Crowd Control

On March 23,^, 2012 the U.S. Senate, acting in bipartisan fashion, probably because they mistakenly thought it was April Fools Day, resoundingly passed the JOBS Act.  The JOBS Act, which stands for Jumpstart Our Business Start-ups, is primarily intended to create new jobs by helping small and very small companies have more ready access to capital to grow and thus hire more people.  The goals of the JOBS Act are very important to the growth of our economy.   There have been a million articles on it, but I am putting a few links in HERE and HERE for your convenience.

The JOBS Act has many different provisions.  It enables smaller companies, those with less than $1 billion of revenue, to go public while avoiding and/or postponing some of the more onerous and costly Sarbanes Oxley IPO regulations.  An existing law that required companies with more than 500 shareholders to undertake various SEC disclosures has been changed to enable companies to avoid this until they have 2000 shareholders.  And the law also makes it easier for companies to advertise private stock sales to potential investors.

One of the most significant aspects of the JOBS Act, however, is the legalization of a concept called “crowd funding” under a sub-bill called the CROWDFUND Act, which stands for the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act.  Now that’s a mouthful.  Anyway, crowd funding is essentially the process by which small private companies can solicit small private investors by any means necessary, but primarily through online and social media approaches.  Think eBay for start-up equity instead of Beanie Babies or Giants tickets (SF, not NY).   Again, there have been many articles on this topic, but here is a good one.

Under the version of the CROWDFUND bill passed by the Senate, entrepreneurs will be allowed to raise up to $1 million per year through approved online crowd funding portals (a ton of these organizations have already sprung up to serve the impending market). The amount investors will be able to spend will be capped based on their income, with some people only allowed to put in a maximum of $2,000 and maximums set around $10,000.

The crowd funding portion of the JOBS Act was highly controversial, primarily because there was, as the full law’s name implies, a significant concern that mom and pop investors could potentially be defrauded by being sold a bill of goods. I mean seriously, it’s called the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act.  Now that’s a mouthful.  You gotta worry when “Deterring Fraud” is part of the title itself.   Appropriately, many of our representatives in Congress were fearful that without access to full due diligence records and without personal knowledge of management, unsophisticated investors may as well just go to Vegas and roll for the hard eight (or the hard nine if they are really thinking outside the box).

As I think about the CROWDFUND Act, I think that there is good reason for concern, but I think that the reasons that have been expressed to date are somewhat of a red herring (no financial pun intended).  There are definitely ways to avert fraud and increase the flow of information to potential investors.  Crowd funding exchanges can be licensed and certified; companies selling through the exchanges can be due-diligenced by the exchanges themselves and companies can also be subject to specific disclosure requirements.  The real risk, in my view–the risk no one is talking about—is what often happens to early stage individual investors when a company needs to raise more money after the original infusion of cash.

It is a tough time for early stage company access to capital.  The economy has reduced the number of angel investors and the challenges facing the venture capital market have dramatically reduced the number of firms with available early stage venture capital.  While there are a few frothy sectors (things like games and social networking), most of the industries that raise capital in the venture and angel market—healthcare, energy, whatever—are finding it more challenging than it used to be to find money.  Thus, the crowd funding idea sounds like a good alternative for cash-strapped young enterprises who have exhausted the professional fundraising route.  Hell, anything sounds like a good alternative when your next payroll is due and you are out of cash—couch cushions everywhere are waiting to be frisked.

But here’s the problem I worry about:  the average start-up company in the “sexier” industries (tech, energy, healthcare) needs far more than $1 million (the CROWDFUND limit) to get to the Promised Land.  And at this time, with pressure on alternative investing the way it is, it is very hard for early investors to get rewarded for taking early stage risk.

In the olden days (5-10 years ago), the first investors in a company, often friends and family, put in some money and the perceived value of that investment increased fast as the product got built and tested the market.  As a result, when the next round of money went in, the original investors made money, at least on paper, for the risk they took to get things going because the later investors were willing to pay a higher price per share.  In virtually every case, early investors were also given the right to increase their investment and hold their ownership position in the enterprise constant by investing more capital.  Oftentimes such early investors didn’t have any more money to invest to keep their equity position the same, but that was ok because their original holding had increased in value; they owned a smaller percentage of the start-up, perhaps, but it had a higher value than when they started.

