are categorised into four sub-sections (investor-specific factors, exante investment factors, ex-post investment factors and the impact of crowdfunding). Each section highlights the agency dynamics at the relevant stage of the investment process, starting with identifying the investor and finishing with identifying the impact of crowdfunding models in start-up financing. The conceptual model of crowdfunding is shown in Figure 1.

[FIGURE 1 OMITTED]

Investor-specific factors

Findings 1: Crowd composition.

All interviewees agreed that the nature of early stage start-up investments would demand that the crowd consist of an informed group of investors. These findings are consistent with previous venture capital research, suggesting that the specialised and informed nature of venture capitalists with domain expertise was associated with a concomitant reduction in an entrepreneur's informational advantage (Arthurs and Busenitz 2003; Norton and Tenenbaum 1993; Osnabrugge 2000). For example one venture capitalist commented:

   The challenge for very early ideas is that you need somebody who
   has all the heritage and domain expertise to execute well ... and
   understand what building a product that meets the market
   expectation will require ...

A majority of venture capitalists indicated that crowdfunding environments would be highly susceptible to signalling effects from constituent members. Signalling theory is often used in venture capital to explain a vote of confidence in a venture's stability and intestability (Davila et al. 2003). In the case of crowdfunding, venture capitalists believed that one investor's decision would likely result in additional like-decisions from the crowd. These signalling effects would result in negative perceptions of the credibility of crowdfunding models. Nine of the venture capitalists commented that venture opportunities with highly rated prospects would generally be funded more credible sources of financing. The following statement is indicative of a majority of responses.

   There is also the argument that if a company can't raise
   institutional money there's got to be something wrong with it ...
   if they can't there may be a big question mark on their ability and
   therefore they are really settling for the second-best arena ...

Thus the findings support the need for crowdfunds to comprise suitably informed and experienced investors which has some support in previous research showing that online environments foster the formation of highly segmented groups (Anne and Anurag 2005; Boyd and Ellison 2008). Thus, it is proposed that:

P1 The adoption of crowdfunding in start-up financing is reliant upon a model in which the crowd is composed of suitably informed and experienced investors.

Ex-ante investment factors

Findings 2: Deal screening.

Venture capitalists stated that an initial deal screening process would help ensure that crowdfunding was appropriately managed. This was generally considered to be due to some start-up projects simply being unsuitable for this model. For example, one interviewee commented that '... from the life sciences sector specifically, I see a number of difficulties because you'd need to raise a lot of money ...' In addition, a majority of interviewees nominated that crowdfunding models would require specific deal screening criteria that restricted incumbent access to crowdfunding so as to minimise agency costs associated with adverse selection problems. Within this context adverse selection exists when an entrepreneur has an information advantage and engages in opportunistic behaviour to secure investment (Amit et al. 1998). The value of a crowdfund with specific deal screening criteria was considered in ensuring that the knowledge, skills and/or expertise of crowd members were appropriate to the venture project and would foster the appropriate levels of engagement of the crowd within the venture decision-making process. For instance,

   ... the crowd would be best investing in the opportunities that
   they know more about or that they have had exposure to. If you're
   going to make the most of this model you're going to need to make
   the most of what the investors can offer ...

Eight of the interviewees agreed that whilst deal screening may serve to assist in controlling for agency problems and costs by ensuring deal flow is consistent with the crowd's investment ability, it would not necessarily guarantee appropriate investment selection due to the likely diverse nature (and associated levels of business experience) of the online crowd (Anne and Anurag 2005; Boyd and Ellison 2008). Therefore, based upon the preceding discussion, the following relationship is proposed.

P2 The adoption of crowdfunding in start-up financing is reliant upon a model using deal screening specific to the composition of the crowd.

Findings 3: Deal referrals from knowledgeable and objective sources.

Deals exclusively sourced through referrals may help minimize deal-noise and ensure the crowd is making investment decisions on high quality deal flow (Sorenson and Stuart 2001). This sentiment was confirmed during the course of the interviews with a majority of venture capitalists nominating that the success of crowdfunding models would be reliant upon input from qualified external investment agents to ensure the selection of suitable investment opportunities. The following statement is typical of most responses:

   There needs to be a way of filtering out the start-ups so that the
   crowd doesn't just fund anything ... This would be important for
   the crowd in helping guide them in terms of what is good, by having
   a radar into where all the best deals are ...

