Accredited Investors, part 2

People still want a chance to cheat the middle-class investor.

I was annoyed to see this letter to the editor in the WSJ, whining about “paternalism” and the accredited investor rule.

For those new to the question, here’s what I wrote 8 years ago on exactly this topic because everyone was getting hot and bothered about it as crowdfunding was gaining steam: https://rickcolosimo.com/why-are-there-accredited-investors/.

I haven’t seen any evidence that private offerings have begun providing more disclosure (PPMs aren’t real in this segment of the market for tech startups or “local” startups, no matter what $50k fee crappy business brokers want to charge your) or have improved returns (cherry picking the companies that are going public is shameful; anyone wanting to provide investment advice to non-accredited investors should know better or be kicked out of the industry).

Just tried to update my past research on the percentage of angel investments that return $0.00.
– Here’s a 2022(?) chart that suggests a bit over 50% of angel investments lose money.
– All based on a 2007 study, here are other factors correlated with higher angel returns. What do they have in common? To my eye, most unaccredited investors are not likely to be able to improve their status on these factors. Can the typical $80k salary person analyze financial statements and projections? Some can, but almost none of them can afford the expense of a third party to do that limited diligence.

AngelList published/sponsored this 2020 paper, which provides the following data:

50 company portfolios had a median IRR of about 10%; 11% of these investors lost money.
20 company portfolios had a median IRR of about 7%; 16% of these investors lost money.
10 company portfolios had a median IRR of about 6% 32% of these investors lost money.
1–5 company portfolios had a median IRR 0%.
(Helpfully extracted by Koor.)

The core finding, which is the same as with venture fund investments, is that it’s a portfolio game. Making one investment is incredibly risky. Investors need a range of investments to hope to be lucky enough to have enough wins to generate an overall positive return. The power law is demonstrated throughout the AngelList paper; most of the returns come from very few investments. That matches lottery and slot machines, where claims of “98% payback” on slots is the average, including the person who wins $5m; most people, of course, lose, and the house collects their 2% no matter what.

And, the deeper problem with this data, rarely acknowledged in an angel investor context because the term is so closely associated with tech investing, is that this data is tied to stereotypical angel investments in tech companies, those that are intending to grow 100x, e.g., AngelList. I don’t know of any study that assesses private investments in what I’d call “local” startups: a restaurant, retail clothing boutique, pool hall, a awards & plaques manufacturing company, and so on. Actual businesses where the plan is to grow and become cash-flow positive and produce returns through earnings rather than a massive increase in equity valuation. I don’t think anyone knows what the returns on these investments look like across the board.

The accredited investor rule exists for 3 main reasons: those investors can better bear the financial risk of bad investments, they are more likely to be able to do their own diligence, and they are more likely to be able to pay someone to do diligence for them.

The WSJ letter talks about other crappy investments that government “lets” people make, including lottery tickets and sports betting. The SEC doesn’t regulate those, or they’d require a lot more disclosure, to be sure.

Suitability used to be a word that guided financial advisors. Now it’s “what’s my fee on a sale” as they push Reg A+ offerings because there’s enough disclosure to make it legal to sell them to non-accredited investors. And that’s the balance that the SEC has struck.

It’s NEVER been against the law to sell private securities to non-accredited investors; you just have to give them substantial disclosures. Almost all private companies raising money decline that expense and hope that the accredited investors they pitch will just ask for a pile of documents and a few fancy decks with nice pictures.