No happy endings for virtual investors

There might be a role for new kinds of exchanges in our virtual future, just as the Internet spurred the growth of online trading and alternative trading networks.

But there aren’t going to be any happy endings for investors in todays in-game virtual stock markets.

Virtual shares on the CapEx in Second Life aren’t backed by any real assets, do not involve any legally binding contracts, and the exchange itself exists in a legal gray area that will, eventually, disappear.

In its previous incarnation, as the SL Capital Exchange, investors lost 71 percent of their initial investments, according to a study by Robert Bloomfield, director of Cornell University’s Business Simulation Laboratory. (See full story here.)

The new owner claims to have addressed the problems that plagued the earlier exchanges. (See full story here.)

But, in fact, in my opinion, nothing substantive has changed.

(Does my opinion matter? Not really. But I was a columnist at Securities Industry News for ten years, covering the NYSE, NASDAQ, and other real-world exchanges, their technology, and their regulations. I may have picked up a little bit of knowledge about exchanges along the way.)

No real assets

There are plenty of virtual companies in Second Life that do real work. They run real estate developments and nightclubs, offer design and consulting services, design and sell fashions and accessories, and produce virtual pets.

In 2007, around 3,000 people were making over US$100 a month from Second Life. Those who were based in the United States had to declare this to the tax authorities, by filing “Schedule C: Profit or loss from business” since their earnings would have added up to more than $600 a year. (In other countries, the rules vary.)

These companies are technically sole proprietorships, owned by single individuals. Under the U.S. tax laws, they may operate under the owner’s name, or any other name they want. The money can be kept in the owner’s personal bank account, or in a separate account. They can operate out of the owner’s home, or have a separate address.

In the United States, around 75 percent of all companies are sole proprietorships. Some of these companies are large enterprises, with hundreds of employees, real estate holdings, and other assets — but most aren’t.

According to the IRS, 22.6 million individuals filed tax returns for their sole proprietorships in 2008, for total profits of $264.5 billion — or an average of just $11,700 per company. That means that the average business in the United States is probably run part-time, by a single individual or a married couple, and is nothing to brag about.

In 2007, there were about 800 people making more than $1,000 a month from Second Life — meaning that their profits were higher than that of the average US single proprietorship.

These are real companies. If you want to invest in such a company, contact the owner, and buy a share of the company. If you do so, the company will no longer be a sole proprietorship, but will now be a partnership, and you will now own part of the company’s assets — its intellectual property in the form of virtual designs or textures, its servers or domain names if it has a website, its virtual property, and all of its existing contracts.

You may also want to incorporate as a limited liability corporation, or an S-Corp, in order to protect the personal assets of the owners from the risk of company failure.

You don’t even have to wait for a company to pass the $600 profit mark to buy a stake in it. In fact, a company can lose money — though the IRS puts a limit on how many years a company can lose money without hope of profit before ruling it a hobby.

All it takes is that you draw up partnership papers. You might also want to file a DBA — Doing Business As — form with your local town clerk. In my town, this costs just $20, and allows you to open a bank account under the company’s name instead of your own name. That way, you can keep company finances separate from your personal ones, a step which is highly recommended by accountants and makes your end-of-year bookkeeping much easier.

The story of one “virtual company”

Let’s take a look at CapEx itself. It is both a “virtual company” listed on the CapEx exchange, and a cash-flow-positive project inside Second Life. If it’s own financial reports are to be believed — which you shouldn’t, since the returns are filed as part of a “stock simulation game” and are purely fictional — the project is currently pulling in around 185,000 L$, or US $680, a month.

Right now, it is a hobby, since its owner, Carmen Dubaldi, tells me that the project overall is costing him money. He has invested thousands of dollars, he said, in buying the previous business and upgrading the software. He also pays for computer servers and a website.

Once he starts withdrawing more than $600 a year from his Linden dollar account, however, he will have to declare it as a business on his tax return, and he tells me that he plans to do just that.

He won’t have to call it “CapEx” — he can call it anything he wants. Many sole proprietors simply operate under their personal names. CapEx would then simply be a service offered by that business — it could be the only service, or he can have multiple ventures inside Second Life, all operating under their own brand names, that he reports in aggregate on a single tax form.

