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Small investors got a gift from Congress and the White House on Monday. Unfortunately, for the vast majority of us, that gift is a white elephant.
After years of delay, the Securities and Exchange Commission finally approved new rules that will allow small investors to buy a slice of small, private companies, kindling dreams of getting in on the ground floor of the next Facebook or Google. The changes, four years in the making, stem from one of the few bi-partisan economic bills to pass into law during the Obama years—the 2012 Jumpstart Our Business Startups, or JOBS, Act.
The JOBS Act was great politics, allowing lawmakers to bask in the reflected glow of Silicon Valley, while also appearing to "democratize" finance for Main Street and lend a hand to go-getting entrepreneurs. "Start-ups and small business will now have access to a big, new pool of potential investors—namely, the American people," was how President Obama put it.
But for everyday savers—whose priorities should be boosting savings rates and converting assets into life-time income—the chance to invest in a start-up is unlikely to be more than a distraction. And the risks are substantial.
The idea behind the JOBS Act is to let entrepreneurs "crowdsource" funding, rather than eliminating traditional restrictions that meant they typically raised money just from wealthy "accredited" individuals and Silicon Valley venture capital firms. Starting Monday anyone will be able to invest up to $2,000 in small, private companies a year. Those with income or net worth of at least $100,000 will be able to invest up to 10% of their income or net worth.
As with crowdfunding, would-be investors will be able to shop for attractive projects at Kickstarter-like hubs with name like FlashFunders and SeedInvest. These hubs will have to pass muster with FINRA, the brokerage industry's regulatory body. And unlike some start-ups, participating firms will have to file an annual financial report and be reviewed—although not necessarily audited—by an independent accountant, according to a recent report in the Wall Street Journal.
But there are serious drawbacks, too. Transaction fees are a big one: Crowdfunding hubs typically take 5% to 10% of the money invested, partly from investors and partly from the companies.
Then there's the problem of liquidity: Once money is sunk into a project, it may be difficult to cash out. Under crowdfunding rules investors must typically commit to hold the investment for at least one year, according to The New York Times. It's not clear what if any kind of secondary market might develop to allow investors to sell their equity.
An even bigger issue, however, is that making money from funding start-ups is extremely difficult even for professional venture capitalists, let alone amateur individual investors. No less a luminary than Bill Gates has called the success rate on venture capital "pathetic." One recent Harvard Business School study of venture-backed start-ups found that three-quarters fail, with investors losing all of their money about 30% to 40% of the time—and those are the companies that have been carefully vetted, nurtured, and mentored by teams of experienced investors and entrepreneurs. Meanwhile, a 2012 study by the Kauffman Foundation, an entrepreneurship-promoting think tank, found that venture capital firms had underperformed the public stock market over the past 15 years.
Of course professional investors face down long odds and years of losses in the hope of one or two home runs that will ultimately put them in the black. But even when it's profitable, this style of investing is far better suited to pension funds, university endowments, and rich individuals who have millions in capital and decades-long investing horizons that together allow them to absorb loss after loss while waiting for that one big win.
Also don't forget that the best start-ups themselves actively seek out blue-chip investors. If the next Mark Zuckerberg really is out there, he or she is likely to do what the real Mark Zuckerberg did to raise capital: make a bee-line for Silicon Valley and its robust start-up funding infrastructure.
Tech dreams aside, can crowdfunding start-ups find some realistic niche? Perhaps. The New York Times recently profiled a 26-year-old woman who is considering an attempt to raise money for her $1 million African textile business from loyal fans, who include 100,000 Facebook and Instagram followers. There's nothing wrong with that. But would-be investors should look at those opportunities as more akin to spending money to support something they feel passionate about—like buying a share of a racehorse or a local tavern—than as a way to build wealth.
Meanwhile, the risk that crowd-sourced investments will fail to meet higher expectations is substantial. Kickstarter and other crowd-funding sites that served as a model for the new investments have already stirred up controversy, as contributors find it difficult, if not impossible to hold the fundraisers accountable, despite tens or even hundreds of thousands of dollars invested. To its credit, Kickstarter has no plans to participate, telling the Wall Street Journal: "Not all creative ideas are meant to be investment vehicles."
That's a healthy attitude. Unless your financial future is —with a healthy emergency fund, at least 10% of your salary already going to your 401(k), and a 529 college savings account for your kids—you've got much better things to do with your money than fund a start up.