S.E.C. Gives Small Investors Access to Equity Crowdfunding
nytimes.com
nytimes.com
* The core issue: professional startup investors rely on (a) relatively large portfolios where (b) the winners succeed so outlandishly that they pay for the losers. Savvy investors --- most investors aren't savvy --- intuitively understand (a), but not (b), and you have to fully grok both concepts to make money from startup equity, because it's an equity class that is almost by definition way more risky than normal stock.
In particular: the math on "value investing" probably just doesn't work with startups.
* We have a distorted view of the win/loss ratio of startups, both because so many exits are in fact not net-positive for investors, and because so many startups fail without actually telling anyone (the lights are on, but nobody's home).
* There's probably a market-for-lemons effect bound to apply to equity-crowdfunded startups. Professional investors compete for dealflow. The whole system is designed to route the most lucrative prospects to the pros. There's no countervailing force that routes good deals to mom-and-pop investors who can't offer anything other than incredibly complicated cap tables to startup operators.
* A negotiated event that strikes 25% off the value of a publicly traded company's stock is a major news story (and a likely class action suit). But an event that dilutes startup common stock holders down to 50%, 25%, or 10% of their original valuation? Or that wipes it out entirely? In startup parlance, that's called Tuesday.
* Startups aren't like Kickstarter projects. Crucially: people put money into projects on Kickstarter, not teams. Professional startup investors do mostly the opposite. A project page on Kickstarter is a good prospective for a Kickstarter project, but it's not even close to a prospectus for a company.
Retail investors should get exposure to startups through carefully managed funds that own lots of different startups, not by trying to pick individual winners themselves.
Equity crowdfunding platforms will be responsible for due diligence and standardizing the equity offerings instead of the individually negotiated deals and preferential deals to different investor groups that is the norm right now.
I run crowd-lending analytics and automation platform, PeerCube https://www.peercube.com, for retail lenders on Lending Club and Prosper. I also consult and advise hedge funds and institutional investors on the same platforms. In my experience, retail investors appear to be much more vigilant, perform much more due diligence and selective than the institutional investors. This is primarily due to "own money" versus "other people's money (OPM)" and the amount of money deployed. When you have your own skin in the game, you are more vigilant.
Your arguments are more about maintaining segregation of certain areas for "privileged" classes. Exact same arguments were made when SEC approved retail investor participation in p2p lending in 2008/2009.
Edit: More details on SEC approved rules in SEC press release http://www.sec.gov/news/pressrelease/2015-249.html. It appears there are enough safeguards in place to alleviate investor screw ups.
1. Lending Club and Prosper Marketplace have grown up in a period of historically low defaults. We will see how successful investors, retail and institutional, really are at assessing and managing risk when the current cycle ends and defaults rise. As Warren Buffett said, "Only when the tide goes out do you discover who's been swimming naked."
2. Marketplace lending activity is increasingly institutional[1]. Without institutional money seeking yield, you would not see nearly as much dollar volume in this market.
3. While I would not be surprised to find that some institutional investors aren't very diligent, you should also recognize that the notes they are purchasing typically make up just a portion of their investments. Unless you have a 360-view of a fund, it's not entirely fair to pass judgment on how well the fund manager is managing risk.
4. Assessing the risk of Lending Club and Prosper notes, which are debt obligations associated with consumer loans, is a very different exercise than assessing the risk of an equity investment in a company, especially when that company has little or no operating history.
5. The last time I checked, the notes on Lending Club and Prosper were actually obligations of Lending Club and Prosper and are not secured by the actual loans. In other words, if Lending Club or Prosper run into financial difficulty and can't meet their obligations, investors can lose even if a borrower is still making payments on his or her loan. I would venture a guess that many of the supposedly diligent retail investors you refer to don't actually know this.
[1] http://qz.com/536573/one-thing-putin-and-kim-jong-un-both-ge...
Any advice, other than complaining to my state representative?
