Magical markets

Americans are great believers in the value of entrepreneurs and small business. That faith underlies the JOBS (Jumpstart Our Business Startups) Act, a new law that will make it easier for small companies to raise money and bypass the regulatory “friction” that firms encounter when they go public. The law assumes that people who can’t find jobs may be able to find investors instead, and that small companies will be able to get the financing they need to grow bigger and hire more people. Angel investors, friends, and family will boldly go where banks may fear to tread.

The JOBS Act is an extreme example of Americans’ belief in people’s essential goodness, and everyone’s right to self-fulfilment. Every entrepreneur should be entitled to raise funding from willing investors. It is a uniquely American approach, and capitalistic in the best sense of the word, for it encourages (and democratises) investment, rather than fuelling consumption.

Small (under $1bn) companies can raise money directly from small investors in a formalisation of the “crowdfunding” approach, whereby a project’s principals post their plans on a web site and ask for money, essentially opening up the initial public offering (IPO) market. The theory underlying the law is that a new set of accredited third-party marketplaces, rather than the overburdened Securities and Exchange Commission (which missed Bernie Madoff’s monster ponzi scheme), will ensure that entrepreneurs tell the truth, and that investors know what they are buying. (Of course, that begs the question of how thoroughly vetted and reliable those third-party marketplaces and their vetting systems will be.)

While this initiative was born in the US, many countries are wondering how to jumpstart their own entrepreneurial sectors, and may be tempted to follow America’s lead. So why do I hope that they resist that temptation? Unfortunately, the JOBS Act is as likely to be successful as the US government’s earlier attempts to ensure that American families could buy their own homes. Low down payments, deferred interest, and other enticements made it attractive for people to buy their own homes (or to speculate with second homes) whether they could afford to or not.

Mortgage brokers were happy to get in on the act. Some were driven by an honest mission to expand property ownership; others were driven by greed. Some knew that the people to whom they were selling houses could not afford it; others simply did not want to know. Some played by the rules; others forged documents. The banks that originated mortgage loans sold their portfolios to investors who didn’t really understand what they were buying.

In the same way, the JOBS Act will ease life for some deserving people – and most likely attract many more who are less deserving. The new system will attract scam artists and promoters who will encourage unsuitable companies to seek investment and oversell the companies to individuals who can’t afford to lose the money that they invest.

Safety nets
I wish I had more faith in the system, but the problem is not a lack of good people, good investors, or good entrepreneurs. The problem is that, without regulation, bad people take advantage of the good ones. While regulation and restrictions may hamper small business, not all regulation and restrictions are useless.

Yes, there are some wonderful, honest companies that deserve investment and can’t get it, but they are not that common. I see a lot of startups. Many are appealling and have good ideas, yet most of them fail. Now the quality of even the honest startups is likely to decline as more of them are established, and they will spend more of other people’s money before failing.

For example, with more startups, it will be even harder for each of them to find management, talent, and the right employees. Indeed, many people whom an entrepreneur might have hired will probably become CEOs of competing startups. Meanwhile, all of them will be competing for a finite number of customers, and those companies that make progress will then have to compete for even scarcer scale-up capital from investors.

Many investors in these startups are likely to lose their money. Even under the current system, many angel investors lose money. The best route to success in angel investing is to invest in, say, ten or more separate companies, so that you have the chance of at least one big winner. But, again, a broader investor pool is likely to reduce the average number of investments per investor, with inadequate diversification leading to many more losers than winners.

The faith that drives the JOBS Act is the same magical thinking that drives many internet phenomena: people are good and everyone means well. But the internet’s easy accessibility and low-entry barriers have led to spam and malware and bad behaviour; each new service starts out “clean,” but then ends up requiring its own regulations.

Just ask eBay, Google, or Facebook how much they spend on security, fraud detection, and the like. They don’t want to tell you, which says a lot. As on the internet, so in real life: sometimes friction has a purpose.

Esther Dyson is CEO of EDventure Holdings and an active investor in a variety of startups around the world. Her business interests include IT, healthcare and space travel

(c) Project Syndicate 1996-2012