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Tech groups valued at $1bn are risky business for small investors

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When Apple went public 35 years ago, anyone who lived in Massachusetts and wanted to buy shares was out of luck. State regulators there decided the company was just too risky for individual investors and banned brokers from selling the stock to the general public. Standards for protecting “the little guy” have changed a lot since then. But with each technology boom, more ways of making — and losing — money come to light.

At first glance, today’s small investors at least look a lot safer than their counterparts in the dotcom bubble of the late 1990s, when a barrage of profitless start-ups was foisted on exuberant stock market investors.

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By comparison, the red-hot centre of the tech boom is in the private markets, a place where individuals rarely tread. There, the procession of start-ups claiming the $1bn valuation needed to qualify for “unicorn” status — the aspiration of any truly ambitious tech entrepreneur — has become a stampede.

But the lines have been blurring between public and private, thanks in part to the passage three years ago of the Jumpstart Our Business Startups (aka JOBS) Act in the US. In the latest implementation of one of the act’s provisions, rules will take effect next month that allow companies to do stripped-down “public” share sales (known as “Reg A” offerings) of up to $50m a year. In one key provision, state regulators — such as those in Massachusetts — will not have the power to intervene. That step will be a prelude to the act’s final and most controversial provision — the crowdfunding rule that will let private companies raise small amounts of money from anyone, not just the “accredited”, or well-off, investors they can tap at present.

In a boom, giving Joe Public new rights to invest in the next tech star is hard to argue against. Confirmation bias makes investors optimistic. As with the Apple initial public offering, today’s investors look at successful start-ups such as Uber and Airbnb and wish they had been able to get a piece of the action earlier.

Of course, start-ups rarely achieve such success. Even most professional venture capital investors have failed to make money over the past 10 years.

Worse, start-up investing is the ultimate insider’s game. The best-regarded entrepreneurs prefer to turn to a magic circle of big-name investors whose backing confers instant status and can open doors to help their businesses grow.

Almost by definition, any start-up willing to put up with the hassle of dealing with a large group of amateur individual investors — any one of whom might reach for a lawyer in the event of a loss — is likely to end up being a far less desirable investment.From drone control to grocery shopping, ingestible sensors to sleep monitoring, Silicon Valley is setting the pace

Among more developed start-ups, meanwhile, the race to create “unicorns” could lead to collateral damage of a different kind. Private companies are stretching for the $1bn price tag as proof of their success in a crowded start-up world.

In a study released last week of companies that have reached the magic number, Fenwick & West, the US law firm, found that more than a third were valued either at, or just above, the $1bn level — suggesting strongly, say the authors, that they had negotiated with the valuation in mind.

What the companies are giving up in return gets less attention. All 37 of the companies in the Fenwick & West study have given investors downside protection in the event they are one day sold for less than their valuation. In effect, the backers who agreed to the extravagant headline figures will have first call on the proceeds, reducing the money left over for everyone else. And the more extreme the overvaluation at this stage, the less there will be for other investors if things turn down.

The “little guys” who are at risk in this instance are the employees who hope to get rich from the options and restricted stock units they’ve been granted. They probably feel proud that the companies they work for have been valued at more than $1bn. What they do not realise is that the higher the valuation, the more risk there is to their own hoped-for nest eggs, says Lise Buyer, a Silicon Valley adviser on IPOs.

As long as valuations keep going up, it is easy to turn a blind eye to pitfalls like this. But no tech boom lasts forever.




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