This changes the rules so retail investors can invest blindly in stocks, i.e. without being first informed about the nature of the investment opportunity through the SEC disclosures. It seems pretty reasonable to me that if someone wants to raise money, they should be required to disclose, to the potential investor, enough information about the financial position of the company and the nature of the investment for the investor to make an informed decision. If you want it leveled between institutional and retail investors, I'd prefer leveling in the direction of more transparency for both classes of investors, rather than less. If the issue is just that the SEC process is too bureaucratic, then propose a reform to streamline it, rather than bypassing disclosures entirely.
One thing that makes it particularly needed is that a possible alternative, dealing with misleading fundraising through after-the-fact lawsuits, is mostly ineffective, since successful suits end up as judgments against bankrupt companies, who won't pay them. If a company gets a bunch of investors while not being entirely truthful with them about its financial position/revenues/etc., suing them after it collapses doesn't help you at that point. That's the situation we had before the SEC was created, and was the motivation for the 1933 Securities Act requiring companies to register an offering and make certain disclosures, prior to selling securities to the public.
Your dad (not really your dad, but for sake of example) is a retail investor. He has no idea what he's doing, but he heard "through the grapevine" that he should invest in this one particular startup. He sends them his IRA balance.
A year later the startup exits, but he hasn't been paying attention and turns out he's been diluted to 10% of what he thought he had. Now he has nothing.
And people comparing crowdfunding with "regular stocks" - even on here where it's well known most startups fail - are prime example of which the public in general doesn't know enough about investment to consider it...
I'm not at all sure all of that makes sense, but it's a huge difference.
At the moment, the only logical explanation I can think of for posting such a piece is that you wish to reduce competition for equity by limiting the number of participants in the market. If you can limit the supply of cash, those with the cash can make many demands on those without. tptacek advocates for a limited supply of cash, carefully metered out by the cash-class, so as to preserve their position at the spigot (don't forget, those at the spigot get to take 'their' dividends/interest-payments/management-fees/transaction-fees/what-have-yous out of the stream; before anyone else even gets to see them).
OK
>plowing the proceeds of that work back into startups
So, you receive only cash for your work? No equity?
> seems like bad diversification to me
Ok, so you are invested in startups or tech companies then (if not, what are you diversifying from)? [Note: we have now contradicted claim 1]
>So no, I don't have an ulterior motive.
Maybe. I'm still not convinced that you aren't an investor though.
>Retail investors should get exposure to [x] through carefully managed funds that own lots of [xs], not by trying to pick individual winners themselves.
Said every fund manager ever [who, note, try to pick individual (for some definition) winners].
That's actually a great reason why this may work. Apple was Woz and Job's first company and they hadn't finished college, going into a non-existent sector. No current investor would look at them.
I know several startups that are working on something truly revolutionary with either no funding or very little funding, and I know several highly-funded startups that must be the punch line of a joke (honestly).
Software is the next oil. It's the next great explosion, and it has just started. And if anyone tells you that we're funding tech startups properly, they either don't know what they're talking about -- or they're an investor.
Will some people lose their shirts? I hope not. But we let the poor play the lottery whose odds are calculated and defined to not be possible to win. It seems if we know they can't win, we don't mind; it's when they can win that there's a bit of concern.
I don't want people to lose money either, but it's their right to spend $50 on something they find interesting with the hope of making life better for themselves and their children. And it's liberating to startups that they have more choices than suckle at the teat of the current set of angels and VC's or go home. It's like what happened to music: you can either have a sound and look that fits the major labels and their categories or go home. Angels and VC's have to win so they minimize risk. The people who invest in crowdfunded equity, though, are more likely to forgive losing that $50, so they'll take bigger risks.
And what we need right now, in this software and technology explosion, is more risk and experimentation and new ideas. The winner, in the end, may be the future itself.
Sorry, but this just isn't true. It is possible to win with a single ticket and the return on that ticket could be $xxxx million : $1.
