When the SEC overturned the 80-year ban on general solicitation yesterday, many people thought about call centers, late night advertisements and a return to 1930s hucksterism. Maybe they should have thought about Silicon Valley instead. Due to the JOBS Act, the next few years could cause the entire economy to end up looking much like the startup landscape does today.
Let’s start with a little history. In the late 90s, startups were dominated by VCs writing large checks for entrepreneurs to start businesses. Then the bubble burst and few investments were available, leaving startups out in the cold. Wait – this sounds familiar. Private equity firms and banks invested a lot of capital in the mid-2000s, then the bubble burst, and now non-tech businesses are having a hard time finding loans and capital. As Mark Sunshine, CEO of Veritas Financial Partners, told us, “The largest predictor of bank profitability last quarter was size. If you believe little businesses are served by little banks and big banks are serving big businesses, you’d believe that little banks are having a hard time.” And by extension, so are smaller businesses.
So how does the owner of a small or medium sized business get the capital they need to grow their business? Over the next few years, it could come from the ‘democratization of capital’ – a distributed network of investors who are currently too small to be worth actively soliciting. But, we’re not talking about crowdsourcing. Everyone in this game is accredited.
Let’s go back to Silicon Valley. Many of the big venture funds that fueled the bubble never came back. Instead, a new class of investor appeared. “The major driver of startup capital has been a very distributed network of angels, incubators and early seed stage funds,” Tom Courtney of the Courtney Group described,”Traditional venture capital firms only get involved in companies when they need the significant amounts of money necessary to take a proven idea and grow it enough to go public.” While some would argue there’s a third class of investor, the specialized mid-level VC firm, nearly everyone would agree the Valley has been changed by the explosion of seed capital. In fact, for many startups it’s led to the “Series A crunch”, where there’s not enough institutional capital available to continue funding all of the companies started in the last few years.
A similar explosion in middle market lending and acquisitions could very well be the effect of yesterday’s lifting of the general solicitation ban. For the average accredited investor – anyone with more than $200k in annual income or more than $1M in net worth (excluding their home) – the availability of options will begin cropping up when the ruling goes into effect two months from now. As Sunshine pointed out, “it obviously takes a lot of people investing small amounts to outweigh one large investor investing a lot. Having said that, I think you’re going to see broader investment options for individual accredited investors. I also think you’re going to see smaller institutions getting access to better investment opportunities than they would have without the JOBS Act. It will make economic sense to market to them – the smaller endowments, pensions, smaller insurance companies, etc.”
For groups trying to raise new funds and investment banks representing deals, half of the battle is going to be learning how to communicate with the influx of newly accessible investors. While accredited investors will have a plethora of new options, they’re going to need help finding their way through the minefield. Sunshine cautioned, “Freedom comes with responsibility. Investors who are participating will have to take responsibility for their own actions. There’s no one helping them make decisions if they get sucked in by fraudsters or hucksters.”
As the tech community discovered, firms who help the rest of the industry avoid bad actors start to gain a competitive advantage. Previously, all an investor had to do was show up with a big check and a broad mandate. A decade later, VCs are educating entrepreneurs, talking about how the industry works, how they make money, and why certain deals and teams get investments. Some of the most open, talkative firms are getting access to the best deals because people trust them. Union Square Ventures, GRP Ventures (who recently changed their name to Upfront Capital – emphasizing their openness), 500 Startups and Andreessen Horowitz, have dominated deal sourcing and found outsized returns by being better communicators than their peers.
The broader private capital markets won’t suddenly change, rather they will be required to open up – to communicate more clearly and more often. Yesterday’s vote isn’t going to make private equity to stop being private. The impact isn’t that simple or immediately revolutionary. It’s more subtle; removing the silent friction, the fear of stepping over an unknown barrier. As Courtney expressed, “Are there limits on how many people on Axial can look at a deal? Isn’t that advertising or where is the line? The new rules get rid of any grey lines. People will be able to share more information, more easily. It will accelerate the pace of getting deals done and will fill a need in our capital markets.”
But no matter how open and accelerated the market becomes, trust and personal connections will still rule – as they do in Silicon Valley. An entrepreneur’s best shot at getting funded by an angel or a seed stage fund is still being introduced by other successful entrepreneurs. An investment bank’s best shot at helping a business owner raise capital from individual accredited investors, or any other investor, will still hinge on reputation. As Courtney noted, “We have a history, you know what I like, you know I can trust you. That’s our relationship.” Finding faster ways to build those relationships, like developing new connections on Axial, will drive the future of the industry. As the pool of investors gets larger, firms who are able to most quickly uncover trusted connections and foster deep relationships will end up with outsized returns.
An additional amendment, which is independent of the lifting of the general solicitation ban, was voted 3-2 yesterday and now has 60 days of public comments before the final vote. The amendment would require firms to register their advertising materials 15 days prior to publication in order to allow for some oversight. It would also require firms to register the number and type of investors along with how accreditation of each was confirmed. The amendment could be the regulatory balance necessary for a more open investment environment. If a decade from now we’re not talking about excess dry powder and are instead discussing a ‘quality deal crunch,’ Congress will have had the intended effect.