At any time – either before or after the project becomes a profitable business venture — Dubaldi can sell a real partnership stake in the business to real investors.

But Dubaldi hasn’t brought in partners into the actual CapEx project. Instead, he has listed CapEx on the CapEx exchange itself. That may seem weird, but it happens in real life, as well — Nasdaq the company is listed on the Nasdaq stock exchange.

This means that investors are putting in money into a project, a project which has the potential of becoming a real, profitable company — but they won’t be owning any shares of that actual company.

The “virtual investors” have no actual say in what he does. At the end of the day, all the virtual property is in his name and his name alone. There are no legally binding contracts in place to protect investors. In fact, there are disclaimers everywhere — this is just a game, and the virtual investors are only pretending to own these “virtual companies,” and the “company owners” are only pretending to give out shares and hold board meetings and file financial reports.

“It’s like Monopoly,” he told me. “Do you really own Boardwalk and Park Place? No, you don’t really own Boardwalk and Park Place — you own Boardwalk and Park Place in the spirit of the game.”

By listing only “virtual companies” that have ongoing business operations in Second Life, the CapEx gives its virtual investors the illusion of control, the illusion of participation in a vibrant market.

But it’s no more real than if you were to get an account with an online trading simulation game like SmartStocks, the virtual exchange at HowTheMarketWorks.com, or the Stock Market Challenge game, and buy “fantasy shares” of IBM or Apple.

Of course, it’s easy to be deceived. The Stock Market Challenge game doesn’t have IBM invite its players to serve on its board of directors. Steve Jobs doesn’t personally stop by to address the concerns of the fantasy traders. This happens on the CapEx.

And the financial statements and news announcements issued by the “CEOs” of the “virtual listed companies” look vaguely real — that’s because, to some degree, they are.

For example, the CEO of Virtual Ads, a Second Life-based advertising network, issued an announcement last week about improvements his company made in anti-fraud technology. It looks like a real company announcement. Its sounds believable. The CEO says his goal is to grow the value of the virtual company. The thing is, there is no “value of the virtual company.” The actual value of the virtual company as listed is nothing — there are no underlying assets.

There is real value, because Virtual Ads is making real money from providing a real service, but that’s a separate thing altogether. The CapEx investors aren’t going to share in the growth of that value because they have no actual claim on it. In the announcement, the CEO is only pretending that investors will benefit from the growth of the company — “in the spirit of the game.” And he’s only asking people to buy more shares as part of the game as well, the same way that a fellow Monopoly player would offer to sell you the Reading Railroad. He’s not selling any actual shares.

Are you confused by this? I certainly was. I spent a long time with Dubaldi on the phone trying to get him to explain to me what a “virtual company” was and how you could tell it apart from a “real company.” Finally, it got through to me — the “virtual companies” don’t exist.

“They are fictitious,” he told me.

They are made up for the purpose of the game. That fiction happens to coincide with actual business projects inside Second Life — but have no other relationship to them.

Is it real or is it Memorex?

But with “news announcements” coming out from the “listed companies” on CapEx, it’s easy for an investor to forget the disclaimers — they’re just legal mumbo-jumbo anyway, right? — and start to think that he’s actually buying a stake in a company.  After all, he can buy their products, meet the CEO, attend board meetings. The products are real, and the CEO might actually act on the advice he receives from the board. The dividends are certainly real.  If the company is profitable, the CEO is going to pay real taxes on his real income at the end of the year.

It’s hard to pull things apart — what is true, and what is play-acting within the CapEx game?

The Virtual Ads did, in fact, improve its technology. That part is real. (Or is probably real, I don’t know.) But the underlying value of the shares did not actually increase because that part’s fictional.

A CEO might take advice from his board of “virtual shareholders” about how to run his company. That part is real. But the idea that the board has the power to overrule him is fictional.

The dividends that the company pays out are real Linden dollars. But the idea that they are being paid out by a virtual company is fictional — the dividends are paid by the company founder, out of his personal pocket, and he’s only pretending that a company is paying them, as part of the game.

Sure, the more realistic the game, the more fun it is.

Until the “company CEOs” get tired of playing and go home — and everyone else is left with empty pockets.