Due to the potential diversity in skills, knowledge and experience and also the diversity in preferences and crowd motives, which may represent the reason for a crowd referral rather than the crowd referring on the basis of probable returns, most venture capitalists believed that the referral source should be external from the crowd. For instance, one interviewee commented that, 'The downside with a crowd is that they are not necessarily domain experts and don't really know ... Its probably the case that I am actually going to get misinformation back ...' This appears consistent with previous research in the context of venture capital, suggesting that startup capital investments that use deal referrals are more likely to facilitate deal flows of high quality (Fried and Hisrich 1994; Shane and Cable 2002; Sorenson and Stuart 2001). Based upon the above discussion, the following relationship is posited.

P3 The adoption of crowdfunding in start-up financing is reliant upon a model engaging external deal referrals from a trusted network.

Findings 4: Crowdfunding structure and deal information sensitivity.

All interviewees reported that the crowd would need access to sensitive information regarding a deal in order to conduct adequate due diligence prior to the investment decision. However, a majority of venture capitalists reported that sensitive information is not likely to be available for distribution to a crowd of investors. For example, one interviewee commented that 'The majority of entrepreneurs would be reluctant to share the level of information required to make this workable ...' In particular, most agreed that only information that was protected by patents or that which was already publically available would be distributed to a crowd of investors. For example:

   ... once you have got the Intellectual Property locked down or the
   information is public already, then possibly crowdfunding could
   work ... after you have that protection then you could go out and
   get the funding from a crowd ...

Furthermore, venture capitalists stated that information provided to the crowd would be likely result in unauthorised distribution due to difficulties in ensuring confidentiality. For instance:

   If you're sharing with 1000 online investors ... even though they
   have a financial commitment, you could be almost certain that this
   would leak ...

Overall, venture capitalists reported that the online environment of crowdfunding poses a significant risk for start-up firms seeking finance. This appears consistent with previous entrepreneurship research suggesting that the disclosure of sensitive information regarding startup ventures may be detrimental to the success of an investee company (Fried and Hisrich 1994). Hence, we propose that:

P4 The adoption of crowdfunding in start-up financing is reliant upon a model where sensitive information is not required or distributed to the crowd of investors.

Findings 5: Implementation of due diligence provisions in crowdfunding.

As detailed in the previous section, venture capitalists were not of the opinion that crowdfund investors should be permitted to access to the type of information required to undertake adequate levels of due diligence. Nevertheless, was all of the interviewees suggested that the success of the crowdfunding model would require that each member of the crowdfund undertake their own due diligence to ensure that they make informed investments. For example:

   The crowd would have to satisfy itself about the individual or the
   company or start-up that is asking for money.... There is a lot
   that is necessary in order to. have enough information to make an
   informed decision. This would be a very intensive process for each
   person in the crowd. at least this is a very intensive process for
   venture capital ...

Eight of the venture capitalists reported that given the potential of a large diverse group of crowdfund members, adequate due diligence would be unlikely to be undertaken given that in the early stages of venture creation, the information needed is often highly qualitative in nature. For example:

   How much can start-up companies really tell, how much is this the
   sort of thing that can be written down on a two-page company
   summary and how much is it going and having a coffee with this guy
   who has come up with this crazy idea ...

These findings are broadly consistent with previous research indicating that venture capitalists should undertake a range of comprehensive measures to minimise their information disadvantage and thus make more informed investments (Fried and Hisrich 1994). Importantly, a majority of venture capitalists did agree that crowdfund investors would have the ability and motivation to make a considered judgement, albeit from different information and experiential bases. Thus,

P5 The adoption of crowdfunding in start-up financing is reliant upon a model where investment deals do not have complex due diligence requirements.

Ex-post investment factors

Findings 6: Endowment of the crowd's contractual rights to an external party.

All venture capitalist interviewees self-identified that individual members of the crowdfund would find difficulty in maintaining ongoing involvement in a venture ex-post. This was largely based upon the assumption that large stakeholder groups would promote inefficiencies for the venture concerned. In particular, interviewees nominated difficulties in power sharing and decision making authority. For example:

   If you have a very large number of people participating in this ...
   with an expectation or even a soft expectation that they do
   contribute towards the vision and execution it can cause all sorts
   of problems ...

However, most venture capitalists agreed that crowdfunds should adopt an intermediary to assist in managing the any ex-post investments. In particular, it was suggested that these intermediaries could hold a seat on the board and perform typical managerial functions normally associated with venture capital firms. This approach was believed tantamount to having a crowd of 'silent investors' for the remainder of the investment period. The following statement is typical of the majority of interviewee responses.

