Please sir, I want some more opportunity: rethinking ‘sophisticated’ investing

Sophisticated investing is truly a rich-get-richer scenario. Wealthy investors are getting access to seed-stage startups, and adding a portion of the profits to their already extensive portfolios. In the meantime, lower-income retail investors can only watch from the sidelines.

There are two black and white numbers that permit no ifs nor buts for investors.

To be a sophisticated one, you’ll need either $2.5 million in assets, or a $250,000 a year salary. It’s not what you’d call a ‘sophisticated’ measure. But it’s what’s required of you to join the elite, exclusive cohort of investors in startups.

This entry barrier may go even higher. It was never indexed against inflation, and thanks to explosive house price growth, more Australians are qualifying for sophisticated status than ever before. In 2002 it was 1.9% of the population. It’s now 16%.

Rather than making investment more accessible, the government believes more people are being exposed to risk. They’re proposing a new net worth requirement of $5 million.

It highlights a class divide in which many Australians are still priced out of the housing market. Retail investors are acutely interested in new industry – a pool of support that could be overwhelmingly valuable to startups themselves – but they’re being left out of the running because they’ll likely never qualify for the current definition of ‘sophisticated’ in their lifetimes.

With education and empowerment, everybody wins. So why is Australia so reluctant to revise the rules?

The ‘sophisticated’ criteria was designed to protect Australians… kind of

In fairness to the regulations that keep the average Joe out of startup investing, their original intent was to protect people from getting scammed or hoodwinked into dubious investment “opportunities”.

Entrepreneurs seeking funding can’t talk well-meaning retirees or mom-and-dad business owners into handing over their hard-earned cash. They can’t appeal to low-income investors only to condemn them to ruin when they fail.

There’s no doubt that this is a good thing, but it makes a fundamental (and discriminatory) omission: not having much money doesn’t mean you don’t know what you’re doing. Just like having lots of it doesn’t mean you do.

Under the current rules, a fairly average homeowner in Sydney or Melbourne can join the ‘sophisticated’ club with a signed letter from an accountant. The same goes for people coming into inheritance money. And lottery winners.

The ‘sophisticated investor’ rules have social implications

Australia’s sophisticated investor test is a clumsy, arbitrary relic of class structure capitalism that prevents those who are having a go from getting a go.

Alan Jones – CEO at Fishburners and Partner at M8 Ventures

Times have changed, information flows at lightning speed, and scams are much harder to execute. It’s time to stop pretending the rules are entirely benevolent, and admit they present a social issue.

Young Australians have a keener than ever understanding of highly lucrative and evolving tech markets, but 80% of national wealth is held by those over 45.

If it’s not money, what does make a sophisticated investor?

For one, understanding of risk.

For another, the ability to take a hit.

Investors should be as aware of the psychology behind investing as the mechanics of it. Understanding emotional reactions like impulse, greed, and FOMO, as well as biases like hindsight and hunches, will dramatically mitigate potential loss.

This kind of “training” is so broadly available now, it makes no sense to assume only wealthy investors undertake it (or to assume they do at all). Anyone can learn to invest by reading, researching, and streaming educational content online.

The main difference is the damage that can be done by a bad call (another thing anyone can make).

One thing the threshold does ensure is that sophisticated investors can “afford” to lose. If they sink $20k or $200k into a venture, we know they have either the assets or the income to keep them solvent.

Low-income investors aren’t the only ones missing out

Startups are also suffering. The exclusivity of current rules leave them with no access to a wide and willing pool.

Combined with dwindling angel investment over the past three years, Australia’s nascent startup market is being throttled by needless funding difficulties. Compounding this even further, Australia’s base rates for early-stage funding are straggling behind, with $3.05 invested per capita compared to the UK’s $15.84 (USD).

Even so, angel groups and syndicate funding can only do so much. Angel syndicates like Sydney Angels enable some headway by allowing less wealthy investors to pool funds. You can invest as little as $10-20k, but you’ll still need to be ‘sophisticated’, which isn’t much help for most. Once again, small-time investors are shut out of lower-risk, diversified opportunities.

This type of investment strategy also only accounts for as little as 5% of all angel investments made in Australia.

Outside these groups, seed investment is fragmented and opaque, making it hard for founders to connect with investors (and vice versa). This fragmentation also means best practice is hard to find, increasing the risk of poor or even harmful deals. Many later-stage investors note that they regularly see startups with pre-seed or seed stage terms so onerous, they’re unable to attract any further funding down the line. Naturally, this can cripple the business from the outset.

Crowdfunding tells a different story

Equity crowdfunding landed in Australia in 2017.

An innovative and democratic new format of fundraising, it was set to open the world of startup investment up to retail investors. The beauty was in the protection offered by multiple gatekeeping obligations. Crowdfunding platforms had to conduct extensive DD on companies. Companies needed to provide Offer Documents. Marketing was strictly regulated, with disclaimers plastered on every touchpoint. For startups, it was also a way round ASIC’s 50 shareholder limit.

The problem lies with the cap table. 

What’s easier for an early-stage company’s bookkeeping: a few cheques for a few tens of thousands, or a thousand pledges of $100 each? 

