It may soon be a lot easier for small investors to buy a chunk of the latest buzzy startup. But should they?
Nasdaq, the public stock exchange, recently acquired SecondMarket, an exchange where privately held stocks are traded. That came a day after J.P. Morgan and Motif Investing partnered to allow small investors to buy into initial public offerings at the IPO price—a privilege usually reserved for big, rich investors.
The two deals are different: Unlike J.P. Morgan and Motif, Nasdaq isn’t saying its private exchange will target small investors. But both deals tap into a similar vein, and the timing is no coincidence. And while there's been talk about how great they are for the "little guy," these deals are almost certainly intended to help startups’ founders, early investors and Wall Street service providers.
Up until late-June, only wealthy investors with special accreditation could buy shares in privately held companies. The rule was intended to prevent not-rich people from losing everything by investing in startups, whose failure rate is sky-high. But thanks to some provisions of the JOBS Act that went into effect this year, that’s no longer the case.
The deals also come at a time when it’s easier to sell a Main Street investor on the prospects of “the next Facebook” than a Wall Street investor. As the finances underlying some well-known startups have drawn scrutiny—not to mention the sustainability of their business models in certain jurisdictions—the market for them has cooled.
The portion of IPOs related to tech startups in 2015 is at a seven-year low, and those that have gone public haven't fared well. Twitter and Box are both trading below their IPO prices, and Alibaba is down almost one-third from its IPO price.
The decline of blockbuster IPOs means venture-capital backers have to wait longer to cash out. Some argue this is simply the new normal. Companies will stay private longer, they say, and have more complicated exit strategies for investors, like how Dell recently bought the larger, publicly traded EMC.
There’s truth to this, but it’s also true that some VCs will want sell stakes in a shorter window of time. If there’s a way to do so without an IPO, through Nasdaq’s newly expanded private exchange, or to do an IPO with an expanded investor base, through the JPMorgan-Motif partnership, then why not?
There are plenty of reasons why the little guy may not want to participate in such investments, though. The most important is a lack of transparency.
Public companies must publish quarterly earnings reports. Top executives typically hold public conference calls to explain the reports, and participate in public forums to discuss strategy and business results. Startups don't have to do any of that.
Opacity is not necessarily a bad thing for startups: Discussing earnings every three months, and appearing at hoity-toity conferences in between, can be an expensive hassle for burgeoning companies that are still figuring things out. But it is exactly why investors who receive special accreditation are the only ones who should be able to put money into them.
Privately held stock is incredibly risky, with no guarantees and few legal protections. Even a household name can come with serious liabilities, particularly if it’s in a nascent industry like ride- and home-sharing, where regulations are being debated. To account for that risk, a person with several million dollars to invest can set conditions that startup founders must follow. Someone with a few hundred or thousand dollars to invest can't do the same.
There are some other considerations for small investors. Cashing out in a hurry isn’t an option. And to see how an investment is doing, you might literally have to travel to a startup’s office to view a document.
If the craving to own a hot startup is still irresistible to you, it’s worth noting that you may own some without even realizing it: Pensions, mutual funds and index funds have been investing in high-growth startups for years. And if that’s not enough, there are other safer ways to be part of startup-land than buying privately held stock or jumping head-first into an IPO. You can work for them, advise them, buy their products or write about them on your blog.
But if you’re not trying to roll the dice, you shouldn’t give them your money.
James is a writer from New York City who has worked for startups, and now works at a brand consultancy focusing on tech startups. His writing has appeared in The Village Voice, Investopedia, The Street, BlackBook and AmericaBlog.