I?ve become a very active investor and advisor to start-ups over the past two years, and I firmly believe one piece of legislation is going to fundamentally change business, investing, and entrepreneurship. In fact, I think it will ?unleash a torrent of changes that impacts the whole world in a very positive way. This piece is part 3 of a ?5 part series about Crowdfunding, the JOBS Act, and what all of this means to you. Part 1 and Part 2.
So far, I?ve explained what equity crowdfunding is, and how it?s going to change the entire concept of marketing. Now I?m getting into the meat of this piece: How it will change investing, small and large scale, institutional and private.
How You Can Invest Now
Do you realize that right now, TODAY, the government does not allow you to invest your money any way you want? There are entire classes of investing you can?t do.
For example, if you have extra money (savings), and you want to invest it in a or set of companies, you have only a few basic options: You can put it in the?stock?market or various other exchanges yourself (through places like ETrade), you can buy CD?s or similar things at your bank (low liquidity and terrible return on your money), or you can give you it to a broker and have them invest for you (at places like Merrill Lynch). Those are your basic options, with lots of variations within those categories.
Of course, there are a ton of other possible ways to invest in the capital markets, like venture capital or other types of private equity, but you are legally barred from them?unless you are an accredited investor (essentially, unless you?re rich).
The?best?example of what you can?t do with your money is?invest in an early stage start-up. Literally, most start-ups or small businesses can?t take your money (under almost all circumstances, there are a few small exceptions), and in fact, in the few cases where you could potentially invest in them, you won?t even know or have access to them to offer the money, because they?aren?t even allowed to tell you that they are raising money! I?m serious.
[Understand that this explanation is a simplification of the issues that is intended to explain a complicated system quickly and easily, but the basic truths are correct.]
Why is this? The existing law that governs investing in America was (mostly) written in the 1930?s as a reaction to the Great Crash of 1929, and is very complex and hard to understand. A full discussion is beyond the scope of this piece (and would bore the hell out of you), but before the Great Crash, the presumption was basically that anyone could invest anything they wanted pretty much anywhere. After the Great Crash, the government changed the rules and severely limited what normal people could invest in, and how they could access capital markets. The premise behind this was to protect the small investor from losing everything. A good idea in theory, but the?result?was that the small investor became locked out of the capital and financial markets, unless they went through the large banks. And, what also happened was that it became extremely difficult to raise money to start or expand small businesses. An unintended consequence of these rules is that, over the last 80 years, the only people who could ?profit off the capital markets were the banks and the financial elites. They have gotten most of the upside from the explosion in the American economy in the last century, not?average?people.
The JOBS Act is really the first systematic attempt to change the way that capital flows towards investment since the 30?s, especially with regards to small investors and early stage companies.
What Is Capital, Why Do Companies Need It, And How Is It Allocated?
Before I explain how the JOBS Act will change investing, let me make sure you actually understand what investing and capital allocation is and how they function. This is one of those questions that people assume they understand, but usually?don?t unless they are?experienced?investors or really paid attention in Economics class. Read this section carefully, I?ve tried to make it as simple as possible (skip it if you are an experienced investor, you should already understand all of this).
First off, for the purposes of this discussion, understand that capital = money (most economists would disagree, but it works for this explanation). What investing is, at it?s core, is moving capital to places where it is needed in order to fund an activity that is expected to produce profit, with the further expectation that the owner of the capital will get a portion of that profit as a return on their investment. This is the basic explanation of how wealth is created though capital investment; i.e., how money makes money.
Why is capital needed to create wealth? Well, in order to begin any sort of value-creating, profit-making enterprise, ?there is (almost always) an initial outlay of capital required. Think about it in terms of starting a small business. Lets say you know that there are lots of people at this one place every day, and they are always hungry for tacos, but there?s no tacos there. That?s an opportunity to facilitate a trade that benefits both parties (tacos for money) and create a profit (and wealth). But to serve these people tacos, you need a food truck. So you buy the truck and the supplies FIRST (with investment capitol in the form of a loan from a bank), which lets you be in the right place with the tacos when the people hungry for tacos want them. You make profit, pay off the loan with interest, and keep the rest.
Or take another example: An existing business, a hot sauce company, has strong demand, but needs to buy more machines in order to make more hot sauce. How do they do this? Either they use their money (which is their capital), or they borrow money from a bank (which is the savings of the depositors in the bank) and spend that capital to buy those machines, which allows them to make more sauce, which they then sell and repay the capital plus interest.
