One of the most notorious phenomena in international development is the so-called “missing middle” problem: the scarcity and under-productivity of small and medium sized enterprises (SMEs) in developing countries. Around the world, SMEs can be a leading source of employment and an important driver of innovation. There is a strong positive correlation between the existence of a robust SME sector and high per-capita GDP. Yet in far too many countries, the potential of the SME sector is not being realized.
One cause of SME sector underdevelopment in developing countries is the inability of SMEs to access start-up capital and financing, which can be the “single most robust determinant of firm growth.” SMEs in developing communities face substantial challenges accessing capital, and as a result are often unable to scale or form in the first place. And corruption plays a central role in preventing access to finance among SMEs—by discouraging foreign direct investment, distorting the banking sector, and increasing the costs of equity capital. While corruption poses a significant problem for businesses in many developing countries, SMEs bear the brunt of the harm. Indeed, 70% of SMEs in the developing world cite corruption as a major barrier to their operations.
In the spirit of technological solutions to work around the barriers and distortions created by endemic corruption, equity crowdfunding is emerging as at least a partial solution for SMEs that require capital but are unable to get it because of corruption.
Crowdfunding came to prominence with the success of sites like indiegogo and kickstarter that specialize in donation-based crowdfunding (principally in wealthier countries). The idea behind equity crowdfunding is to raise money for a small business (or a particular project or venture) by seeking smaller contributions from multiple sources instead of having a few backers make large contributions.
There are many potential variations on the equity crowdfunding concept. Some platforms aggregate money from investors and then choose where to invest that money all together. Others merely provide information, to connect investors with businesses by marketing potential investment opportunities. Another model involves temporary equity stakes that expire, revert, or convert into or from some other kind of security. Platforms could alternatively market royalty interests or retain equity in the ventures themselves.
Equity crowdfunding in one form or another is already in effect in many parts of the world. (It became a viable option in the United States last May). Its greatest potential, though, may be in developing countries, in many of which SME access to finance is often hampered by widespread corruption. Indeed, crowdfunding has grown explosively in both developed and developing countries over the past few years.
For ventures based in nations where corruption is endemic, there may be no alternative to financing except to pay a bribe to a financial institution of some sort. Though geographically distant, foreign sources of capital that are perhaps less corrupt could in fact be more accessible. Substantial streams of foreign capital into countries struggling with corruption already exist, whether from public sources in the form of foreign aid or private sources in the form of diaspora remittances. (The latter totals approximately $350 billion worldwide.) Attempts to harness diaspora investment for economic development have failed in the past in part due to concerns about corruption. Equity crowdfunding provides a simple and efficient way to repurpose diaspora remittances from consumption toward SME investment.
Like blockchain property registries and direct deposits into bank accounts for welfare subsidy payments, equity crowdfunding is a way of using technology to reduce the involvement of additional, possibly corrupt parties in effectuating a transaction. Put simply, an investor can pay directly into a venture without worrying that a corrupt government bureaucrat will take a cut before the money gets to the business. Of course, there is still an obvious middleman in an equity crowdfunding transaction – the platform. Substituting the middleman of the platform for a corrupt government official would likely be an improvement, and in addition, the internet-based nature of the middleman provides some protection.
The internet-based nature of equity crowdfunding is also essential to its efficiency in cross border settings. While developing countries lagged historically in adoption of new technology, many are now at the forefront of technological innovation. Given technological leapfrogging, or the “adoption of advanced or state-of-the-art technology in an application area where immediate prior technology has not been adopted,” less developed countries may not in fact be at a disadvantage in this sphere. In addition, crowdfunding allows investors to aggregate investments and diversify risk.
Even outside of access to finance, corruption can be a huge barrier for SMEs. Therefore, we should not expect equity crowdfunding to assuage all of the doing business issues that corruption creates. Nevertheless, if it can be used along with other tools to reduce obstacles for SMEs, equity crowdfunding could be an important economic development initiative.