   It's not uncommon for a group of investors to effectively join
   together with a nominee that basically holds that shareholding for
   a group of investors.... the individual who is empowered ought to
   be in a position to make a sophisticated knowledgeable decision
   about an investment.

There is significant discussion in entrepreneurship literature regarding the venture capitalist's use of contractual clauses in controlling agency-related expenses (Kaplan and Stromberg 2003). In the context of crowdfunding, most of the venture capitalists (nine in total) believed these contractual rights would most likely result in significant inefficiencies unless an external intermediary undertook administrative responsibility (for example, procuring information, additional equity financing, technical advice) for the crowd. Therefore, based upon the above discussion, it is proposed that:

P6 The adoption of crowdfunding in start-up financing is reliant upon a model where the crowd's contractual rights are delegated to an external intermediary capable of making decisions for the crowdfund.

Findings 7: Board representation in crowdfunding models.

A majority of interviewees were of the opinion that board representation for the crowd would facilitate timely decision-making, thus safeguarding the crowd's investment. For example, Crowd investing would need some sort of infrastructure around it similar to what we see in the venture capital industry ... Who is on the board ... would be very important because it's a large part of how we stay involved...' In addition, most suggested that it was important for the crowd to maintain board representation to ensure that the crowd's intentions would be adequately represented. For example:

   Having someone on the board helps ensure that you know how your
   investment is tracking and having some control ... I can't see how
   a crowdfund could operate without these kinds of things... they are
   a very important part of the whole process ...

A majority of interviewees believed that representation should not be selected from within the crowd but should be a person or intermediary organisation that is external to the crowd and is able to represent the crowd's intentions and skilfully respond to critical business decisions for the venture concerned. This is consistent with prior research suggesting that much of the venture capitalist's ex-post involvement occurs through the contractual right of maintaining a position on the start-up company's board (Forbes et al. 2009; Kaplan and Stromberg 2003). Thus, we posit that:

P7 The adoption of crowdfunding in start-up financing is reliant upon a model that allows the crowd to maintain representation on the venture's board.

Findings 8: External intermediary engagement in value-adding activities with portfolio companies.

A strong majority of venture capitalists reported that the crowdfund's portfolio companies would require typical value added support normally provided by a venture capitalist firm. During the course of the interviews it became apparent that value adding at the early stage of venture development was an essential ingredient of new venture success. Furthermore, venture capitalists were of the opinion that it would be difficult for the crowd to provide value-adding support without the assistance of an informed intermediary. For example:

   I think it takes quite a while to develop that value-added
   capability ... after you have been in a specific domain for a
   period of time you just have networks that generate out of
   necessity and you know where to go to get things and I think then
   there is value add and I think that goes with good management ...
   Crowdfund investors will want somebody who has ridden some winners
   and been there in that space.

Importantly the fee-sensitivity of the intermediary undertaking the value added support was identified as an important issue for the crowdfunding model. That is, the crowdfund would need to cover the operational overheads of the intermediary in a similar fashion to the approach adopted by venture capital funds in apportioning management fees to support professional staff roles within the venture capital firm. For example:

   There are rules about how big a fund has got to be to wash its
   face. To pay properly its managers there must be a minimum size
   fund to produce enough fee flow, because people are fee sensitive
   to engage a successful manager who is capable of ensuring the
   crowd's investment is difficult ...

The significance of the crowds ability to provide value adding capability is consistent with research finding that the role that traditional venture capitalist organisations undertake in providing value added support to their portfolio companies comprises the most significant element of the venture capital firm's ex-post involvement (Sapienza et al. 1996). On this basis, the following proposition is presented.

P8 The adoption of crowdfunding in start-up financing is reliant upon a model that allows for the crowd to value add to its portfolio of companies.

Findings 9: Applicability of crowdfunding models for ventures with a limited economic life.

There was consensus of opinion that crowdfunding is potentially motivated by altruistic desires and thus may not be relied upon as a source of capital for start-ups that may require follow-on investment from funding bodies. For instance,

   When the crowd is investing, they might say yes I'm prepared to put
   in one dollar to invest to get it to the prototype ... So they
   might only want to fund it to a prototype, but what's the total
   runway, what is the capital runway, what if that's not all that is
   required ...

Also:

   ... the first time you might raise two million dollars from however
   many people. and then there is a need for a subsequent round and
   you find that you need to get these people to cough up again.
   People might say I won't come in, or alternatively they wont change
   the rights under which they invested ... I think this would be very
   challenging.