Capital allows you to buy the things you need in order to run or expand a business, and that business creates something other people value enough to pay you for, in this case, tacos or hot sauce.
Pretty simple, right? The huge, complex, intricate financial system is not fundamentally different; a capital market is all about allocating capital (money) to where it can be used by businesses to create more profit (and wealth).
This is SUPPOSED to the reason that banks (and the entire financial system) exist.?Banks are, in theory, supposed to take deposits from people and companies, and then use that money to invest in new businesses and projects that generate income (usually through loans, not equity purchase). That?s how banks pay you interest on your savings or CD accounts, by flowing through the income they make from those loans, and taking a percentage for themselves.
All of this happens in an open market where participants are free to bid for capital (in the form of how much interest they pay), and through that mechanism, the capital flows to the place where it generates the highest returns. Capital markets work just like any other market; whoever pays the most gets it, and when prices go up, more capital flows in, when prices go down, capitol is shifted to other investment areas.?This is basic capitalism, and when it works, it creates the huge amount of wealth and growth the world has seen in the past 200+ years (as opposed to socialism/communism, where the state decides where it capital is invested. This is a substantially less efficient process, and subject to much worse corruption and distortion).
In short: A functional, healthy financial system exists ONLY for the proper allocation of capital (money) to its highest valued usage, because this is what creates productive businesses (and thus jobs and wealth) for all parties involved.?
Now, that?s how it?s SUPPOSED to work. Sadly, that?s not really the way it?s working in America today. I won?t go into all the fundamental ways that the American financial and banking system is completely broken, there are lots of books and entire blogs about that, but the point is, the American financial system has for many reasons become distorted and toxic. Capital is not being allocated efficiently anymore (or at least as efficiently as it used to be or could be), and?very few banks actually use their money to invest anymore, at least in the old sense of long term investing in productive businesses.?In fact, the huge ?Too Big To Fail? banks are the worst kind of toxic; they are parasites that exploit it?s host (the American people). They use their deposits (other peoples money) to trade on the large equity markets and exchanges to make huge?outsized profits by taking massive risks and exploiting the knowledge and access inefficiencies that they create in these markets. And they are always profitable because they keep all their profits and push their losses back on taxpayers through government bailouts. They can do this because the large banks have captured the politicians and political process through campaign contributions. When you are busy screwing the system, you don?t spend any time actually investing capital. This is precisely what caused the the 2007-9 US market crash, and the ?reform? since then has been ineffective.
Plainly put: The current American capital markets are broken and inefficient, which makes it very hard for lots of businesses to get the loans or investment they need to operate.
[NOTE: Again, this is super simplified, and doesn't even get into the Federal Reserve System and how it distorts the financial markets (almost all bad), nor does this discuss the role of the SEC and financial regulation and how that affects capital markets (some good, some bad). All you really need to understand is that the US capital markets are systemically and purposefully broken in such a way because this benefits the super rich elite who control the banks and the large corporations, and that isn't changing anytime soon. The only thing that will change it is a true financial crash and a new slew of politicians who are willing to face hard truths and courageous enough to not be bought by the TBTF banks because they are backed by a motivated and informed populace. That day is a ways off.]
How Does The JOBS Act Change Investing?
Essentially, the JOBS Act allows start-ups and small businesses to advertise that they are raising money, and it allows anyone to then invest in those companies for a piece of equity.
This is not a small deal. This is not even a big deal. I think the JOBS Act could be the definitive legislative change of the early 21st century, the small tweak in the system that unleashes a torrent of change by making access to capital easier, fairer, and more rewarding for more people and sparking a revolution in investing (and entrepreneurship).?
This change might be the legislative version of the invention of the transistor?that tiny device was really a small change from the vacuum tube, but it changed everything. It enabled the digital age, and the creation of all the technological devices was all use now. [NOTE: Did you know that almost ALL the wealth creation (and most of the job growth) the US has seen since the 70's is ultimately attributable to the transistor? Seriously, if you look at the data, almost all true inflation adjusted growth has come from the technology sector (or related sectors) over the past 40 years.]
How exactly will crowdfund equity investing bring about all this change? Well, here?s where I connect all the dots from before: quite simply, the JOBS Act will make it substantially easier for investment capital to connect with entrepreneurs who have business ideas, and these entrepreneurs will be able to get substantially more companies funded and running, and those companies will do things that make the things we want and solve problems we have (which is ultimately what creates wealth).
