Arnold Kling  

Funding Start-ups

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Bruce Boston asks,


what are the economic arguments in favor of the two class system of accredited investors and non-accredited investors? And are these economic arguments stronger than the counter-arguments that can be made on this same topic? I'd also be very interested in any input as the estimated economic penalty that non-accredited investors face due to the current SEC policy.

He is referring to the fact that if you are a start-up company, there are regulatory barriers to taking investments from investors with low incomes and net worth. Is this unfair to people with low incomes and net worth?

No.

I have a prejudice against outside funding for start-ups. In Under the Radar, I wrote that "Fundraising is not for businesses. Fundraising is for charities." I was so proud of that line that I used it twice.

To me, an entrepreneur who looks for investors is like somebody who can't swim who finds himself in the middle of a lake. It's dangerous to go near the drowning man unless you know what you are doing. If you are not a trained lifeguard, chances are he will drown you as well as himself.

So as much as I'd like to abolish regulations, just about the last one that I'd abolish would be the one keeping low-net-worth individuals away from start-ups. I think we need fewer fund-raising start-ups and more start-ups where the entrepreneur figures out something to sell that will bring money into the company early on.


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CATEGORIES: Business Economics



COMMENTS (7 to date)
ErikR writes:

The less-than-rich (the SEC's euphemism is "non-accredited investor") are prohibited from investing in more than start-up companies.

Hedge funds are prohibited. As well as any private equity offering (not all private companies are start-ups).

Granted there are a lot of bad hedge funds out there, but it should not be the government's role to make decisions for the unwashed masses who apparently are perceived as unable to think for themselves.

How patronizing.

Yes, investing in startup companies is risky. But why single out this risk? Poor/middle class people get to parachute, race cars, eat too much, smoke, gamble, and take a wide variety of other risks that could have extreme financial impact on their life. And few of those other risks have the tremendous upside that investing in a startup can have.

And the non-rich can mitigate their risk in a variety of ways -- by investing only as much as they're willing to lose, by consulting with experts, by performing their own due diligence.

Even though I'm "poor", I think that I can make better financial decisions for myself than the SEC. And even if I can't, isn't it my money to do with as I please?

So butt out, SEC. (And shame on you, Arnold, for cheerleading the nanny-state.)

Let me see if I understand this correctly. In Arnold Kling's ideal world, all startups would be funded entirely by the founders until they become operating cash flow positive.

You are obviously an intelligent individual, so I'm going to give you the benefit of the doubt and assume that you've never been involved in a startup, and haven't really thought through the implications of this notion. Otherwise, I assume, you would quickly change your mind.

Your first mistaken assumption is that an entrepreneur, given a choice, would rather focus on raising money than selling stuff. This is absurd. Speaking as someone who knows a lot of entrepreneurs, and who is one myself, raising money is somewhere below pumping out the septic tank on our list of stuff we enjoy doing. Most entrepreneurs absolutely despise raising money, and would much rather be making stuff to sell (which is why we're entrepreneurs, after all), but it is a necessary part of being a startup.

In fact, to be a founder-funded, at least one of these three conditions must be met: (a) It has to be a time-and-materials business, such as a consultancy or a contractor with no significant pre-revenue R&D or infrastructure; or (b) the founders have to be independently wealthy. If condition (a) is met, as it often is for businesses like building contractors or technology consultants, then in practice very few startups raise outside money.

The problem is that condition (b) is almost never met. The vast majority of entrepreneurs are of ordinary means, and cannot afford the high probability that a failed startup would destroy them financially. Yet there are a lot of great ideas out there which require initial development and/or infrastructure before they can start bringing in outside revenue.

Like, for example, Google (which couldn't start selling advertising until it had the infrastructure to support lots of searches). Or Apple, or Cisco, or just about any other successful technology company since the 1950's.

Venture capital (and related capital like angel investors), for all its imprefections, serves an extremely important purpose: it connects individuals who want to take risks with their ideas to organizations which want to take risks with their money. It is extremely unusual to find both in the same person.

drtaxsacto writes:

The distinction on investors relates only to one class of investments that being the ones done through the financial markets. I agree that the distinction is a reasonable one.

For start-ups outside the financial markets, which are the vast majorities, entrepreneurs can go to any financing source. A good number of small businesses, which in many areas of the country are the economic engine of the area, get started with a combination of sweat equity and family or outside contributions of capital.

William Newman writes:

Plenty of businesses seem to have minimum size where it's hard for the founder to start small and bootstrap up from there. This is true at all levels of capitalization. I have a fair amount of contact with the world of first-generation immigrant Koreans and Chinese through playing the game of Go in the DFW area. Thus, businesses like beauty supply shops and restaurants, started successfully by people who don't just run out and get a second mortgage on their house to raise the capital, are not just a hypothetical abstraction to me. Or at the higher end, very few of the people qualified and motivated to start Federal Express would have been able to fund it from their own resources.

And, in the middle of the range... Kling writes "I think we need fewer fund-raising start-ups." As I recall, Kling has some experience in the world of software and web servers, where often the major capital requirements are the founders' own human capital. In such fields, bootstrapping tends to be relatively easy. But does he know anything about the history of the computer hardware industry that created his world of cheap web servers? Chips so cheap and powerful that a startup can fund its web servers on credit card debt don't just happen spontaneously. (Rather famously they don't even necessarily happen even if central planners are pushing hard for them. To the best of my nonexpert knowledge, nothing which has come out since the collapse of the USSR has contradicted the general impression that despite its great military importance, their semiconductor industry fell far behind the freer-market chip companies.) I very much doubt that many of the semiconductor manufacturing companies founded before 1985 were founded on the founder's personal capital and bootstrapping. None of the histories that I know seem to suggest it, and setting up to manufacture chips was not so cheap. (Possibly after 1985 or so low-capital bootstrapping became easier, because I started to notice people renting fab services to do the manufacturing for design boutiques.)

History seems to show that it's remarkably hard to win in economic prosperity terms by betting for central planners making decisions about people's best interests, and against people making decisions for themselves. In particular, it seems to show that it's consistently much harder to win than the would-be planners themselves believe it is. (Of course it's easy to win in other terms, like getting a warm fuzzy feeling about paternalism for paternalism's own sake.) Given that pattern, and especially given how easy it is to find important fields which seem to be full of successful businesses which weren't bootstrapped on the founder's own funds, I think Kling should present more supporting arguments before drawing his conclusion that he knows better than founders and funders themselves.

Bill Conerly writes:

Arnold has missed the most interesting point about the "qualified investor" rule. A qualified investor looking for a pooled investment fund can get a highly regulated vehicle (mutual fund), or he can go into an unregulated investment (hedge fund). Investors are increasingly saying that they do not value the protections provided by mutual fund regulation. They are even paying higher fees to be in the unregulated sector. Says something about the value of regulation.

TDL writes:

The "qualified investor" rule also seems somewhat arbitrary. Why is an investor qualified at $1,000,000 in assets and not $2,000,000 or $500,000? What is the amazing event that occurs at the $1,000,000 level? Furthermore, I know plenty of people who have several million in assets and large incomes who know nothing of the financial markets, while I also know quite a few who are extremely competent when it comes to financial matters, but have limited funds. One group consists of either the ignorant (of financial matters) or fools with money, while the other group consists of the knowledgeable individuals of limited means. It seems to me that one becomes a "qualified investor" only because the amount wealth they own (which could have been inherited, won, or been generated by simple luck) and does not require any skill or knowledge. To me this rule is as silly as the agency that has created it. I believe Mr. Kling has not given much thought to the "qualified investor" regulation.

Regards,
TDL

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