Many Australians they dream of starting their very own business. However, they face restrictions on access to startup capital. In Australia you could have an A certificate “sophisticated investor” invest in dangerous early-stage ventures that cannot yet meet costly disclosure requirements.
A “sophisticated investor” is someone with an income of at least A$250,000 per yr or assets of A$2.5 million. However, this qualification not only discriminates against some investors, but is a very limited view of what it means to be “sophisticated.” It also ignores recent changes in the way corporations interact with an essential group of early investors – their customers. Moreover, it robs startups of worthwhile capital.
The argument against “sophistication”
The argument because this limitation is that investing in private corporations with unregulated disclosures is dangerous. They are not subject to the same requirements public company and are potentially harder to evaluate for a layman. “Uninformed investors” should simply persist with listed investments as they are less dangerous and more transparent.
However, there is nothing special about having money that makes you a good investor, and investors also lose value in public markets.
In particular, it is well documented that on average shares sold to the public through an initial public offering perform significantly worse in the long term than other investments. Even if a high-quality IPO involves market, unsophisticated investors will struggle to get a significant allocation, while wealthy and well-connected investors will get most of what they are asking for.
The academic literature calls it “the winner’s curse” in which unsophisticated investors only get shares in an IPO if sophisticated investors think it is a lemon.
Many startups have a unique relationship with their customers
But corporations also have more intimacy with their customers than ever before. Micro-investment startup Acorns recently tried to lift A$6 million through a private placement of shares, at least some of the estimated 160,000 Australian users. According to reports, Acorns users have already donated over A$1 million to assist the startup replenish its money and pursue further growth opportunities.
Acorns could also be a bit unusual in raising this money because it is an investing app itself. It helps its users build wealth by saving “free change” and investing that money for them. So the company’s customer base is at least familiar with the principles of investing.
However, Acorns’ ability to leverage its user base as a source of capital also challenges the notion that only “sophisticated” investors are qualified to participate in early-stage deals. Acorns users are typically young, tech-savvy millennials who are unlikely to pass the sophisticated investor test (which is probably why they use the app). However, by interacting with the app, these users have a unique insight into assessing Acorns’ prospects.
This raises the query of whether the distinction between “sophisticated” and “unsophisticated” investors stays relevant in the world of app-based technology startups. These startups often employ aggressive go-to-market business models that attempt to accumulate as many users as possible relatively early in their lives. Would someone wealthy in money understand this business higher than their customer or user?
By making an investment decision at an early stage, a “sophisticated” investor can try to find out whether the application solves a significant problem in the user’s life and, due to this fact, how deeply the user will engage with it. However, predicting app user behavior is inherently difficult. So who can predict this higher than users themselves?
Discrimination against some investors costs everyone
Under current regulations, many “unsophisticated” users are denied access to such investment opportunities because they are simply not wealthy enough. This deprives investors of an opportunity and startups of a potential source of capital. What’s more, all of us stand to lose when corporations that create amazing products struggle or die resulting from lack of funding.
For startups, using customer support, as Acorns did, would offer a source of capital that does not involve the costs and conditions typically associated with angel and enterprise capital financing. For small investors, this provides direct access to potentially very lucrative (but very high risk) investments that would otherwise be unimaginable or very expensive to access.
Democratizing the way startups are financed could create an environment in which entrepreneurs, small investors and the economy as a whole would profit from financing recent and interesting ventures. But all of it starts with reconceptualizing the current arbitrary notion of “sophistication.”