One problem I see is that an investor may actually be dealing with a lottery-like game without knowing. That is, a particular investment may have actual, calculable odds (would depend on the business model) that are as worse as the lottery model, but are, however, unknown (or even unknowable) to an investor.
I don't think startup investing is for everyone, for some of the reasons you mention below. And I agree there's a risk of the ecosystem developing poorly to be a "market for suckers". But I think the JOBS Act is a net good thing and the concerns you highlight are addressable.
The main problem I have with the "old rules" of investing is that wealth is used as a proxy for sophistication. If you happen to have a PhD in Machine Learning, for instance, you're unable to invest even $100 in AI companies unless you're literally a millionaire. With companies staying private longer, most of the growth in high growth startups is only available to the wealthy. From the data we've seen so far from unaccredited investors trying to invest in startups (but failing the financial requirements) we haven't seen any correlation in financial status and savviness. Unaccredited investors try to invest in the same companies as the accredited investors, and they all avoid the weaker startups. So I'm optimistic about that, at least for the early adopter crowd. And I think as the ecosystem matures fundraising platforms will look less like Kickstarter campaigns and be more optimized for groups of people assessing/vetting startups. (But I'm an optimist and obviously biased.)
The biggest problem with the JOBS Act is the potential for adverse selection. If "the best" startups don't want to touch it with a 10-foot pole for legal reasons, that's a serious issue for the ecosystem. We've been spending a bajillion dollars on legal research and think we have something that makes this nearly a no-brainer for startups, but time will tell. Startup lawyers hate being guinea pigs with new regulations.
At best I think we'll see a lag in mainstream startups using Title III. Instead we'll see small businesses that are underserved by current investors first. With more precedent and familiarity with unaccredited crowdfunding I'm pretty sure we'll see more startups use it. A similar thing happened three years ago with "rich person" crowdfunding – many critics speculated only bad companies would use it, not-bad companies started using it, and now it's generally accepted.
Index funds would be great. The JOBS Act prohibits investment funds explicitly and it's prohibitively expensive to create a fund for early stage startups that unaccredited investors can participate in. However we're working on ways to emulate index funds, and I think it'll be doable by someone in the long-run.
Your comment suggests that by "sophistication", we all mean "understanding the offerings of companies", such as an AI expert knowing the nuts and bots of an AI company's products. I am not talking about that kind of sophistication.
The kind I'm talking about is the kind that tells an investor "don't invest in just one startup, because for the math to work on startup investing, you've got to invest in 10 startups, each of which have a 1/10 chance of success", and then the kind of sophistication that (a) knows how to secure the dealflow to make that kind of investment strategy work and (b) still be OK if it doesn't.
Virtually no retail investor has any experience executing that kind of strategy. In fact: most professional VCs can't either: the asset class as a whole has historically lost money, and is subsidized by asset allocation rules at the large financial funds that plow money into VC firms.
Most startups fail; most of the good startups fail.
I agree: if it's just $100, who cares? But that's not how retail investors approach the markets they're allowed to invest in now. Maybe the JOBS Act should have capped the amount people can invest per year.
Platforms are also required by law to have educational material. And, annoyingly, investors have to fill out a small questionnaire about the risks of investing every single time they invest. So if you invest $100 in 10 companies you'll have to fill out a thing saying you know you could lose all your money and you should be diversifying, 10 times.
Plus, it's in our own economic interest to make it clear how and why diversification is important and that investors make smart decisions. Our whole business model depends on investors making a return since we charge carried interest (i.e. a percent of profits that investors make). This is standard practice for accredited crowdfunding and I expect it to carry over to the unaccredited world.
I think there are strong arguments for revisiting the accredited investor criteria, but you're missing an important fact: wealthy individuals have access to resources, like attorneys, accountants and financial advisers, that the less well-heeled frequently don't have access to. So even if accredited investors themselves aren't sophisticated, they usually aren't without the ability to protect themselves.
