Call me an old fogey, but I find that the American Association of Retired Persons (AARP) is correct in worrying about the loose direct investment allowed by the JOBS Act. This legislation will likely open the door for many fraudulent and poorly-managed companies to take investments from an oblivious public. Moreover, this legislation encourages direct investment in an asset class whose performance is suspect.
Protecting Investors from Themselves
Regulatory barriers were erected to protect investors-the least affluent in particular-from taking on risks they don't understand. By only allowing them to invest in publicly traded investments (or the ventures of their personal contacts), middle and lower class savers were denied access to investments they probably wouldn't understand.
Who are the investing public who do not qualify as "Accredited Investors?" Typically, they are laypeople who are or were employees who do not have the slightest understanding of investing. They don't understand valuation, as was evidenced most recently by the housing bubble. They don't understand the business risks inherent in new ventures, as was evidenced by the tech boom. They also don't understand how familiarity with ongoing operations of a firm is not sufficient evidence that its stock is worth buying. This misunderstanding coupled with an ignorance of diversification leads to many employees buying large stock holdings in the same firm they work for. These people are just regular people who don't have the means to take large risks yet who are not educated about finance enough to avoid them. They need protection from themselves.
Loose Standards Attract Loose Morals
Bear in mind that a lack of regulation can attract nefarious investment schemes which ensnare wealthy, so-called "Accredited Investors." Madoff ran a Ponzi Scheme amid the opaque world of poorly-regulated hedge funds. Many Chinese scams utilized reverse mergers to become publicly-listed stocks while sidestepping the scrutiny of a traditional Initial Public Offering. Many of these firms claimed to have operations and results far in excess of reality, and sold shares at high prices to investors until the truth came to light.
Unfortunately, the JOBS act sets up an environment like this for scammers.
Venture Capital: Why Bother?
More generally, there are many reasons to stay away from the entire venture capital asset class. It seems like the army of well-paid entrepreneurs, investment managers, consultants, and attorneys enjoy spending venture capital while investors suffer low, often negative returns. My impression of venture capital comes from experience writing business plans, helping run a business plan competition, and listening to scores of talks by venture capitalists. I can honestly say that despite all my experience, none of my concerns have been assuaged.
Worse yet, my anecdotally-inspired fears have been confirmed by the extensive experience of thoughtful pension fund managers. The Kauffman Foundation reviewed venture capital fund performance and found that VC funds underperformed the stock market since the mid-nineties. After considerable study of their 20 years of data, Kauffman's Chief Investment Officer, Harold Bradley is highly skeptical of VC. He rejects the notion that pension funds should have any required allocation to startups. In a Bloomberg interview, he suggested that institutional investors should only invest in the top 10 VC funds and avoid the vast majority of other funds. He said, "If you can't be with those 10, the only way to win is not to play."
Many Ways to Lose in the Startup Investing Game
Direct investment enabled by the JOBS Act. Gullible investors can skip due diligence and just deposit funds at a web portal. There are tremendous risks even if the venture is legitimate. When you give money to a startup, you are most likely never going to see it again. This is risky business.
Investment in IPOs. Jumping in when the company goes public is a bad idea that underperforms buying shares in existing companies because the IPO markets are over-hyped and over-priced. For example, shares in Facebook are oversubscribed even though the valuation of Facebook was regarded as too high by 79% of investors. You are better off buying shares in existing, publicly traded companies in the secondary market than you are buying from an investment banker.
Angel investing. Angel investors give entrepreneurs money directly. This is a poorly diversified, often unproven black box and I couldn't recommend it. You would be relying on the character of the entrepreneur for repayment and your own due diligence. You would be better off buying an index fund and slaking your appetite for new ventures by watching Shark Tank on television.
Venture capital funds. Individual investors band together by giving their money to venture capital fund managers (VCs). The VCs find new ventures to invest in, and presumably know what they are doing. (I have no evidence to support that they know what they are doing.) Many of the VCs are former entrepreneurs or have histories of selling firms at prior funds.
This experience is less useful than it sounds since much of success is luck and even the most experienced serial entrepreneurs only have a small number of successes under their belts. Taking a company from launch to IPO or acquisition takes many years and many failures. As such, even legends like Steve Jobs only racked up a few big wins. As human beings we do not live long enough to create track records of enough successfully launched and sold companies to distinguish luck from skill.
Small Cap Stocks: The Savvy Investor's Venture Capital
The Kauffman Foundation's report on the past 20 years of venture capital returns notes that small cap stocks have outperformed venture capital. That's right, boring small caps. In fact, Kauffman found that only four out of thirty venture funds in their portfolio beat a small cap index. Their venture investments delivered lower returns with more risks like liquidity risk, less diversification (firm-specific risk), and the risk of higher fees (legal, etc.) which are sometimes incurred when liquidating a private investment.
Instead of VC, it would be prudent to invest in small caps. One attractive small cap value fund is the Rydex ETF Trust S&P Smallcap 600 Pure Value (RZV) ETF which features a low average price-to-book ratio, low fees, and a low average market capitalization in its holdings. Small cap core exposure can be achieved with the iShares S&P Small Cap 600 (IJR) Index or the Schwab U.S. Small-Cap (SCHA) ETF, each of which provides investors with a solid portfolio while charging low fees.
Will small caps make you rich overnight? No. But at least they won't fleece your grandma.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.