Intelligent Angels and Venture Capitalists Should Invest Outside the U.S.

Are you investing exclusively in U.S. companies? If you think this is a wise strategy, sorry sweetheart, but you are stuck in the 90s. Now that it is 2018, intelligent angel investors and venture capitalists are putting their money into foreign companies. Do you not believe this? Here are four reasons why you should invest outside the U.S. if you want meaningful returns:

Decimalization and SOX

According to Investopedia, “The U.S. Securities and Exchange Commission (SEC) ordered all stock markets within the U.S. to convert to decimalization by April 9, 2001, and all price quotes since appear in the decimal trading format.” Previously U.S. stocks had traded at 1/16 dollar increments, but they traded at penny increments after the decimalization conversion. This has caused tighter spreads, resulting from smaller price increments and movements. While tighter spreads are wonderful for the trading desks at investment banks and high-frequency traders, they are awful for small-cap stocks.

According to AICPA, “The Sarbanes-Oxley Act requires that the management of public companies assess the effectiveness of the internal control of issuers for financial reporting. Section 404(b) requires a publicly-held company’s auditor to attest to, and report on, management’s assessment of its internal controls.” Even with the JOBS Act providing an “on-ramp” for high-growth startups, compliance can cost companies millions of dollars when they go public. AOL went public at $10 million in 1992. No company in their right mind would do that today.

Decimalization and Sarbanes Oxley, deter venture-backed companies from IPOs. This is why we have begun to see so many unicorns, private companies valued over $1 billion, in U.S. markets. When startups cannot effectively go public, they must resort to exits through acquisition. In recent years, startups have been forced to choose between acquisition by Facebook, Amazon, Apple, Netflix, or Google (FAANG). While these exits create lower returns for investors, they also tend to destroy company cultures that startup executives and board members work hard to cultivate. Furthermore, acquisitions are often a way for established players to quash would-be competition, which increases tech-sector consolidation.

There were only 39 venture-backed U.S. issuer IPOs in 2016 - the lowest number since 2009. Compare this with 270 venture-backed U.S. issuer IPOs in 1999. With venture-backed IPOs at historically low levels in the U.S., it may be time for investors to look toward countries that are more IPO-friendly.

De-Risking

In Chapter 6 of Where the Jobs Are, John Dearie and Courtney Geduldig explain that there are too many venture capital funds, and they are investing too much money in U.S. ventures. “As funds swelled in number and size, industry critics say, general partners became less focused, less disciplined, and ultimately, less effective.” Fred Wilson claimed in 2009 that “the venture capital asset class does not scale,” and he advocated a “back to the future” approach of smaller funds, partnerships, deals, and exits.

Since these critics of venture capital are focused on the U.S., they fail to see that expanding the scope of venture capital could solve problems plaguing the industry. Even with larger funds, venture capitalists could add discriminatory nature to their investments by sourcing deals globally. Instead of throwing money at increasingly risky ventures within 15-mile radii of their offices, intelligent venture capitalists invest in the most promising startups, no matter where they are located.

By investing globally, venture capitalists can significantly de-risk their asset class and continue attracting institutional investments, even during U.S. economic downturns.

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Geographic Arbitrage

In Tim Draper’s book, ​How to be The Startup Hero, he discusses how he bought a Willie Mays rookie card in Boston for $600. However, the baseball card would have cost him over $2,000 if he had bought it in San Francisco. After learning the lesson of geographic arbitrage, Draper went on to create a venture fund, called DFJ ePlanet, that invests in startups around the world.

Investors often obtain larger equity stakes in exchange for smaller amounts of capital when they invest in foreign startups. In other words, they get better deals on startups that are outside the U.S. Similar to Willie Mays cards, valuations tend to be higher in Silicon Valley than anywhere else in the world. If comparable technologies are being developed in Silicon Valley and Southeast Asia, it may be a better move to invest in Southeast Asian startups.

In How to be The Startup Hero, Draper explains that “when the government piled on Sarbanes Oxley Act regulations to public companies, our best form of financial exit was sabotaged. Our international investments through DFJ ePlanet were our saving grace.” In addition to utilizing geographic arbitrage, you can see that Draper’s strategy circumvented SOX issues and de-risked his portfolio. Investing abroad can be a powerful move.

Innovators Live Abroad

Where do the top innovators and technology entrepreneurs live? If you guessed the U.S., then you better reconsider.
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Dearie and Geduldig claim that Finland “is the only country where students leave high school ‘innovation-ready’.” At least, U.S. students excel in technical disciplines, right? The PISA 2015 tests, which measure students in 71 countries, ranked the U.S. 38th in math and 24th in science.

Luckily for the U.S., the country’s world-leading universities attract some of the best and brightest students from around the globe. Unfortunately, U.S. immigration policies deter students from staying in the country to work for or launch startups after graduation. Chile, Canada, Australia, New Zealand, the United Kingdom all offer visa programs that are designed to attract entrepreneurs. Intelligent investors should follow the talent and focus on entrepreneur-oriented countries.

How Can U.S. Regulators Reverse These Trends?

As intelligent investors open their eyes to opportunities abroad, the U.S. government may want to wake up and reverse the exodus of early-stage capital. As our society becomes increasingly globalized, geographic arbitrage and de-risking strategies will remain appealing to investors. However, regulators can pursue a number of actions to drive innovation and strengthen the pull of U.S. markets.

Federal regulators should consider tiered price levels in U.S. stock exchanges, similar to Japan and Hong Kong, as well as entrepreneur-friendly immigration policies. Although it is a massive undertaking, education reform may be necessary if the U.S. hopes to stimulate entrepreneurial competitiveness among its citizens. At the state and local levels, tax credits for angel investors can provide useful incentives.

Most importantly, the U.S. needs to build robust startup ecosystems outside of New York City, Boston, and Silicon Valley to create at-home options for investors. This is exactly where Startup Commons can help.

'Arbitrage' Image credit: Creative Commons 3 - CC BY-SA 3.0 - Attribution: Alpha Stock Images - Original Author: Nick Youngson - Original Image.