> With companies staying private longer, most of the growth in high growth startups is only available to the wealthy.
A lot of proponents of Title III offerings use the "average Americans are being denied access to the opportunities the wealthy have" argument but it's not as convincing as it might seem.
First, most Americans are currently not investing in the public markets[1], many because they don't have the money to. They have therefore missed out on one of the greatest bull markets in history, central bank-inflated or not. Providing greater access to private markets doesn't do anything for those who can't even afford to participate in the public markets.
Second, there are plenty of publicly-traded vehicles that provide access to private market investments. For example, for those interested in tech, GSV Capital (ticker: GSVC) owns stakes in pre-IPO darlings like Dropbox and Palantir[2].
> A similar thing happened three years ago with "rich person" crowdfunding – many critics speculated only bad companies would use it, not-bad companies started using it, and now it's generally accepted.
Are you referring to 506(c)? Adoption of this has been tepid at best.
[1] http://www.cnbc.com/2015/04/09/half-of-americans-avoid-the-s...
This is less of a concern when non-accredited investors are investing alongside accredited investors under the same terms. I also think it's the duty of a platform to make sure unaccredited investors don't get unfair treatment.
> First, most Americans are currently not investing in the public markets[1], many because they don't have the money to.
True, but I'm not advocating that every American should invest in super-risky companies. Plenty of Americans (actually, folks from all over the world) definitely want to invest small amounts of money in companies they believe in and want to support. They try, but can't. If the investor limits magically went away tomorrow we'd see an order magnitude more money invested in startups on our platform.
Even though startup investing may not be right for everyone doesn't mean that most people should be legally prohibited from doing it. There are plenty of products I use in my life (personally and for business) that I would love to invest $100 in. I understand the risks, what's inherently wrong with me investing with 10k other people? There's a lot of potential issues with the _implementation_ of a platform (e.g. do investors get enough information? is there adverse selection?), but I don't think there's _inherent_ issue with all possible implementations.
> Second, there are plenty of publicly-traded vehicles that provide access to private market investments.
I didn't realize CSV Capital was publicly traded, that's great - thanks for pointing it out! Maybe I'll buy some shares.
> Are you referring to 506(c)?
No, I meant 506(b) earlier in 2013. The argument was that only companies desperate for money would resort to listing on a crowdfunding platform.
506(c) has a few problems that makes it a pretty weak and ineffective regulation. There isn't much upside in generally soliciting to accredited investors only to counteract the legal uncertainty with the way accredited verification was implemented.
I'm asking: how could the situation be any better with companies that at best have a 1/10 chance of not abruptly ceasing to exist within 2 years?
Individual startup equity for retail investors is a bad financial product. We all know that to be true; it's weird that we're somehow able to pretend otherwise for the sake of argument.
At the seed stage you're looking at returns of 50-5000x if you "win" so there's more margin of error in the 1/10 statistic.
To be clear: I think investing $5k in one startup (and only one startup) is dumb. I'm not saying that's what people should do. And there are legal limits to how much people can invest and requirements for platforms to educate (and ensure investors understand basic risks like failure rates and need for diversification). When you invest $5k across 50 startups that starts behaving like an index fund.
The caveat to the "big win" returns is that it's traditionally hard to get access to the companies that have a real chance at IPO. A small group of people with privileged access make an obscene amount of money and it's hard to break into that insider club due to structural issues with non-JOBS Act regulations.
The health of the asset class, IMO, is dependent on platforms' ability to attract those companies. For equity crowdfunding (when restricted to rich people) it's clearly in the realm of plausibility. The three major platforms all have at least one "Unicorn" under their belt. For unaccredited crowdfunding I'm optimistic given the information I've seen that this is doable, but if I'm wrong it'll be because the new regulations scare away the "good" companies. Not because retail investors are dumb or there's an inherit issue with democratizing access. There will be a law or amendment in the future that fixes any regulatory issue. I'm pretty certain this or something like it is the future if you look forward far enough.
