When VCs invest in startups run by professional investors, they are aware that about third of their investments will be money losers, a third will reach middling returns, and the final third should hit home runs. VC capital is raised from institutional investors, from multibillion dollar retirement funds, university endowments, and financial institutions – whose funds are managed by experienced financial managers well aware of startup investment risks. They are well aware of investment risks and hedge against such risk by applying the portfolio theory, when winners should exceed losers, thereby hitting returns beyond 7% (Calpers targeted return is about 7%). Note that I mentioned the term, portfolio, as a basket of investments in which to distribute risks and achieve expected returns.
Now, let us look to a private, unprofessional investor. I have heard horror stories where the individual investor places his bet with all of his life savings in the financial markets. Then losing it all or most of it by placing his bet on one company stock. How can regulation A help that allows non-professional investors buy stock in early stage companies in view of what occurs to professional ones?
Let us look at the history behind the SEC. During the Great Depression, the SEC was established by Congress in response to the many fraudulent stock market activities where many lost their life savings in the stock market crash during the high flying trading days. The targeted class for SEC protection was the non-professional, individual investor. None had the training or ability to effect due diligence in the companies they invested. Stock trading was manipulated, financials were misleading. As a footnote, I always think it peculiar that SEC licensing, Series 7 and 63, is required between sophisticated parties, since the very purpose behind the SEC rules and regulations was meant to protect the ignorant populace, not sophisticated parties.
And the only time that SEC will enforce protection between sophisticated parties if there were fraudulent misrepresentations behind the investments by third parties – companies and stock brokers. One such enforcement is being considered against Theranos with the alleged claim that the sophisticated investors were defrauded by the company’s claim that their hematology service worked.
Yet many of these transactions were among strangers, but do these rules apply to friends and family? One law professor found it peculiar that the majority of his SEC class students felt that a pizza parlor owner had to register his stock offering with the SEC to friends and family the pizza operator had known for years. He believed that it was against common sense of why the SEC had been established. As I find it also strange that, if an unlicensed individual had been seeking capital from professional investors for a company would require a securities license. Again, the purpose behind the SEC and its enforcement arm was prophylactic – protect the uninformed, uneducated pedestrian investor from misrepresentations and fraud.
Unlike the Great Depression era, we now have the Internet and other forms of direct stock distribution to raise capital that a) do not require access to a stock exchange, and b) reach out to individual, nonprofessional investors without brokers and dealers. Then there is the plethora of startups all looking for capital. Some founded by disreputable founders or highly unskilled corporate managers. I have witnessed founders, whose sole objective was to be absolutely rich, and do whatever indiscretions to achieve that wealth. Apparently, some people founded companies not to change the world, but to achieve higher position in the pecking order.
Regulation A was promulgated to grant access to individual investors access to fast growth companies. The company must register its offering in a similar fashion to a S-1 to raise up to $1 million round. The company can solicit the investors without the need of brokers or dealers. But my feeling is that individuals should consider that even Regulation A is not going to shield them from losing their investment. The regulation only provides transparency to the investor, mitigating only informational risk. However, if experienced VCs still have failing investments after their portfolio companies undergo rigorous due diligence with the same informational platform of a Regulation A, then I foresee that many Regulation A founded companies can suffer the same fate.
Hence individual investors should only invest what they can lose. Or they can pursue the portfolio approach, if there is enough discretionary capital to invest in several companies – not just one. And there is one Wall Street quote relating to investment philosophy that come to mind: “ I rather be lucky, than smart”. Why? Whatever business analytics one can apply to a single investment, things can go wrong for any single company. And the only way to hedge a single bet is to make several, not just one.