Will Crowdfunding Turn Private Markets into the New Public Markets?

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  • on April 25th, 2014

Crowdfunding has existed forever. It has recently become popular via Kickstarter, where companies could raise money by promising to deliver product or a service at a future date. This is not the type of crowdfunding I refer to in this post. By crowdfunding, I mean obtaining equity in private companies.

So, why is this subject so important to someone like me, whose entire edge is in public markets?

First, let me remind you of the main purpose of Initial Public Offerings.

Companies go public:

- to offer liquid exits for founders, employees and private investors;

- raise capital to expand;

- achieve higher valuations;

Investors buy public companies in order to:

- participate in the growth of various businesses;

- protect the purchasing power of their capital;

- diversify income stream;

- achieve higher returns than bond, real estate and cash markets offer;

- speculate.

The IPO market has changed a lot over the past decade. Companies go public at much higher valuation today for several fundamental reasons:

- they raise more money while private, while it takes less money and time to build a major company today;

- companies remain private longer, because they could raise all the money they need from private investors. It used to be that when a company reaches a 100mil valuation, the only viable exit was an I.P.O. Not any more;

- companies reach maturity a lot faster; they go public at much later stage in their growth cycle; most of the value is created while a company is private. There’s a lot less meat left on the bone for the public investors.

Hedge and Mutual Funds have long realized these trends and started to allocate capital to private markets, essentially accelerating the above mentioned developments. As a result, public investors have been in a way excluded from many high-growth opportunities

Don’t get me wrong. Public markets continue to offer incredible opportunities to investors, but today’s markets are very different than the public markets of the 90s, 80s and even before that. Back then, there were hundreds of 100-baggers. The number of 100-baggers in 21st Century could be counted on the fingers of your two hands and only if you timed your purchase properly. One could make a lot of valid arguments of why there haven’t been many gigantic public market winners in the past 15 years. The main argument is certainly the extremely high valuations at the beginning of the period, but there are also some secular trends (reasons) that are not going away.

It has become a lot easier to invest in private companies

Angel List has changed the investment universe for many accredited investors, which be latest counts are about 7 million, only in the U.S.

Each company, looking to raise money on Angel List, provides detailed description of its business – number of employees and their experience, revenues, current investors, previous funding, etc.

Angel List also provides easy and cheap access to experienced investors via Syndicates. Syndicates charge a performance fees, therefore they are only accessible to accredited investors. You could invest alongside Fred Wilson, Joanne Wilson, Brad Feld, Howard Lindzon, Jason Calacanis and many more VCs and angels with proven track record or just follow their footsteps.

The JOBS Act, Title III is about the change the investing game for non-accredited investors. It is expected to go in effect later this year. There are clear limits on how much non-accredited investors are allowed to invest in a given year:

  • For income below $100,000, invest a max of $2,000 or 5% of income or net worth
  • For income over $100,000, invest a max of 10% of income or net worth
  • Investments made in a Title III crowdfunding transaction can’t be resold for a period of one year

Every new law has its pros and cons.

The pluses:

- many people will be forced to become long-term investors; there will be no daily quotes for their investments;

- companies could raise money without the intermediation of Investment Banks, which probably means lower valuation for those companies, when there are no professional sellers to tell an intriguing story. Truth to be told, there will always be huge demand for good salesmen and the best salesmen in the world are Investment Bankers. They will probably engage in those private offering and help companies to boost valuations – just like they do today for wanna-be public companies.

- you will have the opportunity to invest in a business you understand and use at early stages of its growth cycle.  Imagine if you could invest in Uber, Twitter, HotelTonight or AirBnb when you first used them and loved them. You would be a lot richer today.

- companies will have more options for funding – instead of a few hundred VC and a couple thousands angels; they could raise money from millions of people, which should help boost valuation and foster innovation; By no means I say that good VCs and angels will go obsolete; They don’t provide just money, but also indispensable connections and advise that are essential to young companies;

- you will be able to invest in concepts that don’t have a viable alternative in public markets. For example, companies that are currently building the blockchain infrastructure;

- you could potentially enter a lot early in the growth stage of a company that could be huge 5 or 10 years from now;

The minuses:

- no liquid secondary market; this will probably partially change with time, but not being able to sell for a year will be a huge hit on liquidity; no liquid secondary market means no Technical Analysts – an indispensable tool for many investors; Valuation will matter a lot more, but then how do you value a tech company with no revenue, but huge potential. Maybe you just don’t invest in such companies. Reading and following experienced angels and VCs might be your only edge here. A few good starting points are - Fred Wilson, Marc Andreesen and his entire team at A16zHoward Lindzon. Also research sites like  Mattermark and Crowdability and Techcrunch.

- there will be a lot of zeroes, a lot of frauds. Private companies don’t have to report every quarter; people will have to learn to diversify properly and look at private companies as just one asset class in their overall portfolio. Learn position sizing and diversification – if you are only allowed to invest 10k a year in private companies, allocate 2000 to five different companies or even better – 1000 to 10 different ones.

Secondary, Public markets will continue to play an important role in traders and investors’ lives, but there’s a new asset class coming on the horizon – an asset class that hasn’t been available for the majority of investors for a very long time. This asset class will open the doors to some incredible opportunities. It will also open the doors to some incredible frauds. In public markets, being wrong is not a choice, but staying wrong is. In private markets, you might not have the choice not to stay wrong, so choose wisely, use equal position sizing and diversify.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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