But, it does strike me that the Kickstarter model would be far superior if the backers got an equity stake in the company. As it works now, the backer takes a big risk in not getting a product, or getting a crappy product, yet enjoys no upside if the product is a smash hit.
It also strikes me that a barbell strategy to portfolios can be a good idea for some people. That is, invest 95-99% of your money in safe bets like Vanguard mutual funds, and then a few percent in high-risk, high-reward bets such as startups. It is unfortunate that worthy people who are not millionaires do not have the opportunity to do this. Even if people do not net make money from this, if people buy lottery tickets or go to casinos, why not allow them to risk money in a way that has potential to do good for society?
Thing is, I don't see equity crowdfunding as a replacement for VC funding because much of the value that comes from established investors comes from their insight, experience and contacts. If ecf becomes popular enough, VC's will still be able to invest in and advise great companies, but hopefully a majority of the returns will be more distributed.
I don't disagree that the risk is significantly higher in startups/private ventures, and that a vast majority of the money invested will be lost, but hopefully ecf will allow a large enough number of people to invest a small enough amount in each company (a la kickstarter) that the losses aren't catastrophic, but enough aggregate capital is able to be accumulated for companies to do what they need to do.
What is more true is that professional VCs compete for deal flow, and among the things they use to try to compete is advice and their rolodex. But don't confuse the cart and the horse! What's important is the competition.
The problem is that retail investors do not --- cannot, really --- compete for deals. They'll invest in things that have a 1-Click "Buy" button. They won't fly to Palo Alto to take a coffee shop meeting with a promising investment prospect.
So there's an adverse selection problem. The VCs poach the good deals. Some might slip by and land on crowdfunding sites, but the statistical reality will be that the deals VCs have access to are advantaged. Worse: everyone knows this, and a huge part of raising money (long term) at a startup is signaling, and so there are reasons for good companies to avoid crowdfunding even if they can't stand VCs.
Sure, people are going to get scammed, just as they're scammed in numerous ways today, and people are going to throw their money away investing in hopeless companies. But that's not the only thing that will happen. And there's a significant potential for improvement over time in terms of educating investors on risk. I think overall it'll be a big win for everyone despite the abuse. And if it ends up replacing people's even riskier investment schemes (such as the lotto or cousin jim-bob's wacky business idea or the coworkers multi-level marketing scam) it'll be an even bigger win.
If it was just a matter of making sure people diversified, I'd agree with you.
If a business has been around for 10 years and they're running into a tough patch, I think it could be reasonable to think one of their options would be to offer equity in their business in exchange for money.
Investing in that type of business I think won't necessarily produce the same percentage of "failed investments" so much as it will simply provide a lot more options that will earn the investor less than 2x. Long term prospects, perhaps 2x or even 3x returns may happen, but I doubt anyone will be doing this thinking they're going to find a 1000x return.
The only big question is if protecting potential investors should be done through limiting (as it is now), education (example how it is done by AL [1]) or controlling (the startups)
My personal POV is (as with any investments) education.
[1]: http://cl.ly/image/1T3W372A3q0P/Image%202015-10-30%20at%2017...
I disagree with the conclusion of your first point. If the investment is +EV, even after the massive number of "goes to $0", I think it's fine to let retail investors participate. After all, we already let them participate without any oversight or limits in the state-run lottery, which is decidedly and markedly -EV.
* Must protect poor, stupid people from themselves because they're poor and therefore stupid.
I would love to hear more reasons for the investment cap other than protecting investors from themselves. It seems like such a low cap that you can invest in maybe one startup.
I would also love to hear why protecting investors from themselves is a good thing. It's an honest question: what is the merit of putting a cap on what you can invest based on your income? Shouldn't that cap be a personal choice?
