In the age-old debate over the hotly contested concept of “fairness,” Wall Street and Main Street frequently find themselves at odds. Sitting in one corner are the “insiders,” those fluent in the obscure financial vernacular of capital markets and who make their living trading, investing and arbitraging a dizzying array of financial instruments. And in the other corner are those living outside the financial fishbowl and who spend most of their time working in what is colloquially referred to as the “real economy.”
While this blog is too short to tackle all of the issues associated with Main Street vs. Wall Street, I’d like to take a moment to explore the approval by the Securities and Exchange Commission of the JOBS Act, encompassing “crowdfunding” and the notion of allowing “non-accredited” investors the opportunity to support startup businesses.
While I applaud the thought, this is a potential recipe for disaster. I believe it misses the mark with regard to how non-accredited investors could benefit financially without getting blindsided while supporting innovation and jobs.
In a New York Times op-ed, former Wall Street financier and Obama’s “car czar” Steven Rattner expressed his dismay, calling it the “greatest loosening of securities regulation in modern history.” He says unaccredited investors have a better chance of buying a winning lottery ticket than seeing a return on a startup with even a modest track record and growth prospects.
The way the crowdfunding program is currently designed is that broker-dealers, who are licensed by the SEC, will underwrite and be paid a fee of between 8% and 12% to sell securities to individual unaccredited investors. Keep in mind that these broker-dealers are not investing in these companies. Their incentives are different. My analogy would be the now relatively non-existent mortgage broker who “underwrote” mortgage loans, took a fee and moved on to the next loan leaving the buyer and seller of the mortgage, who had a vested interest in the outcome, to deal with the awful aftermath if there was a default.
While I expect that most broker-dealers will try hard and act in good faith, the question remains: “What qualifies them to underwrite very tricky startup technologies?” I have invested in private equity for more than 15 years and do not feel qualified to underwrite startups and feel less comfortable having a broker-dealer taking a fee doing the underwriting for me.
My suggestion, while some will say is self-serving, is to have unaccredited investors not invest directly in startups, but invest in venture capital funds, which invest in startups, or private equity funds, which invest in more established businesses.
Investing in a fund offers diversification, which may be the most important consideration in ANY investment style. Secondly, you have professional underwriters that look at these types of businesses EVERY DAY. Third, unaccredited investors are investing with professionals who also are investing their own money, creating an important alignment of interests. The fees over time might be higher (2% or less per year), but fund professionals do not make any “life-changing” incentives until after ALL investors get their money back plus some level of predetermined return.
Venture capital and private equity funds already are equipped and staffed with experienced professionals to make smart risk/return judgments on investments. They are required to adhere to many securities laws, which are only increasing.
Are there things the venture capital and private equity industry can and should do better to best serve unaccredited investors? Yes. But this industry is well established and funds have lengthy track records. It stands to reason that past performance is the best predictor of future performance.
My opinion: Give unaccredited investors the option to invest and diversify away from Wall Street in private securities with established professional investors who have success in underwriting, building and exiting great investments that adhere to most, if not all, securities laws. This is in contrast to investing directly in companies that most, if not all, unaccredited investors are ill-equipped to evaluate, even with the help of misaligned broker-dealers who are just now getting into the business with no experience or track record.
For more coverage on Evolution Capital Partners, and the lower middle market, see Mergers & Acquisitions' June cover story "Small Deal Sweet Spot."
Originally published by the Crain's Cleveland Business.