Every time a company like Facebook or Twitter goes public, we hear stories about newly minted billionaires who invested small amounts of money in the early days. And we get envious. Not so much of the other guy’s fortune, but because we never had the chance to invest. That’s all changing. Last month the SEC ended a decades-old ban on general solicitation by private issuers, which means that tech startups now can advertise to investors.
Not surprisingly, they’ve taken advantage of the newfound freedom. On the popular AngelList site, more than 1,100 companies began publicly fundraising within 24 hours of the rule change. Right now only so-called accredited investors (i.e., rich folks) can buy shares, but the same federal law that prompted the SEC action also contains an equity-based crowdfunding provision for the rest of us. By this time next year it is expected that all Americans will be able to invest in ventures that previously were the old-boy network’s exclusive domain.
Some critics have argued that it will all end very badly, because con artists will prey on feeble-minded grandmothers. They are wrong. It will end very badly because investing in tech startups is extraordinarily difficult, no matter how honest the entrepreneurs. Just take a look at the top-level venture capital data, according to industry research firm Cambridge Associates. It shows that early-stage VC returns have lagged the Dow Jones industrial average for the one-year, three-year, five-year, and 10-year periods. Early-stage VC returns also have trailed the Russell 2000 for each of those periods and beat the S&P 500 after only three years. And those are investments being made by trained professionals who manage billions of dollars for large institutions.
However, we’re talking about being an angel investor, not a Tesla-driving Sand Hill Road scenester. Unfortunately, the numbers here are even more daunting. The most comprehensive angel data are from the Kauffman Foundation, which several years ago conducted what it called the Angel Investor Performance Project. It found that 39% of all angel investors lost money. That isn’t to say that they failed to beat a public market benchmark. It means that their money would have been better off in an interest-free checking account.
A Boston-area investor named Sim Simeonov dug a bit deeper into the data and found that 66% of angels lost money on first-round investments in tech startups (and a majority of those generated no return whatsoever). More important, he ran a mathematical simulation that showed that median returns varied greatly with portfolio size. Namely, the more investments, the better. Simeonov learned that with five portfolio companies, the median return was breakeven. To double that, your best chances are to have 50 portfolio companies. To triple your money, the number of investments jumps to 150.
There are, however, some caveats to volume angel investing. First, the Kauffman Foundation found that the time spent on due diligence was positively correlated to returns. So if you just hop on AngelList and invest willy-nilly, your odds of success decrease. And if you aren’t a professional investor, how do you find the time to properly vet 150 startups? Second, the proposed equity crowdfunding rules for nonaccredited investors (i.e., the rest of us) would restrict the annual amount of investment to between $2,000 and $19,000, depending on income. To build a 150-company portfolio over three years at the high end would mean an average investment of just $380 per company. Not exactly the size of check that many hot startups would be accepting.
To be clear, I welcome the new rules. Legitimate companies should have the right to publicly solicit investment, and people should have the freedom to partake. But for most people, angel investing is akin to playing the lottery. Just because it’s legal doesn’t mean it’s good for you.
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This story is from the October 28, 2013 issue of Fortune.