Digitization in the Market for Entrepreneurial Finance: Innovative Business Models and New Financing Channels

Digitization, the process of creating a digital representation of a product or a process, is probably the most important transformation of the global economy since the industrial revolution. Entrepreneurial business models are changed as inherently digital products and services are designed to compete on a global scale (Monaghan et al., 2020). Scalability and growth disproportionately reward founders and investors, igniting a cycle of increased attention by traditional and nontraditional investors.

Taking a financial industry perspective, digitization is disrupting the traditional financial services sector, including banking and insurance, driven by a new breed of entrepreneurial companies. These fintech and insurtech companies aim to either offer a better experience to the end customer, including offering totally new services, or improve the efficiency of their delivery of financial services (Bollaert et al., 2021; D’Acunto et al., 2019). Payment systems have started being digitized decades ago with the widespread adoption of credit and debit card. Yet, these early developments did not truly challenge the strength of the incumbent players’ monopolistic rents and largely kept the industry unaltered. With digital transformation, the financial industry has seen radical changes in all areas: smaller more agile players, pioneered by PayPal, have brought game-changing technologies to the payment market. Innovative start-ups have broken the seemingly unconquerable domain of currency exchange. Ingenious players have started using artificial intelligence (AI) and machine learning (ML) to provide tailored management services and advanced trading tools in areas previously simply non existing such as for instance bond trading. Finally, the very essence of finance and banking—lending and capital provision—has been similarly and deeply affected by this phenomenon (Chen et al., 2019; Cong & He, 2019; Thakor, 2020). Banks, while still subject to regulatory supervision, have reacted to the threat of newcomers by venturing into previously unexplored territories (Buchak et al., 2018).

While billions of dollars have been invested in the fintech industry around the globe, there are significant gaps in our understanding of their specific role, and of their impact on customers, other entrepreneurial companies, and incumbents, and about what drives their success (Allen et al., 2021; Goldstein et al., 2019). These are critical questions especially in the light of the COVID-19 pandemic that has massively hit the global economy, challenging traditional sources of start-up capital (Howell et al., 2021) but also spurred digitization at an unprecedented rate.

Second, digitization also alters the type and timing of finance that support entrepreneurs. It has opened alternative financing channels like crowdfunding and initial coin offerings (ICOs), which now complement traditional venture capital (VC) and business angel (BA) funding. This fast and disruptive process has led to a new environment in which the proliferation of innovative funding sources for new ventures has substantially increased the complexity of the start-up financing eco-system. Equity underwriting is considerably simplified and disintermediated (Hervé & Schwienbacher, 2018), offering start-ups the opportunity to obtain finance from a crowd of small retail (i.e., nonprofessional) investors. Moreover, alternative financing channels provide start-ups with a different type of value added (e.g., market test) from the one offered by VC and BA, and funding opportunities that might be particularly useful when other sources are not available (Walthoff-Borm et al., 2018).

Finally, digitization also rejuvenates traditional entrepreneurial finance intermediaries like BA and VC investors, for example, by offering new target search technologies or new methods to assess risk, which is now data driven and significantly more granular (Bartlett et al., 2019).

Within this context of radical change in the entrepreneurial finance ecosystem (Sussan & Acs, 2017), this special issue aims at improving our understanding of the impact of digitization on the market for entrepreneurial finance. We explore how digitization has spurred fintech entrepreneurship, developed new types of players in the entrepreneurial finance ecosystem, and transformed traditional entrepreneurial finance channels. We elaborate the overarching framework of analysis of the special issue in the next section, and discuss the specific contributions selected for this issue in the following section.

In this special issue, we set to provide much-needed evidence on digitization and the market for entrepreneurial finance. We focus on some open questions with far-reaching consequences on the ongoing transformation of the entrepreneurial finance ecosystem and its future growth trajectory. In particular: how the availability of VC and credit markets in affects the development of fintech ventures across different countries; the interdependencies between country-level regulation of digital finance channels, with special reference to ICOs; the change in the boundaries of fundraising following the introduction of blockchain currencies; the disrupting role of P2P lending in replacing traditional banks; the rising role of crowdfunding platforms as digitally distributed information discovery mechanisms; the automation of investment decision in early stage financing through ML selection models; and the link between entrepreneurs’ human capital and the innovativeness of VC-backed high-tech start-ups.

In the following subsections, we will present a more detailed overview of each topic as how papers included in this special issue contribute to its understanding.

The disruption that digitization is causing to financial intermediation opens a number of key questions on public welfare, financial inclusion, discrimination, cybersecurity, and regulation (Allen et al., 2021; Bollaert et al., 2021; Goldstein et al., 2019). Even if we restrict the analysis to the relatively narrower field of digital entrepreneurial finance, the challenges and opportunities for researchers are enormous.

First, as suggested by Farag and Johan (2021), new forms of intermediation in entrepreneurial finance can give us a new way of looking at central themes in corporate finance from new angles. New players differ in the way they produce and process information, which creates opportunities for researchers. This is for instance the case with crowdfunding (Le Pendeven et al., 2021), where the flow of information between firms and investors is much easier to observe and quantify than in other entrepreneurial finance settings. Distributed ledger technology can also provide an unparalleled level of transparency over customer engagement and investor transactions in startups, which opens interesting opportunities to research the effects of financial events (such as M&A and VC rounds) on operating activities.

