How The JOBS Act will hurt the startup industry

Today, Obama is set to sign into law the Jumpstart Our Business Startups (JOBS) Act. In this post I’m going to argue that the passing of the JOBS Act is really bad for the health of the startup industry. Specifically, the JOBS Act is likely to lead to a startup speculative bubble and a subsequent crash (like the dot-com bubble of the late 90s) .

What worries me most about the JOBS Act is not how it loosens restrictions put into place after the last dot-com bubble, or that it lets banks essentially advertise companies before taking them public (although those things are worrisome on their own), but that it legalizes something known as “crowdfunding.”

Crowdfunding means individuals can invest directly into startups at very early stages (like Kickstarter except you actually get a piece of the company). Your average person – meaning a “non-accredited investor” – can invest up to $10,000 annually in return for equity in startups.

Startups are already overvalued and this is going to make it worse. Overvaluation happens when investors start to overlook traditional metrics (such as P/E ratio) in favor of new metrics based more on potential future revenue (like price per user or price per page-view). Early-stage valuations have doubled in the last two years. Companies like Tumblr, Instragram, Pinterest, and even Twitter are being given insanely high valuations based not on revenue but on the number of users they have. This doesn’t matter though, because my argument holds regardless of whether startups are currently overvalued.

At the end of the day, the legalization of crowdfunding means it’s easier for startups to raise money, and so two things happen: 1) startups that weren’t able to raise money before will now be able to raise money, 2) startups that would have been able to raise money before will now be able to raise money at higher valuations.

Let’s consider first the fact that some of the startups that weren’t able to raise money before will now be able to raise money. At this very second, if you have a solid team and/or a good idea, it’s already pretty easy to raise money.

Crowdfunding helps out people who want to raise money to start companies but don’t have access to angel investors or VCs. I’m willing to accept that maybe a few of them have great ideas and are just unfortunately unable to get in front of people with money, but the majority of people that weren’t able to raise money before were turned down because they had a bad idea or a bad team.

So crowdfunding will let regular people (who are less likely to be able to asses the risk of a potential investment) invest in companies that angels and VCs deemed to be too risky. That’s not good for the health of the startup industry.

And companies that would have been able to raise money before will now be able to raise at much higher valuations. This follows from basic economics: more potential investors and more money equals more demand, which leads to higher prices for startups. That’s not good for the health of the startup industry.

Let’s take a look at another consequence: there will be a lack of tech talent to back up the creation of all these new startups. Developers are already in extremely high demand. Each new startup that gets funded will need at least a small team of developers. There simply isn’t enough tech talent out there to sustain twice the number of startups as there currently are.

As demand for developers increases, developer salaries will shoot through the roof. Remember, it will be easier than ever for startups to raise money, so they’ll spend a lot more of it on tech talent. I can see salaries for lead developers climbing upwards of $300k a year (in many cases they’re already getting $150k-$200k). What’s more, given an overall dearth of talent, in some cases unqualified developers will be put into positions of lead developer or CTO when they shouldn’t be. That’s not good for the health of the startup industry.

More startups means it will become harder for good startups to stand out. That means even with a good product, startups will have to start spending money on marketing and advertising to even get noticed. That’s not good for the health of the startup industry.

Finally, what happens to all these startups one year after they raise money? At that point they’ll have burned through their series A and will need to raise follow-up money, but many of them won’t be able to. Crowdfunding might sustain early-stage investments, but since the typical Series B investment is around $4 million (and crowdfunding legally caps out at $1 million annually), these startups will have look for financing from traditional VCs. A lot of them won’t be able to get it. They’re either have to raise down-rounds, or dissolve the companies.

That’s the part that worries me. As far as bubbles go, that’s what you call a “pop,” and that’s definitely not good for the health of the startup industry.

 olly via shutterstock