What I am definitely arguing here and now is that there is an inherent hypocrisy in the way we legally treat lotteries and the way we treat investment. Both are seen by their "players" as vehicles for potential financial windfall, and the riskier and less responsible of the two is wholly unregulated and even state-encouraged, while the other is tightly controlled and very difficult to get involved in.
Yes, and I just said we should regulate lotteries tightly and limit how much people can gamble on them. That removes that hypocrisy.
> That really depends on your perspective. I personally think that using wealth as a proxy for... well, really for anything other than wealth, ...
If you read my other comment, it has more to do with the risk of them surviving [financially] poor decision making.
Someone who makes $100k and puts $10k into risky bets is more likely to survive than someone who makes $30k and does the same thing. Its a question of scale.
> then you should focus on providing better financial education, instead of restricting the fiscal agency of everyone else in the same income bracket.
Education requires the student to be motivated to learn. There are plenty of resources to learn about financial decisions and community colleges teach relatively cheap personal finance classes.
The reality is these bets have ~10% chance of success. People [in aggregate] have a history of being duped into putting too much money into highly risky bets that they don't understand. That doesn't include the outright scams that have happened in the past.
At the end of the day, we [the taxpayers] are on the hook for things going badly. [i.e. In the form of investigation, entitlements] So yeah, we should have some say in how much is on the hook. So yes, when I'm on the hook for bailing people out of poor decision making...I don't want them to dump their life savings into it.
> Those with an annual income or net worth of less than $100,000 will be allowed to invest up to $2,000 in a 12-month period, or 5 percent of the lesser of their income or net worth, whichever is greater. Those with an income and net worth of more than $100,000 will be permitted to invest up to 10 percent of the lesser of their annual income or net worth.
This is pretty reasonable.
http://www.bloomberg.com/news/articles/2015-03-30/u-s-consum...
Most people really don't even save up to these limits.
Besides, you really should be dumping the money into tax advantaged accounts anyway. At that point, to hit the cap, we are talking 33% or more of your income being saved. Very, very few people hit that number and they mostly are the /r/FI types who wouldn't touch this except for a minority position in their investments.
Randomly picking stocks - which is heavily advertised on TV, radio, and by your personal broker - has at least as bad of a chance. Yet we glamorize it, do we not?
...do we?
Most of the investment advice I read says to use things like Vanguard ETFs for broad market funds.
The majority of people only have like 401k type situations [which is basically like Vanguard] that are essentially that or essentially no savings.
The statement about professional investors "want[ing] to invest in companies that have the potential to be disruptive to an entire industry" is really not accurate. The vast majority of dollars raised through Regulation D offerings go to financial issuers (investment funds), not "disruptive" startups. Reg D is also commonly used to raise capital for real estate ventures and funds.
Although they certainly don't constitute the majority of Regulation D offerings, "ordinary consumer and retail businesses" do use private placements to raise capital, but the real reason it's more challenging for these businesses to raise capital is not that all professional investors are looking for hundred-baggers. It's that they know there's a strong likelihood they'll never see their capital again at all.
This said, I don't have a real problem with Title III. The SEC can't protect investors from themselves, as evidenced by the fact that investors are still defrauded to the tune of more than a billion dollars a year by penny stock schemes. But it's worth observing that the biggest proponents of equity crowdfunding are usually those who stand to profit from facilitating the sale of securities to investors. You'll notice that very few of them ever talk realistically about how those investors are going to get their capital back.
https://www.washingtonpost.com/news/wonkblog/wp/2015/10/29/t...
"Their latest book, Phishing for Phools, takes the idea further. Not only are people vulnerable to making mistakes with their money, they argue, but the market is exceedingly good at exploiting them."
“The economic system is filled with trickery, and everyone needs to know that,” they write in the book’s opening pages.
Our unfortunate reality is that of a socialization of investment; something discussed from Marx to Keynes.
In the next decades, the idea of investing become blur and centralized.
https://www.contentful.com/developers/docs/references/conten...