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It Could Get a Lot Easier to Invest in Startups. Here’s Why That’s Bad

By:
Ryan Derousseau
4 min read
US Securities and Exchange Commission Chairman Jay Clayton prepares to announce a new task force on market integrity and consumer fraud at the Justice Department in Washington, DC, July 11, 2018. - Jim Lo Scalzo&mdashEPA-EFE/Shutterstock
US Securities and Exchange Commission Chairman Jay Clayton prepares to announce a new task force on market integrity and consumer fraud at the Justice Department in Washington, DC, July 11, 2018. Jim Lo Scalzo&mdashEPA-EFE/Shutterstock

The SEC may soon make it easier for small investors to bet on so-called unicorns, billion-dollar start-ups like Uber, Lyft, AirBnB. But while big-time venture capitalists may have made millions betting on these companies, that doesn't mean you will.

Last month, Securities and Exchange Commission Chairman Jay Clayton stated that the agency would research reducing restrictions on those defined as “accredited investors.”

Accredited investors refers to those folks with at least a net worth of $1 million or who can show income of over $200,000 for three straight years. With that status, they can place their wealth into areas of the financial world that Main Street investors can’t, including private equity and venture capital opportunities, like in startups.

Since the announcement, a debate has unfolded between financial advisers and economists over the benefits of such a move.

This potential opportunity to dive into the venture capital world, however, isn’t as clear-cut of a golden ticket as you might think.

Startups aren’t stable investments

You don’t have to look far to find a can’t-miss startup that ended up in the trash heap. Just this month, biotechnology startup Theranos closed down, after once having a valuation that surpassed $9 billion. It turned out the machines it used to test blood samples didn’t work.

While this is a dramatic example of startups ending up in disrepair, other darlings have closed for various reasons. Last year saw the demise of Jawbone, a wearable device manufacturer that once had a valuation of $3 billion.

Even if the company doesn’t actually fail, there’s a chance it never surpasses that valuation you’re buying into. According to a study released last year, companies with at least $1 billion valuation were overvalued by an average of 49%. Nearly 1-in-10 of those companies were overvalued by 100%.

They lack transparency

One reason those betting on startups end up holding the short-end of the investing stick is due to the amount of information available for the firm. Since they’re not public, the company doesn’t have to provide as much information about the financials or results.

Due to this lack of information, it creates a lot of unknowns. It’s one reason why brokers that have investor disputes on their record sell more private placements than brokers without such disputes.

Yet, even when you find good firms, you’re not necessarily going to hit it big. Venture capital funds started in the 2000s have underperformed the S&P 500, while those that began in the 1990s – during the Internet boom - outperformed."

History is not on your side

Even in the glory days of the Internet boom, many small investors got tripped up trying to buy in to latest hot start ups. Some bankers paid fines for "spinning" IPOs, or initial public offerings.

In exchange for underwriting commissions, bankers doled out under-priced shares to executives who could buy them at a profit and quickly resell them, when pent-up demand temporarily inflated the price.

Small investors were often the ones left holding the bag.

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