Who Should Invest in Startups?

/// Who Should Invest in Startups?

October 1, 2013  |  Blog

Should middle class Americans invest in tech startups? Outside of the small circle of angels and venture capitalists clustered in Silicon Valley doing it currently, should anyone?

This question has been prompted by the Jumpstart Our Business Startups (JOBS) Act. Signed into law in April 2012, the bill relieves small “emerging growth” businesses of complying with certain regulations deemed burdensome.

The JOBS Act also has provisions to democratize fundraising, the first of which took effect this week.

Since 1933, Federal law has prevented private, early stage companies from publicly seeking investors out of fear that the dearth of information would result in snake oil salesmen disappearing with investors’ money. On Monday, Title II of the JOBS Act took effect and ended this prohibition. Now startups can tell the public – in press releases, on Twitter, or through a viral music video on YouTube – that they are raising money. Instead of seeking out the small number of known investors in Silicon Valley and other startup hubs, entrepreneurs can advertise for investors and wait for the world to come to them, cash in hand.

But this will not democratize investing in tech startups – only open up the aristocracy a bit. Investing remains limited to “accredited investors” – individuals above a certain level of wealth.

That is where Title III of the act comes in. When approved by the Securities and Exchange Commission (expected in 2014), it will allow anyone to invest. Startups will be able to crowdfund their ventures like an art project on Kickstarter – $5 at a time – if they feel inclined.

The opening up of fundraising possibilities for early stage companies is meant to “jumpstart” their growth. But some have argued that it will also allow the American middle class – and not just wealthy investors – to benefit from the growth of companies like Facebook and Palantir.

Since only accredited investors can invest in startups, only wealth individuals and organizations can invest directly as angel investors or (more commonly) indirectly via a fund invested by venture capitalists. The general public has to wait to invest in emerging growth companies until they go public and offer shares on the stock market.

The logic is that since going public and being offered on a stock exchange comes with more disclosure requirements and quality controls, it is safe at that point for anyone to invest. Prior to that, only accredited investors are assumed to be sophisticated enough to understand the risks – and cushioned from the blow of failed investments.

The problem is that new technology companies like Facebook have been waiting longer and longer before they go public. One venture capitalist writes:

Microsoft went public in 1986 at roughly a $500 million market cap. Today, Microsoft has a market cap of $234 billion. Thus, the public investors in Microsoft have had the opportunity to realize $235.5 billion in market cap appreciation; the private investors had only a $500 million head-start. From IPO, a single share of Microsoft stock has appreciated close to 500x.

Facebook, by contrast, went public in 2012 at roughly a $100 billion market cap. That means that, whatever public stock price appreciation Facebook has over the coming years, private investors have had a $100 billion head-start against the public investors. Even if you were prescient enough to buy Facebook at its public low of approximately a $50 billion market cap, the private investors remain way ahead. If you bought Facebook stock at its IPO, to realize a similar multiple that Microsoft’s public shareholders have earned, Facebook’s market cap would need to reach nearly $50 trillion, roughly the size of the total market capitalization of all publicly-traded companies in the world.

With these technology companies going public later and later, the general public is increasingly missing out on the wealth they generate.

Risky business

Some see the more democratized world of startup investing as a revolution. The CEO of a company that facilitates crowdfunding predicts that it will “rapidly transform from a world of private boardroom deals towards a more open, collaborative, and efficient online process, much of which will center around investment crowdfunding.”

Others are less impressed.

For some, the devil is in the details. Venture capitalist Fred Wilson wrote back in August that the rules proposed by the SEC were too burdensome and the potential penalty (a one year prohibition from public fundraising) stringent enough to drive startups away from raising money this way.

Others think the entire thing is a stupid idea.

“Today’s a big, exciting day for anybody who has found it simply too difficult, to date, to throw their money away on idiotic gambles,” financial journalist Felix Salmon wrote on Monday. He sees thousands of investors funding unworthy startups that will burn through investment money without amounting to anything. He quotes an angel investor who derides “the notion/dream that somehow the internet can disintermediate social and relationship capital”:

I’d argue that this is precisely what the internet can not do: if you’re going to invest in a startup, you’d better know the founders, and you’d better know something that most people do not know. Information asymmetry is the only way to lower the risk profile on such crazy risky investments.

