By: Jeremy Colless
There have been a number of interesting articles published recently discussing the growth in tech startup investment and the associated risks for investors (especially retail investors) attracted to the sector. These articles include opinion pieces in the AFR including “Investors should beware backdoor tech listings” by John McDuling and “Beware a barbell bubble in tech as investor demand outstrips startup supply” by Adir Shiffman
Some of the issues addressed in these articles include:
- Valuations – the existence of a “tech bubble”
- “Backdoor” listings – a private company being acquired by a defunct listed shell company in exchange for shares in that company. The private company then becomes the new owner of the shell company, which it uses to list their business.
- Adverse selection – companies using “backdoor” listings and/or equity crowdfunding have been unable to raise capital via more sophisticated or traditional methods
- Equity Crowdfunding – is it a viable source of funding for early stage ventures
Both commentators suggest retail investors should take great care when investing in tech startups.
John McDuling writes “Retail investors are being enticed to put their money into untested tech companies. And that’s making people nervous“. In this article McDuling quotes Andrea Kowalski, investment director at Bailador Investment Management “if it comes from investors that may not have that level of knowhow and end up funding businesses that don’t warrant that level of funding, we are going to potentially see in a few years, more tears from the investor side“.
In his article, Adir Shiffman comments “A further demand-side distortion will occur when start-ups are able to seek equity crowdfunding from retail investors, an imminent near-term likelihood. This marketplace risks becoming an unregulated cash bonanza for the unscrupulous and overzealous“.
John McDuling suggests that retail investors should not participate directly in startup investing but rather hand their money to VCs with “the expertise and ability to reduce risk by taking many small bets“. He states “Unless you have a lot of discretionary capital to throw around, investing in individual equities is already risky enough for most people. A backdoor-listed stock or illiquid crowdfunded equity stake involves another layer of risk and complexity.
There is no argument that early stage startup investing is a highly risky endeavour. Any investor, whether HNW or retail, should have a well thought out investment strategy before investing in early stage ventures. Investors need to make lots of little bets at an early stage and take conviction driven decisions in startups that have proven traction and real metrics – revenue, customers etc. Hope is not an investment strategy (“What is the best way to angel invest million dollars”).
However, the idea that retail investors are protected by existing regulation (or even worse by more regulation) and/or should not even be able to participate in a range of alternative investment opportunities is simplistic and anachronistic.
Investors should have the right to choose how, where and when they invest their money. However, if they want that right, they also need to take responsibility for the decisions they make – which means they need to educate themselves about the risks and opportunities, and formulate well constructed, diversified and long-term investment strategies.
Multi-asset (equity, property and credit) crowdfunding has the potential to provide investors with fractional access to alternative investments. In its current form the government’s proposed equity crowdfunding legislation will not reduce the risk of adverse selection for retail investors, but rather increase that risk (“The risk of adverse selection in retail equity crowdfunding”).
Regulation is one protection against unscrupulous issuers and sponsors, however equity crowdfunding can be self regulated if platform operators follow a policy of alignment between issuer, sophisticated investor and the crowd (“The risk of fraud and the importance of alignment between parties in equity crowdfunding deals”)
Retail investors, SMSFs and wholesale investors are all gaining new and exciting access to alternative investments. Equity crowdfunding, P2P lending and fintech more broadly will continue to disrupt and challenge existing financial market incumbents, fund managers and regulators.
In time, investors will benefit from lower fees, greater transparency, better alignment of interests and improved access to markets and investment opportunities.