The Economics of Startup Fundraising: Why Market Structure Matters

The story of startup funding usually involves bold and risk-taking founders and investors. However, there is much potential in market structures. The organisation, accessibility, and allocation of early-stage investment markets profoundly affect other markets and the economy in terms of effectiveness, expansion, and long-term productivity. 

The friction, gaps in information, and inefficiencies fuel the outcomes of both investors and entrepreneurs further, perpetuating the same issues. 

Capital Allocation and Economic Efficiency  

The economic theory of capital markets states that resources will be allocated to the most productive use. In practice, early-stage investment markets have more uncertainty than the public equity and debt markets. 

Startups generally lack:

• An insufficient number of operational years  
• Intangible assets  
• Predictable future cash inflows  

All the above conditions contribute to the information asymmetry that exists between founders and investors. The entrepreneur is the one with the in-depth information regarding the product, the team, and the roadmap. On the other hand, the investors have to use the signals, do the due diligence, and use their networks to make the best estimate. 

Capital allocation becomes less efficient when the asymmetry of information is greater. This means that the higher the quality of a startup, the more difficult it will be to fund it. At the same time, the weaker the fundamental aspects of a business may be, the easier it will be to obtain funding because of superior networks.

For market design, structural issues arise.

Search Costs and Market Fragmentation

Search costs are an overlooked economic barrier to financing a startup.

Founders frequently spend months locating suitable investors by investigating top angel networks, approaching venture capitalist funds, and contacting startup fundraising services. Meanwhile, investors look through thousands of decks every year to find a handful of worthwhile investments.

This is a bilateral search problem, which leads to more transaction costs on both sides.

The lack of a cohesive market results in:

• Closed networks for investors
• Syndicate and club deal flow that they won’t share with others
• Brokers and middlemen charge a lot of money

The need for a warm introduction to acquire an investment is greater for founders

The lack of cohesion increases the demand for the market to be transparent, and the market slows the process of collecting capital. This increases the economic friction of a cohesive market.

The problem is more than an inconvenience. It impedes the productivity of the entrepreneurs in the market.

Information Asymmetry and Signalling

The early-stage market is especially susceptible to signalling distortion.

Well-connected founders gain:

• A more prominent brand and greater recognition
• Association with more prominent accelerators
• Funding from more well-known top angel networks

These signalling factors can bring in more funding, even if the core substance is comparable to the less well-known startup.

Social proof is relied on heavily by investors to mitigate risk. If the reputed angel syndicate takes part, others may follow.

First, managing risk is a protective reasoning approach. Second, this reasoning may facilitate the further concentration of capital in certain areas, industries, or among specific founders.

In economics, signalling is one way of decreasing uncertainty, but can result in a distortion of equilibrium.

The Function of Market Design Intermediaries

Intermediaries are in place to minimise friction. In the marketplace for startups, this is particularly relevant to:

• Angel networks
• Institutional brokerage
• Investment clubs
• Crowdfunding

Specialised startup fundraising services

Each of them has a distinctive role when it comes to minimising searching costs, and in most cases, these roles are complementary.

• Clearly, for an intermediary to efficiently act, they must:
• Reduce asymmetries in information
• Lower the costs of a transaction
• Increase the access to capital
• Improve the quality of match

If an intermediary can achieve these, there is a net increase in the productivity of a market.

Family Offices and Increasing Sources of Capital

Activity from family offices financing startups has increased in the past few years. Many family offices that have previously focused primarily on wealth preservation, now allocate some of their capital to venture and growth equity as part of a diversified portfolio.

This change has structural implications.

Family offices typically engage in the following practices:

• They work with extended timelines
• They face less restrictive frameworks
• They are direct deal participants or co-invest alongside angel investors

Their involvement boosts the ecosystem's liquidity and brings in 'patient' capital.

From a macroeconomic perspective, the improved ecosystem liquidity also aids the startup funding market's resiliency through less risk-taking periods from the institutional venture capital market.

Access to family office funds, however, is often reliant on personal relationships, again underlining the importance of network access in the nascent stages of market development.

Regional and Sector Concentration

The structure of the market also determines the geographic flow of available capital.

In the United Kingdom, a large portion of venture capital is still invested in London and the Southeast. Although there are signs of growth in regional ecosystems, this structural concentration still remains.

When funding resources are concentrated in a small geographical area:

• Local startups receive excessive funding
• Regional startups face a disproportionate funding search
• Overall, economic growth is stunted

This concentration brings about a productivity challenge. If promising ventures in the peripheral areas of the economic core are unable to secure funding efficiently, the total output of the nation is reduced.

Improving the flow of resources within a region will also increase the efficiency of capital investment at the national level.

The Cost of Inefficiency

The structural inefficiencies present in a system magnify the risk that will always be present in the innovations that drive the system.

Startups whose owners struggle with multiple different network systems for a long time incur opportunity costs from:

• Less operational focus
• Slower product development
• Delayed hiring

These costs are often not documented but are real.

Also, investors that lack transparency about the funding gaps of the sponsors and how sponsorships have succeeded in the past fund the gaps of the sponsors in a less than optimal way.

Market transparency diverts potential value from real economic activity.

Funding Market Improvement

A funding market for early-stage businesses that is economically efficient has:

• Reduced funding search efforts
• Transparent funding performance
• Standardised legal documents
• Clear funding performance costs
• Access to a range of investors

Market infrastructure improvements can decrease friction and better align interests.

For example, technology-enabled funding path approximators attempt to minimise funding friction and funding path complexity by paying less for funding paths and having less friction. These approximators centralise funding path performance data and funding costs to improve the efficiency of finding the optimal route for funding.

The purpose is not to reduce the potential of funding. This must be priced and a focus placed on funding the rapidly growing opportunities.

Startups must fund themselves, but there is a lot going on in the background. The economic fundamentals are present: asymmetry of available funding information, high funding transactional costs, funding networks, and geographic funding concentrations that can be exploited.

How well innovation is paired with investment is determined by market structure.

With the UK focusing on becoming the world’s leading startup ecosystem, optimising the operational structure of first-stage funding markets is as equally important as optimising the level of funding available. Reducing the structural barriers of opacity, friction, and limited access can increase the flow of productive ventures, and remove the structural limits placed on high potential ideas.

In the economics of innovation, the flow of capital is as critical as the volume of capital.