On October 23, 2013, the SEC published its proposed rules (“Regulation CF” aka “Crowdfunding Regulations”) that will allow the general public to invest in privately-held companies for the first time in over 80 years. Considering there is significantly more wealth held by the general public than the professional venture capital funds, this change has the potential to transform the early stage financing environment.
However, there are significant risks in these types of investments that many people might not recognize. Let’s not forget that the SEC restricted the public from these types of investments in 1933 in part due to the losses sustained from the stock market crash of 1929. Granted, modern individuals have access to significantly more information about potential investments than our grandparents would have had, but that does not make these investments any less risky.
Smart entrepreneurs know that personal relationships with influential people are a key to growing successful companies, and the best way to get influential people incentivized to help is to get them to invest. The general partners of venture capital firms have deep relationships that can be leveraged to help an entrepreneur. In fact, many of the early reference customers of startups are other portfolio companies of their investors. “Value added capital” or “smart money” are terms used to describe investors that bring more than just money to the table, and entrepreneurs are wise to seek out these sources of funding first.
The net effect of this is that the smartest money gets the best deals, and the lower quality (“riskier”) deals filter down to poorer quality capital partners. The poorest deals don’t get funded, for good reason. With Regulation CF, all the companies that could not raise capital from smart money will get a new opportunity to raise capital from the general public. The term “adverse selection” was originally used to describe the positive correlation of risky individuals with their propensity to buy insurance. Risky individuals buy more insurance, so if insurance companies only look at their pool of applicants to establish their risk models, a poor outcome results. Likewise, if a group of investors only see a pool of crappy deals, they will think the best of them is a gold mine.
“You don’t have a better bad idea than this? “This is the best bad idea we have, sir. By far.” – Argo
This explains why even professional investors exhibit herd behavior when doing deals. Entrepreneurs seeking funding are constantly asked who their lead investor is, because the quality of their lead investor is perceived to be correlated to the quality of the deal. This is not to say that all crowdfunding deals are inherently bad deals, but the $1M cap on funding rounds makes them particularly risky. Had the SEC capped the deals at $5M, crowdfunding would be a viable source for later funding rounds. Companies raising second or third rounds tend to be less risky. Entrepreneurs would have the option of raising the majority of their rounds from smart money while carving out a piece for the general public, reducing the problems of adverse selection.
This is not to say that all crowdfunding investments are necessarily bad. VC firms invest in companies that they believe will return 10x or more on their investment and these have traditionally been high-growth tech companies. These firms completely ignore certain industries because of the lower expected returns of the deals. The new crowdfunding rules could open up financing for these kinds of businesses. There are probably a lot of individuals that would be happy with returns of only 2x or 3x.
These types of firms are traditionally favored by private equity funds and require a different type of investment analysis. Rather than looking purely at growth metrics, as one might do with a tech company, investors should evaluate these deals using traditional valuation metrics. In addition, understanding the exit strategy is important. Exits of tech companies are generally via a strategic acquisition or an IPO. While there are certainly acquisitions outside of the tech world, they are less frequent. Investors in non-tech investments must take care to understand what must happen for them to actually realize their return.
The new crowdfunding rules proposed by the SEC are expected to transform the current financing environment by opening up private deals to the general public. However, due to adverse selection, many of the deals available to the public will necessarily be of the poorest quality. Investors that want to participate in crowdfunding deals should look beyond the tech industry for good quality companies in industries that are eschewed by traditional VC firms.
EIR @ Idealab, Investment Committee @ UCLA Venture Capital Fund