The JOBS Act reminds me of the old joke about the elephant and the blind men. An elephant looks very different depending upon which part you’re touching. There’s lots of hype around the concept of crowd equity for sure – almost breathless at times. This week’s announcement that the SEC is moving forward with rules to effect the intent of the Act – to allow unaccredited investors (i.e.., not wealthy people) to invest in startups through on line exchanges – was no exception. Make no mistake, allowing people who are not well off to invest up to $5,000 in the stock of a small privately held company is a big change – it undermines 80+ years of securities laws based upon a simple principle: in the absence of a test for financial sophistication, having sufficient assets to absorb an investment loss is the best protection for investors.
But, is it a big deal for startups and investors? Sadly, as a practical matter, there are aspects of this new regime that will create an adverse selection bias against the best opportunities being available on online exchanges targeted at non accredited investors. Here are some of the reasons why I have this concern:
Most Exits Are Not Public Offerings
Investors invest to make money – this means that they must have a way to monetize their investment. A company becoming publicly traded is undoubtedly the best way for small shareholders to achieve liquidity. However, most liquidity events are not companies becoming public. The most likely outcome for a startup investment is – ready? The company failing. The second most likely is a sale of the company as a whole. And, in this case what the seller gets back more often than not is more stock (think of it as the equivalent of winning a pie eating contest and getting more pie). Without a public offering, holders of crowd equity are going to have a hard time getting money for their investments. I sincerely doubt that this reality is likely to be widely known by the participants in the online portals – Facebook is the exception, not the rule.
Crowds are Not Wise
One of the primary rationale behind letting the not wealthy invest in startups is that it will be done solely through online exchanges where the wisdom of crowds will monitor and weed out bad investments or shady promoters. Nice idea, but the words wisdom and crowds don’t often interact when it comes to hard things that require expertise. What I have seen through my teaching of group dynamics and being a former hedge fund trader, is that absent some sort of credentialing process, groups tend to dumb down, not smart up, when it comes to complex challenges like investing.
You can use the wisdom of crowds for capturing group behavior and sentiment (which is why I think that crowd funding of projects works well), but it falls apart when sophisticated analysis is required. For example, Wikipedia, the acknowledged symbol of the wisdom of crowds, is actually a curated site with a group of experts that edit and confirm the content. Another example? Look at your own Facebook feed. What is being talked about generally is interesting for gathering sentiment, but when you are looking for information you tend to look to the experts in your feed – people whose opinions you respect. My point is that it will not be the crowd that regulates investments online, it will be the people who turn out to be reliable indicators of the quality of a company. In other words, the crowd will seek and crave curation – and I am very concerned that this craving will result in greater possibility of manipulation from supposed experts. Because….
Experts Will Not Be Incentivized to Curate for the Crowd
While it’s nice to imagine that enlightened people will inform and lead online investment behavior, and I am sure some will try, the reality is that having a good sense of what makes an investment compelling is a skill. It is skill that is gained through experience, contacts, hard work and a bit of luck. Even if you believe that startup investing success can be quantified (see 500 Startups), the tools for doing so are not developed easily or for free. In my experience, people who invest their own time and money to develop investment skills tend to want to be compensated for it with something other than karma. The availability of competing online models that will allow for compensation (Angel List syndicates, for example) and physical world possibilities (being a GP in a venture fund or making direct investments as an Angel investor) will undoubtedly shade the interests of skilled experts in crowd equity markets.
Having Small Stockholders is a Nuisance or Worse
As mentioned above, most exits are business sales where stock (or cash) will be paid to the stockholders. Dealing with small holders in a corporation, particularly a startup, will add compliance expense and logistical challenges. Moreover, the securities laws principles and state corporate laws governing the purchase of stock for stock may make certain transactions impossible if there are non-wealthy small holders in a company. This is not a small point. I’ve done hundreds of M&A deals over the years, and companies that have small holders are a nightmare. And, nothing in the JOBS Act addresses these issues.
Because of these limitations and challenges, my concern is that the JOBS Act online exchanges will not attract the best companies – it will not be worth the effort for the companies, nor for the experts who support them. I fear that the pull of proprietary deal flow – where the best deals are closely held by those that have the best skills and networks – will remain in place. A parallel online market – centered on accredited investors – seems much more likely to challenge existing structures. And, crowd funding on projects, which relies much more on sentiment, will also succeed. But, crowd equity? I just don’t think it’s worth the hype.