Qualified investor rules have never made a lot of sense to me. I have met a lot of sophisticated investors who aren’t particularly wealthy. I have met a lot of wealthy people who aren’t particularly smart about investments. More importantly, it has always bothered me that there is a thicket of regulation designed to stop small investors from investing money however the hell they want to, especially given all the apocalyptically horrible yet SEC-approved products are already available to any small investor who wants to commit financial suicide. Not to mention government-run lotteries.
So, for the libertarian in me, the JOBS Act, which theoretically legalized non-wealthy individuals making equity investments in private companies, seemed like a no brainer to me. Of course people should have a right to do this. For the impact professional in me, it means that all of these cool social ventures and businesses in my community would have a whole community of fellow travelers to draw upon - people who would invest in early stage, risky businesses with positive social impact that didn’t fit the risk/return profile for venture money or bank loans. And for the Kickstarter addict in me, all the companies I give money can now give me a tiny sliver of ownership instead of a t-shirt. In fact, the only part of me that WASN’T excited about equity crowdfunding was the investor.
Because these are going to be terrible investments. Per my previous posts, I am not even sure investment is the right term for them. And because we call them “investments” we will decide 3 or 4 years from now that equity crowdfunding was a failure despite all of the positive community, economic and social impact it will have in the interim. And then, I fear, it will go away.
It’s hard to get reliable data on venture capital returns, but the data we do have suggests that professional venture investors as a group have pretty lousy returns. Even folks who are high on it agree that all of the returns come from a handful of superstar investments, your Googles and Facebooks. VC firms work very hard to identify those potential superstars, they drive as hard a bargain as they can on the initial terms of investment, and then they support (and push) that company with all of their might to get to a high-multiple exit in 3-5 years. (This push to exit is something a lot of people forget. Your ownership in a profitable private company is not a good investment until it is acquired, goes public or finds some other way to return money to you.) It is not a profession devoid of knuckleheads, but a lot of them are very good at what they do, the best companies come to them first for investment and and they put a lot of brainpower and resources into maximizing their returns. And most these firms return less than an index fund. Many actually lose money.
I have been listening to the Start Up Podcast. It’s worth checking out as it’s basically like watching a slow motion car crash as it happens. In a recent episode, the narrator, who is also the entrepreneur, who is also raising money from individual investors, states on multiple occasions that the great thing about equity crowdfunding is that it gives normal people the ability to invest in the next Facebook. I can’t say this strongly enough - the next Facebook does not want or need crowdfunding. You will not be an investor in the next Facebook. The next Facebook is happily taking investments from professional VC investors, who are seeking out those companies and providing them with all of the capital and networks they need to attempt that kind of explosive growth.
So, a crowdfund investor won’t have access to the big hits that make a professional VC portfolio work. They also likely don’t get great terms on the investment in the first place, since one of the nice things about crowdfunding is that it puts much of the control back in the hands of the entrepreneur. (Not necessarily bad for the universe, just bad for returns.) They also won’t have any leverage on their own to drive their companies to quick exits (Again, this is probably great news on many fronts, but it hurts returns.) Finally, I expect and hope that people will invest outside of traditional sectors in businesses that interest them and/or are in their communities. Taken in aggregate, this means that the return on a portfolio of crowdfund equity investments is almost always going to be horrible. Like lose half your money horrible. Like lose all your money horrible.
I’m not going to spend any time explaining the absolute crap-fiesta that has been the SECs rollout of the JOBS act. Others have done that better than I can. I will say that, understandably, as an agency in charge of regulating investments, they are framing these transactions as investments. I assume one of the reasons they are dragging their feet is because they see the coming apocalypse - individual investors committing significant chunks of their net worth to finding the next Facebook and losing it all.
OK, now I am super sad. The four of you should be too. Let’s cheer ourselves remind ourselves why equity crowdfunding is awesome:
Literally the ONLY significant bad thing that I can think of is this: almost all investors will get less money back from their crowdfund equity portfolio than they put in. That’s it. That’s all the bad news. But because we are talking about them as investments, and regulating them like investments, that is the only metric which will matter. And by that metric, they are guaranteed to fail. They might fail badly enough that we make them illegal again.
So, how could it be different? I think the SEC ship has sailed and, frankly, it probably wasn’t realistic to believe we would regulate them differently. It would help if people stopped talking about the next Facebook and started talking about it like Kickstarter with a chance to get some of your donation back. I think the patronage lens of Kickstarter is a better lens than investment lens than regulators are giving it. I am proud to say that my home state of Oregon is framing it explicitly as a community building, rather than capital accumulating, tool, but my inner libertarian still gets fired up because Oregon places a lot of restrictions on what consenting adults can do with their money, and that blunts a lot of the potential in the process.
I guess this relates to my earlier post about investment being a false analog for what we are trying to do with our impact-oriented money. My hope, to the extent that I have any, is that the first people who jump into this world for impact will find the right opportunities and be able to articulate why this is a great tool for them before the “next-Facebook” crowd loses their shirts and that terrible press starts rolling in.
Patrick Maloney lives in Portland, OR where he helps nice people working on cool stuff. He tries to limit his blogging to things about which he knows something.