Crowdfunding: Small Business Boon or the Next Mortgage Backed Security Disaster?

By Charles Smith,

Much ado about something,shutterstock_112959457-e1388358800228

The hand wringing by the SEC over the JOBS Act is not without justification. The real issue is about investors not understanding what they are getting into. And the level of understanding regarding intricacies of an investment isn’t determined by an investor’s net worth. Its determined by their experience and knowledge, neither of which are parameters under the JOBS Act. While part of the issue is about disclosure, the rest is about understanding the issues and pitfalls, knowing what you don’t know. As a bit of background, Title II of the JOBS Act permits the general solicitation of accredited investors. If the SEC ever agrees on a set of rule, Title III would permit the general solicitation of unaccredited investors. The wealth of an investor is a poor proxy for sophistication. Investors come by their wealth in different ways, and there is a far cry between making one’s wealth as a privately held business owner, as a professional athlete, a movie star, or as an heir.

Invest in what you understand

The very simple truth is that prudence dictates that we should only invest in that which we understand. The JOBS Act permits small business owners and startups to solicit investments over the internet and by other means. Startups are a particularly dangerous asset class, as witnessed by the professional venture capital firms that saw tremendous losses from the dotcom boom on the late 1990’s. Venture Capital never fully recovered, and is about half the size it was a decade or so ago. In the words of Prof. Jeff Sohl, Director of the Center for Venture Capital Research at the University of New Hampshire, in a phone call with me: “the Venture Capital model is broken”. It would stand to reason that if sophisticated venture capitalists have struggled, the unaware are mere cannon fodder.

I’ve been in corporate finance for 35 years, and I continue to learn more every day about what makes a company tick. That said, the longer I study it, the more everything points to the corner offices and board of directors. This is the subject of ‘corporate governance’, and it’s all-important. It’s especially critical in smaller companies, where a single person can make a difference, one way or the other. It can make a difference in larger companies too, which is why presidents of Fortune 500 companies are so highly compensated.

The most dangerous investment

The most dangerous of all investments is a privately held startup with complete control by the officers of the company, that lacks a board or directors, lacks independent board members, or that has a majority of its shares without representation on the board. This is a situation that is ripe for self-dealing and myopic decision making by the management. Now, take this and have it run an inventor of the next “disruptive technology” without experience in running a company, and you have a recipe for disaster. There are a few basic things investors need to understand about the law of the survival of the fittest in Corporate America. First, new, young and small companies are the riskiest. They have limited or no management depth, little or no infrastructure, heavy or complete reliance on a single product, and high customer concentration. The loss of a single manager or customer could tank the company, as could a single product recall. These companies survive by the mere skin of their teeth, and require skill, focus and commitment by the management team. Next, the resume of the managers and board are critical to the success of a company. Take new or inexperienced management and an inexperienced, compliant or non-existent board, and you have the makings of a tax loss.

Divided and conquered

Under the JOBS Act, innumerable small investors will put relatively small amounts of money into startups and small companies. Because each investor individually has a tiny voice, the control of the company is entirely in the hands of the founding management team. There may be one or more manager/stockholders, and they will run the company to their benefit. If we think that large public companies pay their presidents too much, we are about to find out that the potential for self-dealing does not just exist in large companies. Another problem with large numbers of small investors is getting a vote on anything that management isn’t completely in support of. Having sat on a steering committee for one of the top 100 bankruptcies in the US, I can tell you that it is mission critical to be able to get a class of investors to act. Even if you know how to contact other investors, with such a small stake in the company, inaction or delay is virtually guaranteed. Now, imagine that you don’t even know who the investors are.

Mortgage backed security deja vu

To make matters worse, neither the JOBS Act or any proposed SEC rule requires an independent board with appropriate experience and skills. Instead we will have highly fragmented ownership of the company with no effective outside stockholder influence. This is almost precisely the formula that caused the chaos in the mortgage backed security debacle of the Financial Crisis. Mortgage backed securities are fractional interests in pools of mortgages held in trust. As an investor in a mortgage backed security, you would own a tiny fraction of any individual mortgage in the pool. When an individual mortgage was in default back in the old days, the lender might have renegotiated terms to prevent foreclosure. Here, where no security holder had a voice, and the servicer had no financial interest, there was no one to right the ship. This is the concept of governance at its worst. If investors are to be protected, equity crowdfunding will need to provide for independent board members that represent these small outside investors. These independent board members will need to have voting power equivalent to the stockholders economic interests. Only in this way can the interests of the “crowd” be protected. One way to approach this is that the crowd funding site maintain a list of qualified candidates for board membership, and each investor must vote for one or more of the candidates before their investment is accepted. By so doing, there will at least be some protections in place, and these protections could extend, as but one example, to the conditions under which the capital raised is released to the company.

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