The SEC Chairman recently announced a policy initiative to enable the ordinary investors to invest in private companies. Currently, only wealthy accredited investors are allowed to invest in private companies. His stated goal is enabling small investors to get access to alternative high-quality investments, such as in private tech companies like Uber and AirBnB. But this policy, even if implemented, may not work as intended because the ordinary investors may not want to invest in private startups and private companies, especially digital ones, may not want ordinary investors. Digital entrepreneurs seek investors who understand their business, can cope with significant early losses, can take risks, and can advise them on operations.
The SEC Chairman recently announced a policy initiative to enable the ordinary investors to invest in private companies. Currently, only wealthy accredited investors are allowed to invest in private companies. His stated goal is enabling small investors to get access to alternative high-quality investments, such as in private tech companies like Uber and AirBnB. But in our view this policy, even if implemented, will not work as intended because the ordinary investors may not want to invest in private startups and private companies, especially digital ones, may not want ordinary investors.
It’s worth noting that the average investor does have alternative options to indirectly invest in digital startups. While most of the private equity companies are private, a few like Blackstone Group, KKR, Carlyle Group, and Apollo Global Management are traded on stock exchanges. Many public traded companies, such as Alphabet, Intel, and Apple are, in part, venture capitalists in disguise. While investors may not have the opportunity to invest in Uber, they can potentially invest in similar ventures via KKR or indirectly invest in similar businesses such as Waymo or Titan by investing in Google and Apple, respectively. Furthermore, pension funds are increasingly looking at investments in private equity funds. This may be a better model for average investors to get exposure to private companies, for several reasons.
Digital startups often seek to grow quickly and so report large losses. They therefore seek investors who understand their initial losses and can facilitate secondary rounds of funding when their operations grow. In addition, given their quest for organization leanness, digital startups seek investors who have the expertise to help outsource their noncore business functions, such as production, distribution, marketing, and payroll processing. In addition, venture firms are constantly scouring for opportunities to get their invested company acquired, which is an increasingly attractive exit route for digital entrepreneurs, given the IPO’s long-drawn process and mandated holding-period requirements for initial investors.
Thus, digital entrepreneurs choose their financiers not only for their contributed capital but also for their partnership value and exit options they create for the company. Available capital now significantly exceeds viable investment opportunities so digital entrepreneurs can afford to be picky in choosing their funding partners. By 2017, the number of total private equity funds reached 7,700 and the amount of free investible funds reached $1.7 trillion. With so much private capital chasing good investment opportunities, digital entrepreneurs prefer to remain in private hands until the time they are ready for regulatory compliance, quarterly financial reporting, and public investors’ demand for regular profits, as required post IPO.
Gone is the heyday of the 1990s when firms with simply an idea and little or no revenues could do an IPO. The median age of technology firms, backed by venture capitalists, doing an IPO has reached eleven years and is increasing. Eleven years is a long period for a surviving digital company, during which time, the value of its initial investments can jump several folds. For example, the initial investments of $25 million, made by Kleiner Perkins Caufield & Byers and Sequoia Capital in Google in 1999, increased by more than hundred folds by the time Google went public in 2004. Thus, the most lucrative investment opportunities, with the highest payoff potential, never see the light of public market. They are cornered and nurtured with patient capital by private investors, some of which make huge killing in those investments. By the time, those opportunities reach public markets, if at all, they are fully priced. Public-market investors, therefore, cannot hope to become wildly rich as can some lucky private equity investors.
But a lack of wildly profitable investment opportunities does not justify the opening of private market to public-market investors. Opportunities pursued by private funds carry large risk and require long time horizons. The median holding is five years, some investments take ten years. General partners of private funds extract large management fees, but it takes a minimum of six years to evaluate their performance. In contrast, investments in public equity markets, through mutual funds for example, diversify risks and impose low management fees. Their performance can be assessed almost on daily basis and the investments can be quickly liquidated through stock markets. Thus, the economics of private equity funds do not favor the investments from ordinary investors, who do not possess the surplus wealth, ability to pay high management fees, and have the patience and risk-bearing capacity of rich investors. Moreover, can the average public investor stomach losses that VCs incur when their investments fail?
In sum, SEC’s chairman’s proposal mentioned at the beginning of this article, while laudable in intent, is unlikely to work. We do not expect ordinary investors to come running to digital startups nor do we expect digital startups to start welcoming ordinary investors, even if the regulations were changed.