[It's important to understand the ?difference between wealth and money; in short wealth is the things we want and need to live, and money is whatever medium of exchange we use to get them. If you need more explanation, read Paul Graham's essay?about this, he does a fantastic job explaining it.]
But the JOBS Act will not just open up new money to flow into the capital markets. I think the way the new money post-JOBS Act money will act will be fundamentally different than the current money in capital markets works, and THIS is what will cause serious change.
Right now, none of the private equity firms or investment banks are worried about this?they think that the crowd is stupid and can?t pick the winners. They think that their analysis is the best way to do things. Not only do I think they?re wrong, I think they look at businesses in a fundamentally incorrect way, and that the crowd?in the aggregate?will look at potential businesses the right way.
Wall Street asks, ?Can this business make money??, and to answer that question, they begin with what exists. What the current market is, how to fit in that market, etc. They think like MBA trained suits, because that?s what they are. This is how pretty much all capital markets work, because they are all filled with the same types of decision makers who were all trained in the same places and think the same way.
This is not how the average person thinks, and its not how the crowd will invest. They will invest in a fundamentally different way. They will think ?Does this business make (or do) something that I want?? Or they will even think, ?Does this entrepreneur want to do something I want to happen?? They will invest to make money, yes of course, but they will begin under the assumption that they know their own needs, and will fund projects that meet those needs. They won?t think like suits, they?ll think like actual consumers, like human beings?because that?s who they are.
I am not guessing at this. We?ve already seen this. It?s precisely what is happening on Kickstarter. It?s just a pre-order platform for consumer goods?and it works. It has unlocked an entire new sector of creation, and this is a platform that doesn?t even guarantee you get ANYTHING!
I have not seen anyone talk about this or think about this. When people make predictions, then tend to just take the status quo and go form there. This is not an expansion of the status quo. The JOBS Act brings a fundamentally different investor to the capital markets?it brings the consumer to the capital markets, and lets them try to pick the winners based on what they predict they will ACTUALLY want. This is an incredible, seismic shift in how investment capital will be allocated.?And I think more often than not, it will not only work, it?ll work really well.
How Specific Financial/Investment Industries Will Be Disrupted
I?ll explain briefly how the JOBS Act and equity crowdfunding can disrupt several different aspects of investing. Remember, each of these is a fairly basic explanation, as I could write a 10k word piece on each of these individually:
1.?It will disrupt the VC community
The venture capital community has done some great things over the past 40 years. It can take much of the credit for helping develop and fund the tech and internet industries. And it developed simply because the American capital markets were broken and inefficient even then.?But the problem is that it has become fat and complacent and full of lazy money chasing bullshit, instead of finding and financing truly great companies.
How does the JOBS Act disrupt this community? By doing very much what angel investors are doing to VC?s right now: presenting entrepreneurs with other sources of capital that give better terms, forcing VC?s to change their methods and investments, give start-ups better terms, and offer more added value. Pretty simple market economics.
Several VC firms see this writing on the wall, and are already adapting, like First Round Capital.
2.?It will disrupt the angel community
Just like angels disrupted VC?s, equity crowdfund platforms will disrupt the angel community; through competition. When the capital floodgates open to companies, the best companies especially will be able to command much better prices of capital (in terms of giving less equity for better terms).
I believe that many angels will adapt though, and the smartest ones will eventually become the centers of the crowdfund equity world. How? By being the gatekeepers and trust agents that sit between the platforms, start-ups and the crowd. The best angels will build personal brands that all three parts trust, and thus they can be the first money in to do their due diligence and authenticate companies and let the crowd know they are safe, they can connect platforms and companies, they can advise and consult with companies to get them in the right place, etc, etc. They can add a ton of real value to all sides of this exchange.
[This is called building a syndicate, and the early versions of this are already being done on Angellist. I will cover this in Part 5]
3. It will disrupt multiple aspects of?private equity
Very broadly speaking, a private equity firm is a company that adopts a certain investment strategy, then uses it to invest large sums of money in various ways; e.g., leveraged buy-outs, growth capital, venture capital, etc (a VC firm is a specific type of PE firm). Without getting too complex, there are tons of private equity firms and for the most part, they exist to exploit the inefficiencies in the capital markets.
