Generally speaking, there are two ways a person can generate income:
- Exchanging time and effort for money
- Investing capital to generate returns
Nearly every person living in a modern country has access to both, and utilizes both. Most of us enjoy the benefits received through capital investments, at least through retirement funds.
Historically, investing one’s capital in a low-cost index fund tracking the US Stock Market (such as the Vanguard 500 Index Fund which tracks the S&P 500) has done very well. This is still the method I follow for the bulk of my assets. However, as can be seen in the figure below1 (taken from a FundersClub guide) most value creation is moving from the post-IPO to the pre-IPO stage. This means, that as time moves on, ordinary people, who are forbidden from investing in private companies, are less and less capable of reaping the rewards of growth.
Back in early 2015, I discussed the effect this has on inequality and the importance of the JOBS act in Venture Capital and Equality. Well, on May 16th, 2016, Title III of the JOBS act went into effect (similar changes will come into effect in Israel by the end of 2017). This means that ordinary people, who are not wealthy accredited investors can now invest in startups. There are many online crowdfunding platforms which allow everyone to invest in startups from the comfort of their home, with the most prominent being Wefunder 2.
This even includes people who are not US citizens.
Great! Except, not exactly. We need to discuss the downsides first.
There are many risks to investing in startups, and I’m not going to talk about them. What I want to do is outline the problems with startup investing for new non-accredited investors under the new regulation. As always with regulation, there are unintended consequences and second-order effects.
Equity Crowdfunding Downsides
Being a publicly traded company entails a lot of headaches: having to follow US GAAP (generally accepted accounting principles), providing quarterly reports to shareholders, etc. The thinking behind these regulations is to make sure that potential investors have as much knowledge as possible at their disposal before making a decision to invest. One of the main reasons companies opt to stay private for so long is to avoid all the overhead required to provide this transparency. In order to protect investors in private companies, the regulation requires that they be accredited investors – wealthy individuals who can afford to make some bad bets.
The JOBS act allow non-accredited investors to invest in private companies. In order to protect them, it imposes new regulation on the startup raising money (mainly following GAAP and having external accounting audits). And here’s the thing: this is still an expensive headache, especially for a young startup. Which means that companies that can avoid raising money using the new regulation will most likely go the old fashioned way – from accredited investors. This, in turn, means that the potential for finding good startups using Regulation Crowdfunding is lower. As Mesh Lakhani says, “Access is a very important factor in venture investing”, and you will have significantly less access than accredited investors.
The next downside is that even with all the new regulation, startups do fail all the time. The potential for losing all of your investment is much higher than when investing in an S&P 500 company. There is nothing special here – this has always been the case, except that now the general public is exposed. In order to mitigate this risk, the JOBS act places a limit on how much an individual can invest per year, as a function of yearly income and net worth, thus ensuring that people don’t bankrupt themselves investing in startups.
One of the benefits of the new system is that you can invest even very small amounts of money, thus allowing you to diversify without taking a second mortgage. However, this also inadvertently leads to another major issue. If a company succeeds 3 and reaches another round of financing, such as a major seed or A round, then traditional VCs will enter the picture. For justifiable reasons, these more institutional investors do not want a messy Cap Table. That is, they don’t want to see a company with thousands of different investors, from whom they will have to collect signatures before certain actions can take place. In order to mitigate the risk of this scaring away future investors, many contracts will include a clause that separates major investors (usually accredited investors who put up at least 25,000$) from smaller ones. The latter will then give up their voting rights to a designated investor, who may even force them to sell their shares prior to a new financing round. This is not always the case, but it is definitely something to look out for.
Finally, even with the new regulation, the transparency is very low. Prior to investing a person should consult all of the available information, including Form C and the financial documents (balance sheet, income statement, cash flow, and stockholder equity), try and find as much information about the company using the internet and acquaintances, etc. How to conduct due diligence warrants a dedicated post.
Startup investing is risky, and especially more so for non accredited investors4. Nonetheless, I think this is a wonderful development.
You can head on over to Wefunder and start looking around. Investments can start in as low as 100$ (that’s one hundred dollars).
The figure is obviously misleading, since you need to normalize to time-since-IPO. Nonetheless, the trend does appear to be real. ↩
That’s an affiliate link that will give both of us 10$ ↩