As a result of this, most venture capitalists believed that crowdfunds may inappropriate for start-ups focusing upon realizing value over the long term. A complicating factor that was also widely recognised was that venture capitalists perceived crowdfunding to be a risky and unsecure source of capital given the number of individual decisions required for crowd capitalisation. For example,

   ... you are dealing with individuals rather than institutions ...
   and their capacity to default on what is agreed and to not provide
   the money when it is required will create a very intolerable
   situation ...

Based upon the preceding discussion is proposed that:

P9 The adoption of crowdfunding in start-up financing is reliant upon a model with a limited economic life and where the portfolio companies do not require follow on funding.

Findings 10: Use of exit options in crowdfunding.

A majority of venture capitalists believed that the crowdfunding model of start-up financing would be more suitable in situations when an exit-funding option could be reached quickly and would be most appropriate for start-up ventures that could reach market commercialisation of their products in a relatively short period of time. One venture capitalist commented that,

   My feeling is that it would not work where there is significant
   capital requirement. It would be better in the situation where you
   could fund a business through to profitability by way of them
   getting a product to market ... industries have a very low capital
   requirement.

In addition, a majority of interviewees commented that a structure around exits may ensure that crowdfund investors could realise their returns. In particular exiting processes were perceived as time consuming and some investors, if enabled, would hold out on exiting in the hope of receiving higher returns in the future. This was viewed as acting as a disincentive for crowdfund investors:

   A very real problem for investment groups like this is that you
   will have some investors that don't want to take the next round's
   offer because they would have been diluted or they are not
   receiving the exit price they think they are entitled to. When
   negotiating agreements, this is a real problem because you want to
   make sure that the group has some common understanding or they will
   not want to work together ...

Finally, five of the venture capitalists reported that a set of optimal exits may negate the need to negotiate with each individual crowdfund member when the economic life of the fund was finalised. That is, an intermediary could engage a set of appropriate exit options. Thus, we propose:

P10 The adoption of crowdfunding in start-up financing is reliant upon a model selecting deals where exits are reached quickly or where optimal exits are pre-determined.

The impact of crowdfunding

Findings 11: Contribution of crowdfunding to the innovation process.

Overwhelmingly, all venture capitalists believed that crowdfunding would provide access to a new pool of funding and that this new pool of funding would generally have a positive impact. However, while many acknowledged that this financing model would attract some startup firms that currently may find difficulty in raising finance through traditional means, most did not believe that crowdfunding would enable firm-level innovation. For example:

   That whole financing ecosystem relies on an idea being protected,
   now that idea is either protected by trademark or IP patents or
   it's kept as a trade secret i.e. no one publishes anything about
   it ... Crowdfunding would require to a certain extent that an
   entrepreneur expose an idea to a very broad base of participants
   ... that loss of confidentiality of an idea I think actually
   destroys the element of innovation that can be monetised over time.

Also:

   I think the concept of crowdfunding in certain areas is a
   fascinating one. I can certainly see that it has a lot of merit for
   one-off events for example, but as a basis for innovation and
   seeking investment and returns, I suspect it is not something that
   will gain any traction, and is potentially quite dangerous.

The venture capitalists perceptions of the agency control mechanisms required for the adoption of crowdfunding in start-up financing documented in this study represent significant barriers and restrictions to how and when the model can be engaged. Therefore, the success of the crowdfunding model appears to be predicated on how appropriately it is engaged in the startup financing realm. Where crowdfunding can be harnessed, there is a great potential for innovation in these areas to be exploited by an interested and informed crowd of investors willing to assume these high level risks. Thus it is proposed that,

P11 Where crowdfunding may be harnessed, there is great potential for innovation in these areas to be exploited by an interested and informed crowd of investors willing to assume high-level risks.

CONCLUSION

This exploratory research aimed to capture the salient agency dynamics influencing the adoption of crowdfunding in start-up financing. Given the paucity of prior research in this area, a convergent interviewing approach was used to identify venture capitalists' perceptions of crowdfunding agency dynamics throughout the investment process. Venture capitalists were interviewed so as to gain in-depth understanding of the actual agency dynamics in a variety of situations in which they occur (Gartner and Birley 2002). As well as being experienced and informed investors, venture capitalists maintain a close working relationship with the entrepreneurs and managers of their portfolio of companies (Arthurs and Busenitz 2003; Bottazzi et al. 2008). Previous research has investigated this relationship using an agency theoretical lens (see Arthurs and Busenitz 2003; Bolton and Scharfstein 1990; Cumming 2005; Norton 1995) finding that agency problems and costs are particularly apparent in the investor and investee relationship. Therefore, mechanisms that control for agency problems and costs typically dictate the structure and form of the relationship between these two parties. Importantly this research has identified what mechanisms are required to ensure the appropriate application of crowdfunding models in start-up financing.