For example, many larger banks or other institutional investors won?t put money in?small growing start-ups because they have restrictions that they can?t go into companies with less than 5mm a year in sales.?As a result, there exists a whole industry of arbitrage that does these things called ?roll-ups? where a PE firm will buy three similar firms with 3mm a year in sales in a similar industry (9mm total), then turn them around and sell them to a private equity firm for 15mm (as a example). These roll-ups make a ton of money exploiting these inefficiencies in the market.
There are countless examples of how PE firms use the conflated and ridiculous securities regulations that restrict capital markets to their advantage, and place themselves between money and companies that need it. By opening up these capital markets, the JOBS Act will help alleviate at least some of these market inefficiencies and?unlock immense amounts of value.
4. It will disrupt the IPO market:
I will quote this Washington Post piece that quotes Mark Cuban extensively, he explains it better than me:
In large part, those and other changes in the JOBS Act were intended to help new firms raise small amounts of capital to get their ventures off the ground. However, some investors say the changes may actually have a greater economic impact by helping established companies that are ready to expand ? firms they say have all but given up on the possibility of an initial public offering on Wall Street.
?The stock market has become a platform not for creating capital to help companies grow, but a platform for financial hackers, where most of the activity is just algorithmic and high-frequency trading,? Mark Cuban, a business magnate and owner of the Dallas Mavericks, said in an interview following the same event on Friday.
?In the ?90s, you would raise $5 million or $10 million in an IPO, but those days are gone, and that has created this black hole for companies,? he said.
Speaking on a panel with Cuban, Weild noted that the ?the number of small IPOs started to fall off a cliff in 1998 with the implementation of electronic stock markets.?
During that period, the number of initial offerings per year has fallen from about 500 to about 130, he said. Of those, 80 percent used to be firms raising less than $50 million; it is now down to 20 percent.
?So only about 30 small IPOs every year,? Cuban estimated, based on those figures. ?That?s crazy.?
Instead, most firms reach a size in which they are too large for more private capital but too small to go public in today?s market. In many cases, he said, rather than continuing to grow, they get acquired by large corporations that could have been their competitors.
?Had they been able to go out and raise, say, $10 million in a small IPO, maybe there is another company out there pushing important medical technology or financial innovation,? Cuban said during the interview.
?Not only does this cap the growth for that company, but it reduces competition, which kills the economy and kills job creation.?
Cuban says crowdfunding and general solicitation should help firms at that critical stage of growth raise more money, giving some of them the jolt they need before entering public markets and allowing others to continue growing as a private venture.
5. It even has the potential to disrupt?American financial law itself
American financial and securities law is just totally fucked up in every way.?The presumption in securities law is against being able to sell shares to outsiders until permission is granted. This might not shock you at first, but think of it this way:
?If we applied the logic of securities law to consumer goods, commerce as we know it would come to a grinding halt?federal and state laws do impose lots of requirements on the producers, distributors, and sellers of goods in the United States, and much of our political wrangling is over what?s a sensible level of regulation?But notice the main difference from securities law. In the consumer context, freedom to engage in commerce is presumed. Small companies have permission to get started, to sell products and services to anyone, and to advertise anywhere. In securities law, the presumption is against selling shares to investors until permission is granted.?
This is a fucking nuts. I explained this above, and it is absolutely contrary to any notion of economic freedom.
I think that as the JOBS Act starts to work, it will be improved and then the concepts applied to numerous other aspects of American financial life.?Make no mistake, the JOBS Act is far from perfect. It still limits the small investor too much, and still concentrates too much power in the hands of a very select, rich, few. But its a start, and if it works well?which I think it will?we?re going to see more and more areas of securities law get examined from the perspective of making them more open to consumers.
How I Think This Will Playout
Here?s basically what I think will happen. My guess is this is the timeline of the first five years:
1. The JOBS Act unlocks a massive amount of capital that is either sitting on the sidelines not invested, or just parked in mutual funds, bonds, or various other stocks to moved to other investments. Right now, most of the major financial institutions are not paying attention to this, they think there is not just not enough money out interested in crowdfunding and that it will go nowhere. They?re wrong, there is a TON of money out there and ready, it?s just in small amounts and spread all over the place. Billions of dollars, ready to go into action actually doing things.
