When Firms Are Potemkin Villages: Formal Organizations and the Benefits of Crowdfunding

Scholars have long been interested in the reasons why firms exist, arguing that they have efficiency and productivity benefits over other approaches to organizing. We examine why entrepreneurs often form firms, since entrepreneurial ventures are not large enough to accrue many of the expected efficiency benefits from formality. Instead, we argue that there are reasons besides efficiency (and regulation) that cause firms to exist. We suggest that an unrecognized implication of new institutional and ecological theory leads entrepreneurs to establish firms as a legitimating agent, and to allow them to act in industries with existing firm populations. We test this theory by examining a unique sample of crowd-funded startup companies, to empirically identify the advantages of formal versus informal organizations with different types of third party entities. We find that adopting the mantle of a formal organization helps entrepreneurs in contexts where they operate with other formal organizations, but not in interactions with other types of resource holders. We also demonstrate that crowdfunding may have substantial benefits for entrepreneurs beyond fundraising.