Given that crowdfunding is an emerging trend, this research provides a preliminary guide to assist entrepreneurs in how to appropriately engage with crowdfunding capital sources in the context of start-up finance. For example, deal screening criteria may limit what start-ups are appropriate candidates for crowdfunding. As such, this research provides the first criteria in identifying appropriate start-ups for crowdfunding. That is, start-ups with high information sensitivity, complex due diligence requirements, and a long duration before an available exit would not be appropriate candidates in accessing finance through crowdfunding models.

For investors and venture capitalists, the identification of the agency control mechanisms relevant to crowdfunding in start-up finance may help ensure that this online form of capitalisation is engaged appropriately. This is particularly important given the high costs incurred when failing to adequately control for agency problems (Kaplan and Stromberg 2004; Sahlman 1990). For this reason, the model identifies how investors can control for agency related problems and costs. In addition, agency dynamics are identified (and conceptualised) throughout the investment process. This information may be useful to practising venture capitalists or other stakeholder investors analysing the investment process by highlighting ex-ante and ex-post agency cost controls.

The success and longevity of crowdfunding in start-up finance may depend on ensuring the model is appropriately engaged. By doing so, the uptake of crowdfunding may provide access to socially embedded capital that is typically not available to entrepreneurs. However access to this capital is dependent on the restrictions set in place for the appropriate use of crowdfunding. Nevertheless, facilitating capitalisation in this way may provide a new pool of finance and help contribute toward bridging the equity-financing gap.

Limitations

Differences in managerial orientation and experience may limit the predictive application of this study in adopting crowdfunding in start-up financing. The relationships proposed in this research may be relevant to the interviewed venture capitalist's experiences, successes and risk preferences in new venture investments. As such, the venture capitalist's personal experience as an investor may influence their perspective of the adoption of crowdfunding models in start-up financing. A further limitation of this research is dependent upon how venture capitalists value, perceive and engage with online communities and social media. That is, the perceived credibility, longevity and capacity of crowdfunding in start-up financing may be dependent on the venture capitalist's personal online behaviour.

In addition, the interviewees' perceived understanding of crowdfunding may limit the construct validity of this research. Whilst great care was taken to ensure all venture capitalists were presented with a complete definition of crowdfunding, there still remains scope for the individual venture capitalist to personalise and interpret this information differently. Whilst this research highlights the agency dynamics apparent in crowdfunding models when applied to startup financing it does not seek to explain the agency dynamics present when the crowd funds not-for-profit or cause-related ventures. Therefore, these findings are limited in their predictive application to other uses of crowdfunding.

Furthermore, the size of the sample, the contextual information of the interviewee respondents as well as the qualitative methods of data collection and analysis may limit the generalisability of these findings. Therefore, whilst 'replication logic' (Yin 1994) may be claimed with convergence determined between different venture capitalists with proximal similarity, the predictability and generalisability of the findings should nevertheless be limited to the context of early stage financing (Johnson 1997).

Theoretical implications

This research extends our understanding and application of agency theory in start-up financing, specifically, and the venture capital industry, generally. In particular, we examined venture capitalists' perceptions of the agency dynamics relevant to crowdfunding as a source of start-up financing. Through focusing upon the investor-investee relationship, this research provides new information as to what mechanisms venture capitalists consider important in this relationship design. Thus, this research highlights agency control mechanisms relevant to early stage financing. In addition, this research exposes the complexities of the principal-agent relationship before and after the initial investment decision. In particular, venture capitalists have identified the elements of venture capital they consider most important and most likely relevant in contributing to risk minimisation and success, thus controlling for agency problems and agency costs (Osnabrugge 2000). Our findings provide new information regarding how these mechanisms can be applied throughout the investment process in the context of crowdfunding start-up ventures and is the first investigation of the perceived agency cost controls throughout the investment process from an Australian perspective.