The well-oiled PR machine leads us to believe that Australian retail investors are funding $2, $5, $10 million equity crowdfunding raises. But in reality, the ‘sophisticated’ money is still doing the talking. A classic example is the fintech startup Thrive (now Thriday), who raised $3 million via Birchal last year. As Birchal’s press release celebrates, Thriday enjoyed one of the ‘most successful campaigns to date’. But almost in the same breath, it discloses the ‘increased VC engagement alongside private investors’ seemingly provided the bulk of the raise.

It’s also damning hole in the regulations’ ‘protection’ argument. If retail investors are allowed to take risks with equity crowdfunding offers, why not give them access to safer markets with distributed risk?   

Xinja provides a cautionary tale. A promising Australian neobank that initially raised ~$5 million of capital from retail investors in two separate rounds on Sydney-based platform, Equitise.

Just 2 years later, the company crashed and burned, and guess who was left holding the bag? The retail investors that carried Xinja through the first round. 

Banking regulation boss Wayne Byres called it a “successful failure” because depositors’ money was returned. But investors didn’t get their money back. We wouldn’t call that successful, Wayne.

Currently, retail investors can invest up to $10k on equity crowdfunded deals

But these deals are often at oversized multiples. They value (often) pre-revenue companies at unrealistic numbers. Often, these investors aren’t digging into the Offer Document, looking at price per share vs. shares on offer, or ascertaining fair valuation. They’re just investing based on a Facebook ad or video pitch. 

But it’s perfectly legal because of that ubiquitous disclaimer: “always consider the risk warning and offer document”.

The dissonance is that an everyday investor can put $10,000 into a crowdfunded startup because they like the startup. They can give double that to a friend with a harebrained business idea or get rich quick scheme. But they can’t put that same amount into a quality fund. When it comes down to it, sophisticated investors are the ones who are truly protected, by getting access to highly vetted and regulated opportunities.  

The pay-to-play moat around millionaires needs a refresh!

Sarah Grace Worboys – Venture Strategy Director at Saniel Ventures

How are other Western countries managing their ‘sophisticated’ investors?

To be an accredited investor in the States, you’d historically need to be worth USD $1M or make USD $200,000 per year. But there’s another path for those who don’t tick these boxes. 

For $175 in fees, roughly 60 hours of study, no firm sponsor, and a 130-question three-hour test, you can obtain a Series 65 license. This makes you an officially accredited investor, granting you access to: 

  • Private investments
  • Venture capital funds
  • Real estate funds
  • Angel opportunities
  • Securities not registered with the SEC.

But as you might’ve guessed, there’s a catch

“A person seeking accredited investor status by passing the Series 65 exam would also need to be licensed as an investment adviser representative in their state and would need to comply with all state-specific licensing requirements (e.g. paying dues, etc.).”

This limits Series 65 exclusively to those in the financial services industry. It’s better, but it’s still not what you’d call ‘inclusive’.

The situation is similar in the UK

People with ‘relevant experience’ like company directors, angel investors, and finance professionals can self-certify as a sophisticated investor. But they must:

  • Have been a member of a business angels network for at least six months; or
  • Have made at least one investment in an unlisted security in the previous two years [something of a catch-22 for many]; or
  • Have worked in a professional capacity in the provision of finance to small- or medium-sized businesses in the last two years or in the provision of private equity; or
  • Be or have been within the last two years a director of a company with a turnover of at least £1m.

The truth is that retail investors remain far from protected

If they want to invest their savings or hard earned cash, they will. Cut out of the running of real innovation and young companies they’re passionate about, the investor whose salary just isn’t cutting it will look elsewhere to try and brighten their horizons.

NFTs, crypto fads, pumped up penny stocks on ASX Bets, and outright gambling are natural draws. There’s risk in every single one.

That said, investing shouldn’t be gambling. It’s not binary, it’s not rolling the dice. It involves far more strategy, skill, complexity, and calculation. Plus, the “we can gamble at the casino, so why can’t we yolo into a startup?” argument isn’t quite compelling enough.

Finally, there’s the tax perspective

Sophisticated investors currently get preferential tax treatment for investing.

Non-sophisticated (retail) investors are capped at $50k for ESIC tax incentives/offset. But sophisticated are capped at $200k.

One solution is to increase the number or size of investments that non-sophisticated individuals can make under ESIC in order to level the playing field. Another is to give people exposure to tax-efficient funds and syndicates over individual investments. The key to leveling the playing field lies with giving non-sophisticated investors access to lower-risk, higher-diversity investments.

So what’s the way forward?

Naturally, scrapping the rules all together would undo the partial protections they do offer. What’s needed is nuance.

Establishing a way for intelligent investors to prove they understand the system and its risks would be a start. ‘Qualified Investor’ certification could take into account years spent in a certain industry or in the financial domain. 

“HENRYs” (High Earner, Not Rich Yet) form a huge and untapped market. They have extensive knowledge of the Australian investment ecosystem and could start making meaningful contributions to it. They might earn in excess of $200,000 a year, but as things stand, they’re leaps and bounds away from sophisticated status. 

Emulating UK or US systems is one option. But the current ‘sophisticated’ side of this has a strong lobby and a proven history of lining tax coffers. Why change it now? 20 years after the rules were established, the issue arises once yearly in half-hearted debates, and the status quo continues. 

Democratising the way startups are financed could create an environment where entrepreneurs, small investors, and the economy as a whole could benefit from financing new and interesting endeavours.

But it all starts with policy change and re-conceptualising the current notion of “sophistication”.

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