Let’s Help the SEC Democratize Investment in Tomorrow’s Technology

Recent proposals by the Securities and Exchange Commission to broaden the definition of an “accredited investor” able to invest in private capital markets and expand access to capital for entrepreneurs are game-changers for the industry.

Allowing more people to invest in early-stage companies, as the SEC proposed in December, heralds a long-overdue democratization of the market. Simplifying, harmonizing and improving the exempt offering framework, as the SEC proposed in March, will promote capital formation in unlisted companies while preserving and even enhancing important investor protections.

Together, these steps will unleash huge untapped reserves, enabling tomorrow’s technologies to grow faster, for the benefit of all.

The digital revolution powering rapid advances in healthcare, agriculture, transport, food security, sustainable energy and other areas of progress, is being driven largely by start-up technology companies whose rapid route to market is not only benefiting mankind but also making millions of dollars for investors. The pandemic has shown how important these new technologies can be in a crisis, with companies from Amazon to Zoom helping us to endure weeks of lockdown and social distancing.

Until now, only a select few could invest in such companies during the high-growth stage before they were traded on the public markets – even though such investment is actually the bulk of finance raised by companies.

While public offerings accounted for $1.4 trillion of new capital raised in the decade to December 2018, the SEC estimated that more than twice that amount – about $2.9 trillion – was raised through private placements.

Pre-IPO investments carry higher risks, but also offer much higher rewards. Investors want to get in on those deals and invest in promising companies before they go public. But the number of people able to enjoy early-stage investment is limited by strict regulation about who has access to these companies and their potential high returns.

“The number of publicly-listed companies has gone down significantly, while some of our fastest-growing – Uber, Lyft, Slack and others – accumulate a significant amount of the growth in the private markets before going public. It’s always been my belief that we must do more to safely provide everyday Americans access to those opportunities to the extent we can,” Rep. Anthony Gonzalez (OH-16) told a House subcommittee on June 25.

“My objective is for retail investors to have access to investment opportunities that are aligned with professionals,” responded SEC Chairman Jay Clayton. “One of the great things about our public capital markets is that retail sits right beside institutional. They get the benefit of that professional alignment of interest. When you move into the private markets, you want to make sure that you maintain that alignment of interest.”

The changes that Clayton’s SEC is now proposing are a welcome step toward achieving that goal.

As investors race to grab an early stake in the next Apple or Beyond Meat, under existing rules most people are prevented from even participating. Most of the estimated 14 million American households that even today meet the criteria of accredited investors, let alone the general public, don’t get a chance to join in until after the company’s IPO, by which time the major profits have been made by those lucky enough to get in early.

In recent years, the rise of equity crowdfunding platforms has provided a route for accredited investors to join this exclusive club. When Beyond Meat had its spectacular IPO in 2019, and Lemonade more than doubled its opening offer price on the first day of trading on the NYSE in July, private investors were among those who had helped build the companies pre-IPO and were able to benefit from their successful public launch alongside the select club of institutional investors.

Even if a company’s IPO fails to fulfill all the hype, early-stage investors can still benefit. That was the case when Uber began trading publicly last year. Uber had recently bought Jump Bikes, an electric bike company, which was financed by private capital. Despite Uber’s lukewarm IPO, investors with a private stake in Jump were able to make money because they were able to invest early.

The SEC proposals, if they are adopted, means more of this democratization, allowing smaller investors an opportunity to get in on the deals that until now have been reserved for an exclusive and very small group of people. The proposals also mean that more start-ups will have easier access to private capital, enabling the smart people whose innovation we need more than ever in our post-coronavirus world to move fast and fix things.

Investor protection groups have, understandably, expressed reservations about the SEC’s proposals, fearing they could expose “vulnerable investors to private market risks they are ill-equipped to face.” These fears must be taken into account in any changes that are made, and sufficient safeguards set in place to ensure that unscrupulous advisers do not take advantage of investors who cannot afford to take the high risks involved in early-stage funding.

In order to mitigate the risks, smart venture capital investors understand that you must spread your investments across a portfolio, actively go to work for your companies, and receive special share rights as a reward for the risk.

More start-ups will have easier access to private capital, enabling the smart people whose innovation we need more than ever in our post-coronavirus world to move fast and fix things.

To be sure, investing in start-ups is not for the faint-hearted. Most technology start-ups fail, even here in Israel, where a unique combination of chutzpa, confidence, culture and military innovation has created a “Start-Up Nation” celebrated in the book of that name and second only to Silicon Valley.

Smart venture money realizes that the work doesn’t end with picking the investment – it’s just the start. Private companies have no requirement to report financial information, so you need someone to watch your investment, represent your interests and add value to the company itself by getting involved.

The best equity crowdfunding platforms will conduct extensive due diligence on all investments with a company’s customers, competitors, partners, and teams to determine if the investment is right. Even though such an in-depth vetting process might knock out more than 95 percent of the companies considered, crowdfunding platforms should offer investors only those deals in which the platforms are confident enough to invest their own money alongside the public. And the platform should only accept as investors those who are wealthy enough to afford to take a bet on an asset class that remains very speculative.

Despite the risk, the benefits are clear. The venture asset class has proved so successful that smart investors like the Yale Endowment increased their allocation from 13.7% in 2014 to 19% in 2018 with the aim of investing 21.5% of all assets in venture capital in fiscal 2020. For the year ending June 2019, Yale’s venture investments outperformed all its other long-term asset performances, returning 20% over 10 years and a whopping 241.3% over 20 years.

Yale’s experience shows that investors who approach these assets with adequate caution and through trusted advisors can mitigate the risks and show lucrative results.

Picking the right deal is only the start. The need to manage these investments constantly going forward is paramount. After the investment, platform representatives should sit on company boards, provide governance and guidance, leverage their network to continue adding value. This practice allows the best crowdfunding platforms to aggregate the impact of the crowd on behalf of these companies as they closely manage the investments on behalf of the platform’s members.

Successful IPOs like Lemonade and other exits like the recent acquisition of CyberX by Microsoft – both companies with equity crowdfunding investors – demonstrate the success of this more democratic but still professional approach.

The SEC’s proposals will broaden the number of people able to participate in these exciting opportunities, democratizing investment in the technology of tomorrow.