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In 2015, John Donovan was listening to a podcast when he heard about an entrepreneur who was hoping to start a business in the podcast space. Considering the topic and the audience, it would seem that this entrepreneur could easily reach a large number of potential investors. However, US regulations at the time prevented companies from raising capital from unaccredited investors, i.e. people who are not certified as having high net worth.
“In 2015, if you wanted to raise capital from ‘normal’ people and give them an equity stake in a company, you had to file financial statements with the SEC. You basically had to become a public company,” said Donovan, assistant professor of accounting and PwC faculty member at the Mendoza College of Commerce at the University of Notre Dame. “You’re talking about small businesses looking for $100,000 and having to comply with the exact same regulations as a company like General Motors.”
Following SEC regulations associated with the JOBS Act in late 2015, the rules changed depending on the amount of capital raised, but only slightly. Startups should always provide audited financials or hire an accountant to review the financials before raising capital from unaccredited pooled investors – all of which can get expensive and complicated, although there is very little evidence to demonstrate the value of these requirements.
Prior to working in academia, Donovan was a certified public accountant at PricewaterhouseCoopers (PwC), where he became interested in startup financing. “It’s a very important part of our economy. Job creation is largely driven by the emergence of new businesses and access to capital for start-ups,” he said. “Yet there isn’t a lot of evidence in our research looking at the role that accounting and financial reporting might play in this space, largely because the data is really hard to come by. And here in the United States, we demand that [startups] not only provide it, but have it reviewed by an accountant.
Donovan decided to go in search of data that could help determine the importance of accounting and financial reporting in the startup space. He described his research in the article “Financial Reporting and Corporate Finance: Evidence of Equity Crowdfunding», published in Sciences de gestion.
While the US has separate regulations in place, Donovan found the UK to be quite the opposite. “In the UK they said you could provide whatever information you wanted. It’s all voluntary, there’s no need to audit or review it,” Donovan said. “So I thought the UK was a really good lab to see what that market would look like outside of regulation. I wanted to see first if the companies were disclosing that at all? And if they are, How important is it really to reduce information asymmetry and let investors know what’s going on with the company?Do they even react to this information?Does this help companies raise capital?”
To answer these questions, Donovan collected the data manually by tracking every UK-listed company on Crowdcube, the world’s largest crowdfunding platform, over a three-year period to see how much capital they were actually raising and what information they had provided to investors to help raise this capital. His findings both supported and challenged some repeated perceptions among startup investors.
“The popular belief is: – I only worry about growth. I’m only worried about the future prospects of this business,” Donovan said. “I think what a lot of people have in mind is that every potential tech company wants to be the next Uber or Facebook or a huge growth app. But many small businesses are not. About a quarter of my sample were actually food and restaurant businesses. A lot of startups, especially in this market, are just trying to do something simple like start a restaurant or find a new sustainable cafe.
Donovan’s research has shown that, contrary to popular opinion, financial reporting does indeed matter in the average case. Investors respond to having more financial details and are more likely to provide capital to companies that provide financial information. However, this is not a single statement. Company assets and liabilities tend to only really matter after more mature companies have had significant operations.
“It makes sense,” Donovan said. “If you only have one month of historical income or assets, that’s irrelevant. What I’ve found is that at three years, that’s when information has started to become relevant. And that’s about the median company entering that market in my sample.”
Donovan also found that reporting historical information about assets, liabilities, and revenue has an indirect positive effect on a startup’s future, as raising capital is tied to future asset growth. He suggested that entrepreneurs could use this information to reevaluate their relationship with accounting and consider having financial statements to provide to potential investors when raising capital.
He uses this study in his undergraduate accounting classes to help illustrate the importance of accounting to successful entrepreneurs. However, he hopes others will recognize this area of research and its potential to improve entrepreneurs’ access to capital in the United States.
“In the UK, this market has become more important than private equity or venture capital. It hasn’t happened here in the United States yet,” Donovan said. “The big question is, are regulations in the United States potentially harming entrepreneurs? Is it too expensive? And if so, what should the regulation of this market look like?
Originally posted on Mendoza News.