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President Obama signed the JOBS Act into effect on April 5, 2012, endeavoring to make capital more accessible to small business owners. That law required the SEC to write new rules for equity crowdfunding, and they released their new guidelines on May 16th 2016.
For the first time, the average investor could theoretically invest like a Silicon Valley venture capitalist. They would no longer be shut out from backing the hottest startups, and now everyone in the US would be eligible to invest in the next Facebook.
While this idea sounds great on paper, it fails to acknowledge that startup investing is hard. Really hard.
75 Percent Failure Rate
According to Ghikhar Ghosh, a senior lecturer at Harvard Business School, over 75 percent of venture capital investment firms fail to provide returns to their investors. Digging into Ghosh’s findings, the Wall Street Journal adds that “the common rule of thumb is that of ten startups, only three or four fail completely. Another three or four return the original investment, and one or two produce substantial returns.”
Professional angel investors and venture capitalists build an entire job around identifying, vetting, and investing in the next big thing. Yet a maximum of one in five investments will actually generate a worthwhile return.
There are lots of reasons that startup investing is hard, but the biggest factor is that investors are throwing money at companies that have no track record, minimal revenue, and are only ever rarely generating a profit. It might be more accurate to call it gambling instead of investing. So should we all just skip out on investing and throw money into the stock market and 401(k)s? I think there’s a better option.
Investing in Businesses, Not Startups
Equity crowdfunding opens up incredible possibilities for companies and investors alike to unlock the value derived from entrepreneurship. Not all people are entrepreneurs, but they can still see some of the same financial benefits.
Intelligent investing begins with understanding what kind of investing you want to do: startups or businesses? While startups are technically businesses, let’s define “business” as an organization that’s profitable today, not three years down the road.
Most startups today ignore profit to play an entirely different game. Their goal is growth at all costs in order to secure the next round of funding. Each funding round theoretically increases the company’s value, dilutes the previous investors, and provides a further runway to make it to the next round. This process continues until the company fails, gets acquired, or completes an IPO that leaves average investors shut out. Investors typically never see returns.
Businesses are different, though. They have a proven commercial model, an established customer base, and are most importantly generating a profit. Their valuations aren’t based on marketing, buzzwords, and hype. Their valuations are based on cold, hard numbers, like how much revenue they are generating and how much of that revenue is profit.
Think about your local pizza shop or construction company — these are classic businesses, not sexy startups developing disruptive technology.
There is no denying you can be successful playing the startup investment game, but I prefer investing in that which is real, tangible, and measurable. I don’t want to invest based on what a company representative and the media tells me. I want to invest based on the company’s financials.
The true purpose of the JOBS Act was not actually to help the average investor find the next Facebook; it simply provided small and medium-sized businesses with greater access to money. Many business owners in the US have seen their growth suffer from a lack of access to capital.
While Silicon Valley VCs risk their money on the never-ending quest for the next Google, I’m happy to back tested, revenue-generating businesses that consistently earn a nice return.