By introducing crowdfunding as a topic for academic exploration, this research builds on social capital theory relating to resources embedded in online communities and social networking sites (Ellison et al. 2007; Utz 2009). That is, this research presents a model detailing how online communities and 'crowds' can be effectively engaged in light of apparent growth and the emergence of crowdfunding trends. Furthermore, this research explored crowdfunding as a vehicle for bridging social capital embedded within online environments. Using an agency theoretical perspective, a unique understanding of how online communities can be utilized to best manage and allocate their resources in start-up financing contexts. Therefore, this research provides preliminary insight into the use of agency control mechanisms in collaborative (social networking) models which are based on receipt of small contributions from online investors.

Finally, this research adds to prior social capital theoretical research investigating the development of business models centering upon virtual communities (Bughin and Hagel 2000; Hagel and Armstrong 1997). Businesses that successfully harness social media in the context of commercial transactions may have significant leverage opportunities through greater access and information sharing with consumers (Hagel and Armstrong 1997). Hence, with the growth of virtual communities directly impacting on traditional business models (Bughin and Hagel 2000), this research provides a basis for future measurement of agency dynamics and leveraging resources embedded within online communities.

Implications in the market for start-up finance

The identification of the agency control mechanisms relevant to crowdfunding in start-up finance may assist in ensuring that this online form of capitalisation is engaged appropriately so as to promote venture creation and sustainability. This is particularly important given the high costs incurred when failing to adequately control for agency problems (Kaplan and Stromberg 2004; Sahlman 1990). This information may be useful to practising venture capitalists or other stakeholder investors within the context of ex-ante and ex-post agency cost controls. By doing so, the uptake of crowdfunding may provide access to socially embedded capital that is typically not available to many entrepreneurs. Whilst access to this capital is dependent on the restrictions set in place for the appropriate use of crowdfunding, facilitating capitalisation in this way may provide a new pool of finance and help contribute toward bridging the equity-financing gap.

Venture capitalists represent only one stakeholder in the market for start-up finance. Therefore, further explanation and exploration of perceptions from informal providers of start-up finance and an investigation into entrepreneurs' perceptions of crowdfunding models is recommended.

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Andy Ley, Griffith University

Scott Weaven, Griffith University

Table 1. Profile of venture capital firms

                                          Respondent

                        A       B      C        D       E        F

Type of firm          Fund     Fund   Fund   Private   Fund    Fund

Professional staff     < 5     < 10   < 5      < 5     < 5     < 10

Total capital
raised *              < 30     < 80   < 80     < 5     < 30    100+

Current portfolio
companies             < 20     < 20   < 10     < 5     < 20    < 30

Investment
range *                < 1     < .5   < 5      < 1     < 1     < 10

Geographic
preferences          AUS **    AUS    AUS     Local    AUS      AUS

Industry             ICT ***                                   ICT,
preferences          Biotech   Any    ICT      ICT     ICT    Biotech

Board seat
required               Yes     Yes    Yes      Yes     Yes      Yes

Management
support available      Yes     Yes    Yes      Yes     Yes      Yes

                                   Preferred business stage

Pre-seed stage                 Yes

Seed stage             Yes     Yes             Yes     Yes      Yes

Start-up               Yes            Yes      Yes              Yes
Early stage            Yes            Yes      Yes              Yes

Expansion              Yes            Yes                       Yes

IPO

                                        Respondent

                        G        H        I         J         K

Type of firm         Private   Fund     Fund      Fund     Private

Professional staff     < 5      < 5     < 10       < 5       < 5

Total capital
raised *              < 10     < 30     100+      100+       < 5

Current portfolio
companies             < 10      < 5     < 10      < 30       < 5

Investment
range *               < .5     < .5     < 10      > 10      < .5

Geographic
preferences           Local    Local     AUS       AUS      Local

Industry
preferences            Any      Any    Biotech   Biotech     ICT

Board seat
required               Yes      Yes      Yes       Yes       Yes

Management
support available      Yes      Yes      Yes       Yes       Yes

                                 Preferred business stage

Pre-seed stage         Yes      Yes                Yes       Yes

Seed stage             Yes      Yes      Yes       Yes       Yes

Start-up               Yes               Yes       Yes
Early stage                              Yes       Yes

Expansion                                Yes       Yes

IPO                                                Yes

* Millions of dollars (AUD); ** Unrestricted nationally within
Australia (AUS), *** Information and Communication Technologies (ICT)

Note: some demographic information presented here has been rounded to
absolute value to protect the anonymity of interviewees

Source: developed from the findings of this research