Fast-forward to the current venture capital marketplace, however, and things look very different than they did 5-10 years ago in all but the rarest of cases.  For the start-up company superstars, the ones that blow the doors off, it is very easy for them to raise professional capital to augment the early stage cash that got them off the ground.  However, VCs have become very fickle.  They are happy to reward those investors that continue to support companies (“support” being defined as “put more money in and keep supporting it”) and equally comfortable punishing those investors who don’t.  How do they punish them?  By pricing the new equity in such a way that it essentially washes out the early guys, leaving them with next to nothing or less. The fabulous parting gift is a note that says, “thanks for the memories, now go away.”  This sounds very cruel, but as they say in the Godfather, it’s business not personal.  The thinking that goes on here is that those that take the risk on an ongoing basis should receive the reward.  It is not illogical thinking, but it has a negative impact on those investors who cannot continue to support small companies by continuing to invest capital as the companies evolve.  Those investors limited to $10,000 through the CROWDFUND Act may have their hands tied.

Truth of the matter is that the average start-up company typically goes through more than one attempt at the brass ring.  Early business models often fail and entrepreneurs go back to the drawing board to try and reinvent their original vision.  That’s great, but it also puts early investors’ capital at greater risk, as new investors consider that old money as money that died along the bumpy road to success.  Old money is rarely considered important money by the next investors in, and that old money is as often washed out in the same way as the early money that resulted in positive progress.  In other words, start-up investing is hard.  Wear a helmet.

So in summary my fear is this:  start-ups may benefit from the $1 million of fuel they get from crowd funding participants who are, in essence, dabbling in venture capital, but the participants themselves may be left looking like that Monopoly money guy with the empty pockets.  Venture capital is not a dabblers’ game.  It may have sounded fun and kind of sexy when you put in your $10K, but in the end you may be holding nothing in your hands but air.  And when that happens a few thousand times, crowd funding participants are going to be mad and feel that they were taken after all, even though no fraud has been perpetrated.

This doesn’t mean that individuals shouldn’t be allowed to invest in start-ups, quite the contrary.  It just means that those who do must be sophisticated enough to go into these deals with eyes-wide-open, knowing that the risks aren’t just around whether the business idea is good, but around how future funding may impact their holdings.  And that is a lesson that I do not believe the average crowd funding participant will understand (or even hear) in the way that sophisticated individual angel investors do.

There are other risks to crowd funding.   Adverse selection is potentially one in my view; I think it is reasonable to worry that the preponderance of companies raising money through crowd funding will be mediocre because the preponderance of great ones can more easily raise professional capital.  There will always be examples of why this is not the case, but, like they say in dating, investors must kiss a lot of frogs before they find a Prince.  It is so easy to fall in love with start-up company entrepreneurs and their wild ideas, but those of us who have been doing this a long time quickly find that for every one deal we do, there are literally hundreds or thousands that we didn’t do.  Picking a good startup investment is an incredibly tricky game and there is no doubt that practice improves the outcome.  Even those of us who do this for a living make plenty of mistakes, as can be seen by the number of venture-backed start-ups that drown in the lily pond despite having been kissed by plenty of investors.

Another potential risk I see in crowd funding is that of disconnection between investor and enterprise.  It seems to be a truism that the more hands-on and engaged early stage investors are, the better the company does—this is why professional angel investors are so valuable if they come with not just money, but direct experiences and contacts that can give a young company a head start.  When the investors are from outside of the relevant industry and aren’t even known to the company, much less involved, will the company itself be disadvantaged?  It is very possible that the investors will be, as they are not there hanging out with the company to shepherd their investment the way professional investors do.

There are many things about the JOBS Act that are extremely beneficial to young companies, particularly those that are venture-backed.  For this reason many of my colleagues and people related to my field are ebullient about its passage.   I think this ebullience is very justified.  Making it easier for young companies to raise money and prosper is definitely the way to create more jobs.  The vast majority of new jobs in the nation come from young companies, particularly those that are accelerating through recent IPOs.  Even more interesting to me, a vast portion of new job creation is coming out of the healthcare field, so anything that makes it easier for healthcare companies to prosper is a good thing for my business.

I’m just a little worried that the crowd funding portion of the JOBS Act isn’t fully baked.  It is very difficult to convey the risks of early stage investing to the masses.  During the Internet bubble of the early 2000s, we saw the foreshadowing of this potential problem, as many individuals couldn’t help themselves but throw money at the latest Internet sensation only to see their kids’ college funds go down the tubes along with so many Aeron chairs and air hockey tables.  “Sorry, honey, we wanted to send you to Harvard but how does Chico State sound? Mom and Dad lost your college fund in an on-line pet food store…”   As the saying goes, those that forget history are doomed to repeat it.