Early Investing

The New Way to Generate Wealth

The New Way to Generate Wealth
By John Fanning
Date September 9, 2020

Note: A few weeks ago, we welcomed John Fanning to the Early Investing family. Today, we’re pleased to bring you his second column. If you’re not familiar with John, he’s worth getting to know. He was the founding chairman and CEO of napster. He has an impressive track record as both a founder and startup investor. And he’s one of the sharpest minds in the space. — Vin Narayanan, Vice President, Early Investing

Wealth inequality in America is no secret. The rich get richer, the poor get poorer, and the middle class continues to shrink. 

Why is this happening? Historically, stock ownership was the greatest wealth equalizer.  But it’s become less effective at generating wealth because of government regulation.

I’m not talking about the regulations imposed on large corporations in order to promote competition or preserve the environment. That’s not the issue here.

The big problems are the regulations adopted in the early 2000s . They’ve made it very inconvenient for companies to go public. And they’ve made it virtually impossible for small, early stage companies to file for an IPO.

For investors, this is a serious problem. Early stage startup investments are where the highest potential returns can be found — in companies whose greatest years of growth are still ahead of them. 

Take Amazon for example. When it went public in 1997, it was worth $438 million. But there’s no way that Amazon (or most other companies) would go public with a valuation that low today.  If it were going public now, Amazon would have likely waited until it was worth at least $1 billion (and perhaps a lot more)! And stock market investors would have missed out on a significant chunk of Amazon’s growth.

That’s because Congress and the SEC over-reached in their attempts to curtail risk in the wake of housing market woes, the 2008 financial crisis, the dot-com bubble bursting and the high-profile bankruptcies of a few supposedly blue-chip companies.

One of the prime culprits is the Sarbanes Oxley Act. It requires companies filing for an IPO to hire expensive third party auditors, investor relations committees and accounting oversight committees to prepare and approve financial reports.These reports are too expensive for early stage companies to produce. 

The result is that early stage companies are staying privately held for longer. In 2001, the average age of a technology company going public was 3 years. In 2018, it was 13 years. By the time companies go public and can be traded in the stock markets, their periods of high growth are far behind them.

High returns come from high growth. So the older the company you invest in, the lower your potential for high returns. Unfortunately, most of the companies on the NASDAQ or NYSE are these mature, later-stage companies.

The irony of all this is that these government regulations were designed to shield middle class Americans from losing their money. But in doing so, the government also shielded middle class Americans from gaining money. These regulations created a system that makes it easy for the rich to get richer through access to private markets, while denying those of lesser means the access to lucrative investment vehicles. 

Now, the only way for Americans to win big lies in investing in early-stage companies in the private markets. Until recently, that opportunity was reserved for the wealthiest and most well-connected of our society.

But thanks to the 2012 JOBS Act, regular investors can now invest in early stage companies while they’re still private. It’s the great equalizer that the government took away in the first decade of this century. 

Investors again have the chance to invest in the next Amazon, Google or Uber while they’re still private — and growing. And that can lead to real wealth generation.

But it’s taken years for us to get here. And in the meantime, those government regulations only increased the wealth inequality. The next time government officials impose a regulation, maybe they should consider the unintended consequences: who are they really hurting, and who are they really helping?

For more of his thoughts on building wealth through private market investing, follow John on Twitter, and LinkedIn, or visit his website: www.john.fanning.com

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