It may sound appealing to open up investing beyond the cozy circle of the startup scene. But when it comes to investing in two twentysomethings with an idea (rather than two other twentysomethings with a different idea), it’s best to be cozy. Reading about their idea online won’t do.

Since the discussion of Title II of the Jobs Act has mostly been between those championing it (because they have a vested interest in crowdfunding) and those pushing back on their breathless descriptions, we thought it would be valuable to seek the boring middle ground.

Investing in the stock market can easily amount to throwing money away on idiotic gambles. That is why personal finance advises investing in mutual funds with a diverse portfolio of companies. The idea is not to pick winners, but to enjoy the market rate of return. Investors who do try to beat the market generally hire full-time professionals to do it for them.

What could be the equivalent in startup world?

When it comes to giving your money to a professional investor, the answer is pretty clear. That’s what current venture capitalists do. They invest the money of very wealthy investors and large investment funds for a management fee and a cut of the profits. The only obstacle to a crowdsourced venture fund would be the venture capitalists’ disinclination to deal with thousands of investors instead of a select few.

Angel investing, the process of investing smaller amounts of capital in very early stage startups, has typically been done independently. Angels invest their own money, perhaps as part of a pool with several other angels.

But as of this week, there are new models to open it up to outsiders. Angel investor Tim Ferriss, for example, is allowing accredited investors to invest in startups alongside him. In this way, ordinary investors benefit from the experience of an insider choosing the investment in exchange for a cut of any profits.

We don’t know of any precedent for investing broadly in the venture market, instead of trying to pick winners. But we can imagine one. Stanford University, for example, has begun investing in its students’ startups. To avoid picking winners, the fund offers to invest in any startup to come out of StartX – a Stanford-affiliated startup accelerator – that meets minimum funding requirements from professional investors.

Similarly, we can imagine crowdsourced funds playing the role of mutual funds by widely offering funding to any startup that meets certain criteria. In that way, the fund would diversify across startups while benefitting from quality control of investing only in startups able to raise money from experienced investors.

Is it worth it?

If people figure out investment vehicles like the ones described above, startups could be a high risk, high reward investment with a legitimate place in individuals’ portfolios. They may even let the rest of America in on the wealth creation driven in tech centers like Silicon Valley.

The question is whether the possible benefits are worth the risk of investors (and eventually, the general public) having their money stolen by fakestartup.com or wasted on actuallyincompetentstartup.com.

While the narrative of helping the American middle class benefit from the wealth created by companies like Facebook sounds appealing, the problem is that venture capital has not been a good investment (on average) since before the dot com bubble.

The Kauffman Foundation is a nonprofit that supports entrepreneurship and entrusts a fair amount of its endowment to venture capitalists. In a report last year reviewing venture capitalist performance, Kauffman found that “venture capital returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in venture capital.” Since investing in startups is riskier than bonds or ordinary stock, it needs to deliver higher returns to be worthwhile. But Kauffman found that only 20 of the 100 funds they reviewed beat the market by more than 3% – before accounting for the VC’s 2% fee and 20% cut of the profits – and mostly on the strength of gains from before the dot com bubble burst.

This suggests that ordinary Americans are not exactly missing out on a golden opportunity. And more money pouring in from outside investors would not be unlikely to find good investment opportunities. Kauffman also found that smaller venture capital funds did better (or at least those below $500 million in size) and argued that “with six times the capital invested every year this decade than was invested in the entire decade of the 1980s, too much capital is the problem.” The number of good opportunities is just too small to support the entrance of everyone’s retirement savings, or even just a large number of outsiders looking for a piece of the action.

It’s an appealing storyline that ordinary Americans should be able to get in on the wealth created by the next Google or Facebook that currently goes just to a small number of industry insiders. But people don’t seem to be missing out on that much. Just as each smash hit like LinkedIn hides countless failed attempts to be the next billion dollar company, a few well performing venture capital funds hide the fact that most experience lackluster returns. The answer to the question of who should invest in startups may be… the people who do now.

Link: Who Should Invest in Startups?

Priceonomics – Alex Mayyasi

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