Olav Sorenson: Money

Olav Sorenson is currently the Frederick Frank ’54 and Mary C. Tanner Professor of Management and Director of the Core Curriculum at the Yale School of Management, and Professor of Sociology, at Yale University, where he teaches electives on entrepreneurial finance and venture capital, as well as modules on strategy, innovation and organization design. His primary stream of research pertains to economic geography, focusing on how entrepreneurship influences the growth and competitiveness of regions within countries.

1 Why is your work relevant to a broader audience outside of your specific discipline?

The work on crowdfunding is an offshoot of some of the earlier work I did on venture capital. What has always interested me is the public policy angle. There are both explicit and implicit subsidies for venture capital, both in the United States and in other countries. The important question is: is it doing something for society? Those subsidies have costs; its expenses could be allocated to other things. One of the early papers that I did on venture capital is looking at whether funding venture capital seems to be creating jobs and economic growth. I found pretty strong results that venture capital seems to create quite a few jobs and economic growth. To give you the sense of the magnitude of our estimates: one venture capital-backed company would create on an average of 300 jobs and an average income associated with those jobs are $80–100,000 a year. So not only quite a few jobs but good jobs, actually, on average. But, of course, one of the issues of venture capital has been—if you look—96% or 97% of venture capitalists are men, more than 90% of venture capitalists are white, and there has been recent research showing that there is tremendous homophily in funding decisions: most of the people getting money from venture capital are also white men. So one of the things that people get excited about in crowdfunding is that it potentially opens access to entrepreneurial finance, which, from the research of venture capital, creates lots of pretty good jobs to a broader set of people. And so eventually I’d really like to look at the ethnic and gender distribution of those funding decisions. It also struck me that we could look at the geographic distributions. Venture capital is a very local business. Most venture capitalists won’t invest more than sixty to a hundred miles past where their headquarters are. One of the things that‘s interesting is that crowdfunding, at least, on the Kickstarter and Indiegogo data, is really happening everywhere. Not only does it expand access in general but it also seems to be extending access to venture capital because we found that regions that had success with crowdfunding campaigns are more likely in subsequent years to get venture capital investments, even places that haven’t had venture capital investments in the past.

2 What are the “commons” that your specific research fights to preserve, protect, contest, or share?

I think the central issue is equality of opportunity. The fact that in the current state of the world—the way that venture capital is organized—most of the opportunities for capitalizing or starting a startup based on an idea depends potentially on your gender, ethnicity, and where you’re located. That’s not equal opportunity. So we’d like to have a set of institutions that enable anyone that might have an interest in a potentially profitable idea anywhere to get access to the funding they’d need to get that kind of startup going, based on that idea.

3 What is at stake in your work? 

[Crowdfunding] is a relatively new thing because it’s been heavily regulated. The equity side of crowdfunding has been illegal on the side of the U.S. in the 1920’s until the May of last year. The Jobs Act, which was passed in 2012, provided the kind of framework for allowing equity for crowdfunding. One of the big questions is: is the risk worth the reward? There is a risk. The reason why it was illegal for so long is that the Security Exchange Commission’s operating principle is to protect investors. Their biggest fear is that what we’ll get in crowdfunding is a bunch of mini- Madoffs. So far fraud rates have been extremely low. Ethan Mollick at Wharton—who’s done a bit of analysis—his estimates suggest that less than 1% of businesses are fraudulent, or—actually, that’s even too strong a word— less than 1% fail to deliver on their promise. As it grows more and more and as people start investing, you can imagine that fraud would creep up. One of the difficulties is that unlike in public security—if you’re investing a stock that’s traded on a stock exchange—there’s a lot of public information that’s available. You’re required to release audited reports and so forth. It’s generally hard to engage in fraud in these public companies. But with these small companies, there’s more opportunities and the SEC just doesn’t have enough staff to investigate them individually. At least, the current expectation is that the platforms themselves are going to be the police: and if they don’t do that effectively, they lose their license as platforms. That’s a little bit of what’s at stake.

4 Has your research encountered physical spaces that potentially perpetuate or exacerbate the issues your work seeks to redress?

Part of the excitement about these platforms is that because they’re virtual they seem to eliminate the spatial distribution of some investors. That’s probably less true than what people believe. If you look at the dynamics of crowdfunding, successful campaigns almost always get their early money from investors from the same city or same kind of region as whoever’s running the campaign. And so it seems like what’s happening is that at first, it’s important to get friends and family to sign on, then it takes on a life of its own and you get much more distant investors. So you still need to have that kind of local element but it does eventually give you access to a larger base of investors. There’s a lot of crowdfunding platforms. You could imagine a world in which there is a handful of platforms for each country. The reason why each country would be the natural basis is because there’s a lot of differences in the laws surrounding equities or debt from one country to the next. But it’s also clear—if you look the kind of people investing regularly in crowdfunding campaigns— that a lot of them are interested in investing in their community. Most of the things on Kickstarter or Indiegogo are products or even things of music or art which are easy to transport. But I think that we’re likely to see an explosion in investments in things like coffee shops and restaurants and boutiques. The physical components are pretty tightly linked with the social. Another paper that I’ve been working on recently: is venture capital more effective in integrated communities? And the way that we’re looking at integration is basically residential segregations. To what extent does the city have different ethnics living in different areas versus intermingled? And we find strong evidence that venture capital is far more effective in more integrated cities. I think the reason why is that it starts to break down some of this homophily where you only get access to venture capital if you’re from the same ethnic group or living in the same region. You’re much likelier to see cross-ethnicity investments in more integrated communities. And that’s very much a physical thing. We use what we call “instrumental variables” which is a fancy statistical technique. But what we actually use for the instrumental variables is interesting: the extent to which the center city is broken up by railroads. It looks like places where there are railroads— where the area is broken up into these smaller units that are bounded by railroad tracks— you’re more likely to get a slum or isolated neighborhoods than in communities where the railroad tracks are running through the center and not creating such sharp boundaries.