A Kickstarter for IPOs: Buyers Beware
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The Fiscal Times
September 27, 2012

Crowdfunding – whether the target is financing a philanthropic initiative, an art project or a business proposal – is a sexy concept and has turned Kickstarter into a household name. And despite the “Facebook fizzle” – the disappointing IPO of the iconic social networking company earlier this year – little generates as much buzz and excitement on Wall Street as an IPO. So, combining these two ideas should produce something truly, explosive, right? Certainly, that’s what IPO Village hopes will happen as it urges investors of all kinds and sizes to visit its website and “get your name on the list as quickly as possible.”

“The list,” in this case, is the roster of ordinary people interested in crowdfunding IPOs that will be underwritten by a small boutique investment bank, First Line Capital, and listed on Nasdaq. Crowdfunding – pooling the resources of investors or donors with relatively tiny amounts of money to put to work, in numbers large enough to offset that small per capita sum – has helped get movies into development and launched new products. Now, First Line Capital hopes it will prove equally successful in generating next-stage capital for its clients, and IPO Village promises that “any small investor” can participate “in the next ground floor IPO investment opportunity.”

The approach is akin to angel investing, with the key differences being that investors will get publicly traded stock and that angel investors tend to be savvy, experienced folks not looking at the deals they fund as a way to strike it rich. Most of them are already wealthy, having made millions as entrepreneurs or executives and who now are risking a relatively tiny portion of their net worth. Moreover, these angels typically are investing in a business in which they have some kind of specialized knowledge: An e-commerce angel might have been an early investor in eBay or Amazon.com, for instance, while someone putting a few thousand dollars into a health-care technology company is likely to have spent his career in that business and be familiar with what’s in hot demand and what technologies are likely to work.

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In contrast, IPO Village is wooing outsiders by openly playing on the feeling of alienation that most Americans feel when they think about Wall Street. “No favoritism!” is one of the group’s rallying cries: If you’ve got $1,000 or so, your money is as good as anyone else’s, and you don’t need to have gone to prep school with the investment bankers to get an allocation of an IPO. That is in tune with the times; the JOBS Act, passed earlier this year, will re-open the door that for the last few years has blocked companies from publicly soliciting investments from the general public in this manner. Emerging growth companies can now raise up to $1 million in new capital via crowdfunding. (IPO Village doesn’t need to wait for the JOBS act to kick in; it is selling equity in companies in the process of going public, not in the private companies covered by the provisions of the new legislation.)

But IPO investing isn’t an automatic ticket to riches, although that is hard to remember when with rare exceptions (like Facebook and the dotcoms) we tend to celebrate the successful deals and place a veil over those that fail to generate hefty returns. An IPO can be the pinnacle of a company’s life cycle – and retail investors without some kind of specialized knowledge or insight can be at a disadvantage when it comes to grasping when that is the case. Crowdfunding – where any single investor is simply a tiny player – can exacerbate that information disadvantage. In any IPO, the insiders are the best-informed individuals, and they have decided this is the optimal time to turn some of their stake in their business into cold, hard cash.

For an investor to make a profit on his IPO investment, others need to recognize the potential of the company. That means it needs to have a certain profile and accumulate a broader following, so that there is more demand for the newly issued stock than there is supply. Alas, the stock market is full of “orphan companies” with solid fundamentals that are overlooked by research analysts and portfolio managers. IPO Village promises liquidity and “a forseeable exit strategy” by virtue of a public-market listing, but that’s only part of the story. If there are no willing buyers, a stock’s price can stagnate and real liquidity can prove illusory.

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Judging from the enthusiastic, even hyperbolic, tone of the press release that dropped into my inbox yesterday, IPO Village is gearing up for a big marketing campaign. That press release cited comments from some early supporters: “This is my first time investing,” says one comment; “I've always had an interest in investing but never knew how,” another notes. From a third: “I put in more than a $1,000 because I will not know how much I will be investing in the future since I am just starting out.”

The idea of only needing to invest $1,000 or so to help crowdfund an IPO – and socking it to an elitist Wall Street on the part of the 99 percent – certainly is calculated to win a lot of fans and transform many into crowdfinanciers. But the kinds of people for whom this approach to investing would be ideal don’t seem to be IPO Village’s target audience or – based on the kind of comments noted above – those with whom it’s resonating.

Unless you’re 23 years old, gainfully employed, and you have just won $1,000 at the racetrack or received an unexpected birthday gift from your grandparents, crowdfunding an IPO shouldn’t be your first foray into investing. (If you want to put $1,000 into a company because you want to give a business a chance to thrive, or for some other reason that isn’t connected to making an investment return, that’s a different matter.) Anyone who really views crowdfunding an IPO as a core investment strategy needs to take a sober second look at what they’re doing.

The harsh reality is that investing shouldn’t be exciting or sexy. The most successful strategy is prosaic: simply saving and letting the magic of compound interest work its wonders. Yes, you may strike it rich in the IPO market. But the vast majority of those who do so are real insiders. It wasn’t the investors in Google’s IPO who fared best because they were allocated stock at that price, but the friends of Google founders Sergey Brin and Larry Page who got the chance to snap up shares when Google was simply two guys toiling in a Silicon Valley garage, and who paid pennies for shares that ended up being worth hundreds of dollars. Nor is there any guarantee that the offerings you can get via IPO Village and First Line Capital will be the next generation of Googles and Microsofts. So if you’re thinking of this as a way to get into the next hot IPO, you may want to reconsider.

IPO Village – and other portals like it – can offer investors who already have a decent amount of liquid cash in their bank accounts and a solid investment portfolio a way to do something a bit more interesting and a lot more risky. If you feel like joining them – if you’re convinced that crowdsourcing is the way to go and the wave of the future – be prepared to lose your investment or wait for years for it to pay off. Studies by groups like the Kauffman Foundation have shown that the five-year survival rate of new companies is less than 50 percent; in some years, 90 percent of IPOs end up trading below their IPO price by year-end.

The democratization of financial markets is a wonderful concept, and I suspect that crowdfunding ultimately will become a significant corporate finance tool for at least some issuers. That doesn’t mean it’s ideal for all investors, however. It’s fine to take big risks, chase momentum and hope for a windfall as long as you know that is what you are doing. Allowing yourself to be pulled into an investment you don’t really understand by the allure of crowdfunding as a concept, and the irresistible temptation to make a rude gesture in the direction of Wall Street elitists, is another matter altogether.

Business journalist Suzanne McGee spent more than 13 years at The Wall Street Journal before turning to freelance writing. Author of the book Chasing Goldman Sachs, she has written for Barron’s, The Financial Times, and Institutional Investor.