Second, our understanding of the relations between digital and traditional financial channels for entrepreneurial ventures is still rather limited. Some previous studies show a positive association between digital and traditional financing sources (Drover et al., 2017). Other studies highlight boundary conditions under which access to digital financial channels makes the receipt of follow-on financing from professional investors more likely (Butticè et al., 2020; Roma et al., 2017). In this special issue, Saiedi et al. (2021) suggests a substitutive relation. We need further research adopting a more fine-grained lens that distinguishes between different types of alternative (equity crowdfunding, P2P lending, ICOs) and traditional (independent VC, corporate VC, governmental VC, BAs) financing channels. Moreover, while conventional wisdom associates alternative financing channels with ventures’ seed stage, there are ventures that use digital finance after the receipt of finance from traditional sources (Colombo & Shafi, 2019). Considering that the financing of entrepreneurial ventures is path dependent, in that their early funding choices persist over time (Samuelsson et al., 2021; Vanacker et al., 2014), it is important to understand how digital finance has changed the sequences through which entrepreneurial ventures receive financing and what are the implications for the performance of these firms, as reflected in their ability to grow and/or go through a successful exit (through an IPO or an acquisition). Moreover, one wonders whether firms created by entrepreneurs who traditionally experience difficulties in obtaining external finance from professional investors, for example, because of their gender (Marlow & Patton, 2005) or because of their firm’s location in peripheral areas far from VC hubs (Colombo, D’Adda, et al., 2019; De Prijcker et al., 2019), exhibit different patterns in terms of sequences of use of digital and traditional financial channels. Do these new players help to alleviate financing constraints for these ventures, leading to a further democratizing of entrepreneurial finance? Further, we currently lack an understanding of what the performance consequences are of these funding differences, both in types of funding and in the timing and sequence of funding.

Third, the proliferation of AI- and ML-driven solutions to virtually every economic activity makes it natural to expect a quick and disruptive application to the complex task of project selection by professional investors, where large swaths of data can be utilized to identify dominant opportunities. However, the potential of a large-scale adoption of big data and ML algorithms opens important operating and ethical questions. From an operating standpoint, we need to understand better whether the identification of future successful trends and ventures is the type of high-signal-to-noise ratio application where ML excels (Israel et al., 2020), or whether the entrepreneurial finance context is too noisy and dynamic to generate reliable outcomes. The paper by Blohm et al. (2021) provides initial evidence of superior performance of data-driven techniques over traditional approaches, especially when investors lack relevant experience. We expect however this area to spur substantial more research that can further probe the existence of an upcoming transformation of investment selection practices.

From an ethical perspective, the success in the adoption of AI/ML investment selection tools won’t be determined solely by its financial performance. A rich and growing literature has recently highlighted how gender and race biases are surprisingly widespread in the financing of ventures (Gornall & Strebulaev, 2020; Hebert, 2021; Zhang, 2021). These biases translate in a systematic underfunding of female and minority start-ups and related vigorous calls to address such differential access (e.g., Lang & Van Lee, 2020). While algorithmic approaches may be expected to be unaffected by these kind of human distortions, the empirical evidence has shown otherwise, identifying a surprising presence of biases that machine supervisors often fail to spot (Manyika et al., 2019; Obermeyer et al., 2019). This evidence has far-fetched implications: from ethical and legal considerations with regard to nondiscriminatory decisions, to the economic effects of hampering the development of new ventures. Broad interdisciplinary considerations with regard to algorithm usage and design are therefore urgently required to ensure equal and unbiased access to funding for early-stage companies.

Finally, the digital revolution poses interesting policy questions. The extent to which the disintermediation of entrepreneurial finance is welfare improving is a matter of debate and, as such, is the extent to which regulators should intervene to curb or promote it. Brummer and Yadav (2019) discuss several regulatory issues with fintech’s trilemma, including regulatory sandboxes and pilot programs. The fact that regulators are tackling fintech issues differently also allows researchers to determine the effectiveness (and unwanted effects) of the different choices (Bellavitis et al., 2021; Cumming et al., 2021 partly build on this in this special issue). Interestingly, some of the new players happen to provide finance to the small and highly innovative firms that policymakers particularly care about, sometimes displacing existing intermediaries. This means that regulators will need to understand how these new players work and possibly reconsider the effectiveness of policies based on subsidizing or facilitating financing via more traditional intermediaries (e.g., SME guaranteed loans).

We are indebted with Johan Wiklund, the editor, for accepting the Special Issue proposal and for constant guidance through the process. We thank conference participants at the 2nd Emerging Trends in Entrepreneurial Finance Conference, Hoboken, NJ; the 3rd Entrepreneurial Finance Conference, Milan, Italy; the EM Lyon Symposium on Digitization in Finance. We thank Tatiana Manolova, Thomas Hellmann, Gary Dushnitsky, and Douglas Cumming for helpful comments. This paper and the entire Special Issue are dedicated to the memory of Mike Wright, Imperial College, who left shoes too big for us to fill.