2. I think once the various crowdfunding platforms get established and get traction (which is already happening), they will start raising some serious money for companies, especially start-ups (this is already happening). This is going to drive tons of start-ups to these platforms for their raises (we?re already seeing this in some places, covered in Part 5).
3. Once that happens, start-ups will stop going to the old places for money?venture capital firms, angel investors?and will start using crowdfunding instead (or they?ll use both). Those places are going to have to change their ways to compete with the crowd. Those that don?t change will go out of business, the ones that do change will do incredibly well.
4. At some point, the next Google or Facebook will be a fully crowdfunded entity, and will get a TON of press, and crowdfunding will move from something on the fringes to something mainstream. Normal people will start pulling their money out of the stock market and away from their money managers and start putting it in crowdfund platforms. This is when the fun starts.
5. Once that happens, we?re going to not just see marginal start-ups use crowd fund platforms, but small established companies that are looking to expand, or bigger start-ups looking to raise 2nd and 3rd rounds of capital. ?Crowdfunding will replace IPO?s as the best way to cheaply and easily raise money to expand. This is when the disruption starts to impact large swaths of the private equity business.
6.??Also, once the Google of crowdfunding hits?once people realize that crowdfund investing is real and works and can make you rich?a FLOOD of crowd money will go into these platforms. I think people may (wrongly) see this as a sort of new lottery, except one that they can impact the outcome of. For the first time in history an average person will able to get in on the ground floor of potentially billion dollar companies without having to be rich, connected, or special in any way. Once people realize this is possible, the amount of money that will flood into these platforms will reach into the TENS OF BILLIONS. As much as goes into the state lotteries, I bet.
7. This will incentivize more entrepreneurs to start companies, because the cost of capital will become so cheap. Which will create more companies that solve our problems and create things we want, which make us better off, etc, etc (and of course, more companies will fail, but more will succeed as well). This is where the parabolic growth begins?not just in equity crowdfunding, but in the number and type of start-ups that come about, and we start to see qualitative changes in the American business and financial landscape. I think there are dozens of areas of business that are criminally under covered and under invested by the current capital markets [I cover this more in Part 4].
8.?This is also when we?ll see the big boys start to get pissed, and attack crowdfunding. Why? Because if the American public is using crowdfunding?to invest instead of?the banks and investment firms and trading platforms, the established players in the financial space lose money. A LOT of money. It will be too big to shut down by the point they begin to really pay attention, so they eventually try and co-opt it. Which also won?t work, because these platforms will benefit greatly from the network effect, and by this point there will be very high barriers to entry (for creating a crowdfunding platform, not using crowdfunding to fund your company).?Here?s how you?ll know this change is good for you: Watch what the mainstream financial media does with equity crowdfunding once it reaches this point. At first, they?ll look at it like this cute little thing they can look down their noses at as they report on. But once the major disruptive company springs up from a crowdfunded source, and people start to shift their capital there, the press will talk all kinds of shit about it. Why? Because it?s a threat to the people who pay their bills: The large financial institutions and broker dealers who advertise on their networks.
9. I think this will also create a fundamental shift in how the American people see investing, how they allocate their money, and how they think about their communities. I believe that a huge percentage of the crowdfund investing will be done NOT on big tech start-ups, but local investing in small business, and this fundamentally changes the way people think about their economy and their lives [more on this in Part 4]. Ultimately, this could signal a long term shift OUT of the heavily regulated bond and equity markets that are currently controlled and exploited by the huge To Big To Fail banks, and into real businesses that really do great things.
The Big Takeaway
Are you starting to see a disruption pattern here?
All these changes have one thing in common: They work FOR the average investor and FOR the average American and FOR the average entrepreneur, and AGAINST the large, rich, institutional organizations.?
Open versus closed. Controlled versus free. Exclusive versus Inclusive. You seeing this? This makes everyone better, except the rich, powerful elites who use their power to control and dominate others. Fuck them.
If more investment capital get allocated to the highest valued usage, EVERYONE wins (except the crappy companies who couldn?t compete).
This has the potential to be a profound and incredible shift in capital flows, one that has never been seen before in American history, possibly even world history. We are standing in the precipice of what could be an incredible unlocking of value and creation and meaning in human history?all because of a seemingly small change.
This is Part 3 of 5. Once I finish this series, intend to compile it all, revise it, and turn it into a long post for other media outlets. Any comments, corrections, ideas or arguments are welcome: [email?protected]