Regulation, information asymmetries and the funding of new ventures

Summary

Focus

Using the new and unregulated crypto sector as a testing ground, we examine how regulation affects the venture capital funding of young and innovative firms. We focus on understanding if and how an increase in the stringency of regulation reduces the knowledge gap between entrepreneurs and investors – a common hurdle in acquiring venture funding. We study how different regulatory interventions at the state level in the United States impact the amount of funding raised by startups.

Contribution

We construct and present a novel index to measure the stringency of state-level regulations in the cryptocurrency industry. This index is available for researchers. We combine the index with granular data on venture capital transactions to shed light on the complex interactions between government regulations and the flow of private capital into new ventures. Our analysis of the introduction of the BitLicense in the state of New York – an unambiguous increase in the stringency of regulation – shows that regulation can have positive effects on the financing of new ventures by reducing information asymmetries.

Findings

We find that more stringent regulation is positively associated with increased venture capital funding. The beneficial impact of stringent regulation is more prominent in financial hubs, where the financial sector is more mature. The granular firm-level analysis of the introduction of the BitLicense shows that regulation can assist young, low-collateral firms, as well as foreign, unspecialised and small investors, by reducing the knowledge gap between entrepreneurs and investors, thereby improving access to funding. This indicates that regulation may not only protect investors but also nurture new ventures.

Abstract

Can regulation ease problems of asymmetric information for young and innovative firms? The new and largely unregulated cryptocurrency ecosystem offers a unique setting to test this hypothesis. We construct a comprehensive measure of regulatory stringency at the state-month level for the United States and find that more stringent regulation is conducive to more private capital, but only in states with a more developed financial sector. Looking at granular deal-level data we trace the increase in access to capital triggered by a more stringent regulatory environment to a reduction in information asymmetries. Consistently with a reduction in information asymmetry, we find that younger firms with less tangible assets benefit more, and foreign investors, investors that are not specialised in the crypto sector and those with fewer investment professionals invest more capital.

JEL classification: D82, G24, G28, O16

Keywords: corporate finance, venture capital, asymmetric information, cryptocurrency