Regulation, information asymmetries and the funding of new ventures

(January 2024, revised May 2025)

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 comprehensiveness of the regulatory framework reduces the knowledge gap between entrepreneurs and investors – a common hurdle in acquiring venture funding. We study how regulatory interventions at the state level in the United States affect the amount of funding raised by startups.

Contribution

We construct and present a novel index to measure the comprehensiveness 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 comprehensiveness of the regulatory framework – shows that regulation can have positive effects on the financing of new ventures by reducing information asymmetries.

Findings

We find that more comprehensive regulation is positively associated with increased venture capital funding. The beneficial impact of comprehensive frameworks 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

We examine the effects of regulation and the motives that underpin it. The development of the crypto sector offers a unique setting due to the absence of incumbents, the lack of pre-existing rules and the fact that governments regulated the sector holistically. We construct a comprehensive measure of regulatory activity at the state-month level for the United States based on state laws affecting the crypto sector and find that both consumers' and entrepreneurs' pressure drives regulation, in line with theories of economic regulation. We also find a positive association between regulation and venture capital funding in financial hubs. A detailed analysis of New York's BitLicense sheds light on the mechanism: regulation reduced information asymmetries, enhancing funding for startups. Overall, our results highlight the complex motives behind regulation, which can address genuine market failures even when driven by the interest of competing groups.

JEL classification: D82, G24, G28, L51, O16

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