I know that I am supposed to embrace all things cool and innovative – Angel List, lean startups, accelerators everywhere for entrepreneurs (with or without business models) and so forth – otherwise, I can’t be seen as a cutting edge VC. The implicit theme when these new ideas are presented, and promulgated, is that what is old is bad and what is new is good. It’s a recurring cycle of innovation – economists call it “creative destruction.” Let me therefore say that I am all for innovation and change – but at the risk of being perceived as an old man shaking his fist at the neighborhood kids (“get off my lawn”) the idea that crowd funding is going to change the startup industry in a positive way is just silly.
I suppose what drove me over the edge and break ranks was a post I just read in TechCrunch “How the JOBS Act Could Change Startup Investing Forever.” Here’s the link. The post, which was written by a promoter of crowd funding, lays out the argument that by making startup financing more democratic and open, more financing will be available for startups, financing will be available for startups that aren’t funded by those silly Angels and VCs (that don’t get most businesses other than technology) and that crowd funding will be able to do the appropriate diligence on investments and avoid fraud through the pooling of information. Implicit in this argument is a belief that there is a large untapped pool of capital available for startups, if we would allow the less wealthy to invest in them, or if we got intermediaries like VCs out of the way.
For those of you who aren’t familiar with this issue, here is a short primer on the current world we live in. If you want to raise capital from investors there are a few proscribed ways to do this:
- You go through a complex process of registration with the SEC, which requires the preparation of reports and financial statements that are reviewed for completeness and conformity with approved disclosure requirements.
- You sell to a small group of people that you know (who could be rich or not), in a transaction that is not generally offered.
- You sell to a slightly larger group of rich people, in a transaction that may be slightly more widely offered.
What you cannot do? Offer to sell investment in your startup in a general public solicitation without complying with SEC disclosure and accounting rules. In short, if you want to ask a large group of people for gifts that is fine, but if you want to ask them to give you money to make money, you have to comply with rules that are designed to provide the investor with some level of consistent information.
The bedrock principle behind crowd funding is that it is undemocratic and inefficient to prevent startups from easily soliciting the public for investments; investors can fend for themselves in the age of the Internet. We should get the gate keepers of capital out of the way, so that people can immediately get at all these wonderful investment opportunities that the rich and gate keepers are hoarding. Put in this way, the argument should appeal to those that oppose regulation and those that hate financial gatekeepers and the 1%. It’s just a winner issue.
So, why am I concerned? There are a number of reasons:
I do not agree that the problem with our financial markets is that early stage investments are not easy to get. The issue is that the capital available to purchase financial investments is in a small number of hands, and generally those funds are managed professionally. There may be some incremental money to be gathered by making it easier for people to buy startup equity, but the level of additional wealth that is truly available for risky investment is not that much larger. The reality is that investible wealth is concentrated in a small percentage of the population – 20% of the population holds substantially all of the financial assets in the United States, with the top 1% of the population holding as much as a third of all financial assets in the United States. The median net worth of American family heads in the 55 to 64 age group is approximately $250,000 (that’s cash, stock, bonds, equity in a house, IRAs and so forth). You can’t really bend the rules of physics. Making investing in startups easier to do is not going to change who has the money and how they view it. For an investor, particularly an investor who works with a professional manager, any investment opportunity is viewed through the same prism – how well does the investment opportunity compensate the investor for risk? Startup investments are risky, and in many cases do not properly compensate investors for the risk that they take. Making these investments more readily available will not change that fact.
It could be, in fact, that the reason why most startup investing occurs through direct interactions and professional management is that there is a risk reducing function that is performed by the VC or the experienced Angel. I know that comment could touch off a firestorm of comments, so let’s just leave it as a “maybe” move on. Suffice it to say that wealthy people tend to believe this, as do the professional managers of endowments and pension funds. Making it easier for these people to directly invest doesn’t mean that they will.
A second issue I have with crowd funding is the idea that a larger group of people making investment decisions together will make better decisions. From the Tulip Bubble in the 1600s to our Mortgage banking fiasco of the last decade, markets have proven repeatedly that large group market decisions are prone to momentum and emotion. On the other hand, what the experience of the US securities market since 1934 has shown is that when you have a market regime in place that requires the provision of consistent information, and a consistent market, you are more likely to have investors participate, and in many cases make good and considered investment decisions. The crowd funding argument in many ways is a rejection of the regulatory regime that levels the playing field; because it is expensive. Sometimes, however, expense is worthwhile.
Which brings me to my third issue: most investors are not sufficiently financially literate to evaluate an adjustable rate mortgage, much less a startup. We do not have a financial literacy test in our financial markets (perhaps we should), so instead since 1933 we have relied on the concept of accreditation, which simply stated is “if you have $1 million in assets, and you make a bad investment in a risky startup you can probably afford to lose the money – or at least hire someone to help you understand the risk.” Crowd funding’s response is – why be so paternalistic – if people want to risk their money they should have the right to.
Which brings me to my fourth issue – when financial markets are not policed fraud occurs. The phrase a “fool and his money” is truer than you can imagine. In my career as an investor and previously as a lawyer I can only say that I am constantly amazed by the level of mendacity that criminals can show when it comes to investment opportunities. Implicit in the crowd funding model is that the market should not be policed, or not policed and regulated as heavily as start up financing currently is. Well, as sure as the sun comes up, you should expect financial criminals to take advantage of the opportunity if crowd funding eliminates regulations that require disclosure and consistent information. My overall conclusion is that when you combine criminals with inexperienced investors you don’t get a happy result. What do I care? Because another thing that has been shown throughout the years of capitalism is that when a market is perceived as rigged or unfair it tends to fail. A startup financing ecosystem that is prone to fraud will rapidly discredit startup investing as a whole.
And on to my next point – even if crowd funding works like its supporters say it will (thousands if not millions of new investors come into the world of startup investment) I am not convinced that every entrepreneur should take advantage of it. Here’s why: startups rarely if ever go as planned. In fact, they generally go really badly more often than they go well. Does it really make sense to have investors in a startup that aren’t ready for this? And, by ready I don’t mean them saying “yep, I’m ready,” I mean do they have the psychology and appreciation to deal with the random walk of startup entrepreneurship. I don’t know whether crowd funding supporters think that all of these new investors will just “be understanding,” or if what the investors feel is irrelevant once the entrepreneur has the money. I am not sure it matters, all I know is that in my experience when certain investors lose money they get angry, and when some of them get angry they get lawyers. In short, I believe that the best way for an entrepreneur to raise capital is to do it from friends and families, sophisticated Angels and professional investors. Why? Because they will leave the entrepreneur to succeed or fail, so long as she tries hard and honestly.
My overall point is that the financial markets that exist today for startups works reasonably well to protect the interests of investors and entrepreneurs. Creating a system that is more “democratic” will not achieve a significant pool of new capital, and has the possibility of discrediting startup investing if people who cannot afford to lose money (either financially or psychologically) are unhappy, or, worse, defrauded.
Perhaps ultimately the crowd funding movement confuses a current liquidity bubble in Angel investing (particularly in Silicon Valley) with a long term change in where capital is aggregated in our economy, or a change in the rules that people who have money use to make investments. I just don’t think that is the case, and ultimately, my conclusion is that crowd funding is unlikely to have a positive effect over the long term on startup financing. Other portions of the JOBs Act, particularly making it easier to reach the public markets in an IPO are laudable and should be supported. But, I think that crowd funding of startups is something better left undone.