I don’t think it is an exaggeration to say that some time in the next two or three months America will see one of the biggest changes to capital markets since the post-recession reforms of the 1930s. At that time rules were established to protect the individual investor from the questionable tactics being used by some to raise money for new ventures. In the wake of the horror stories of the 1920s, protecting the small investor from themselves made sense and was an important part of the Securities Act of 1933.
This was achieved, firstly by requiring companies that were offering shares to the general public to register and disclose pertinent information, and secondly by restricting who could invest in companies before that transparent process came into play. ”Accredited investors” were those deemed wealthy or wise enough to take the risk of investing in startups. The qualifications have been amended multiple times over the years, but basically it meant those deemed wealthy enough to survive a bad investment or wise enough to spot one.
In the modern age where information is cheap and readily available, the concept of the accredited investor began to be questioned. Not only was it a little patronizing, it was also restricting the free flow of capital that is the lifeblood of a free economy. This problem became more evident and more acute following the credit crunch in 2008/9, and the “Jumpstart Our Business Startups,” or JOBS Act, attempted to address it. Under the provisions of the Act, startups will be able to raise capital by “crowdfunding.” Crowdfunding, for those who are unaware, is the pooling of multiple small investments to create meaningful capital for nascent businesses.
The temptation here is to describe this new opportunity in terms of the potential for enormous profit. I mean, can you imagine having invested in Google (GOOG) before it went public, or Facebook (FB) or Chipotle Mexican Grill (CMG)? Having trading room experience, however, I learned a long time ago that where there is great opportunity, there is great risk. I wanted to find out more, so I spoke to Wayne Mulligan, Founder and CEO of Crowdability*, one of several information and education services for those interested in this new opportunity.
The first thing that Wayne did was to point out that the “accredited investor” rules do still exist. The JOBS Act is law, but we are awaiting SEC rules as to how the crowdfunding provisions (Title ii and Title iii) will be implemented. The market is expected to open up around the end of this year. Until then, one must still be accredited to crowdfund, but in anticipation of that day, Crowdability offers three things to subscribers, aggregation of opportunities from multiple platforms, research on possible deals and a diversification tool.
Mulligan obviously has an interest in getting people excited about the opportunity that crowdfunding will provide, but on many fronts he had words of warning for those considering it as an alternative investment. He pointed out that many people feel that the accredited investor rule was designed to keep all of the good opportunities in the hands of a select few, but they are unaware of the significant risks.
“Results are generally binary,” said Mulligan. “The type of startup that seeks pre-IPO funding either gets to IPO or is acquired, in which case early investors get to cash in, or they go under, in which case everything is lost.” For this reason, Crowdability stresses the importance of diversification to those considering allocating a portion of their portfolio to crowdfunding. Venture capital companies, Mulligan says, generally make money on only 20% of deals. The profits on those deals can be significant, which is why these companies make money, but given that success ratio it is obvious that diversification is key.
Importantly, too, by careful selection it is possible to diversify by sector. In the current environment, when people think of startups with potential for spectacular IPOS, they think of tech companies, the aforementioned GOOG and FB, or Twitter (TWTR) maybe. I have some concerns, however, that in a world where TWTR commands a nearly $40 Billion valuation, tech startups are starting to look a little bubbly, so that would hold little appeal for me right now. Helping a successful company with a great product get off the ground, however, does have some romantic as well as financial appeal.
Crowdfunding can be seen as an alternative investment, but like most alternatives, the risks involved make it suitable for only a small portion of your available capital. When the market opens up, some small investment could be fun and potentially very profitable, but is only really suitable for risk capital. Risk capital, as defined by my friend Jim Cagnina of Infinity Futures**, is money that, if lost will not impact your lifestyle, investment horizon or, in his case, the happiness of Mrs. Cagnina.
If the risks of funding startups are understood, and if you are able to diversify enough to give yourself a chance of hitting a home run, then crowdfunding could be an intriguing opportunity for small investors, but, as with any investing, research is key.
*I have no interest, financial or otherwise, in crowdability, nor have I ever received, nor expect to receive, any compensation from them.
**I conduct webinars for Infinity Futures on Foreign Exchange