No contracts or oversight

The CapEx, like other virtual exchanges before it, operates completely without benefit of legally binding contracts or any meaningful oversight.

After all, the founders of the “virtual companies” don’t even have to give their real names. A promise made by an avatar, in a venue clearly labeled as a simulation game, is not going to be legally binding.

Why should the founders continue to participate in the exchange?

Some will do so because it’s fun — and they’ll quit when it’s no longer fun for them.

Others will do it to fund their virtual projects — and will quit when they have all the funding they need, or when the projects fall apart.

And some will participate as a way of getting publicity and good will for their Second Life ventures.

I personally believe that CapEx itself falls into the first and third categories. Running the exchange is fun for Dubaldi. And, on top of that, being a good virtual company is good for business — by serving as a role model for how virtual companies should behave, he can bring in virtual investors. And that means that CapEx will be successful and, perhaps, someday even profitable.

If Dubaldi kicks out his virtual board of directors, stops paying out dividends and otherwise acts like a bad player in his own game, the other players — the investors — will abandon ship. And that means that CapEx the real Second Life project will go out of business just as surely as the stock price of CapEx the “virtual listed company” tanks on the exchange.

If other “virtual CEOs” do the same, they will also take a publicity hit and may lose some Second Life customers as a result. But they get to keep the money their “investors” gave them.

Aside from the publicity problems, and the fact that a bunch of people are going to be really annoyed, there is little downside to taking the money and going off with it.

Unlike real-world stock exchanges, which have the law courts to back them up, CapEx has no authority to demand restitution from company founders, or to seize company assets and sell them to pay off shareholders.

The new CapEx — like the old SL Capital Exchange — doesn’t have any authority to prevent bad actions on the part of participants. All it has is the good will and promises of those individuals.

And there’s a big upside — you get to take your Linden dollars, convert them into cold hard cash, and use the money to pay your doctors’ bills. Your kids’ college tuition. Use it to start a new company. Or just put it into your retirement fund.

And, after all, the folks investing their money knew it was a game going in. They knew it wasn’t real. They knew that it wasn’t going to last. Right?

Murky legal waters

Second Life policy prohibits wagering on any game that has a chance component. Poker, for example, even though it is partially a game of skill, is not allowed under Second Life’s terms of service.

Is a virtual exchange such as CapEx allowed? It clearly markets itself as a game. Personally, I don’t think there’s much chance involved — the “company CEOs” and the exchange operators win, and everyone else loses. But the Lindens may see it differently.

We’ll have to see whether Linden Lab makes a ruling on this — and there probably will be a ruling if the exchange ever reaches any sizeable volume, or large amounts of money starts going missing.

The CapEx game is heavily stacked in favor of the “virtual company CEOs.” The “virtual investors” put in all the money. The CEOs take it out. They only have to give back as much as they want — or just enough to keep the investors happily investing.

Occasionally, a player may time the market right and get out with some money intact — leaving another player holding the bag.

But the vast majority of players are likely to lose most or all of their investment.

Since the virtual stocks have no underlying value — they are not actually linked in any way to the supposed business projects behind them — the trading is pure speculation.

And that trading can only last as long as CapEx continues to operate in a legal gray area, without a firm ruling one way or the other from Linden Lab.

A way out

There is one way for the CapEx to become fully, 100 percent legal and compliant with the Second Life terms of service — if the Linden dollars traded on the exchange are purely fictional.

This is the way it’s done on the other stock market simulation games — you’re not actually trading US dollars. It’s a fantasy portfolio, played with fantasy money.

The CapEx could do the same, allowing players to create fantasy portfolios of Second Life brands and trade them with one another.

That would be as educational as trading actual Linden dollars. Of course, it wouldn’t be as fun.

maria@hypergridbusiness.com'

Maria Korolov

Maria Korolov is editor and publisher of Hypergrid Business. She has been a journalist for more than twenty years and has worked for the Chicago Tribune, Reuters, and Computerworld and has reported from over a dozen countries, including Russia and China.

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  • LeaPatrizia

    The underlying problem is the problem of Second Life itself. What do you really "own" in SL?

    Not the L$, because you only have limited licence to use this token currency, which you can buy or sell to real cash, but just as long as SL operates its service and your account is valid.

    Not the land, even if you bought it, you pay on regularly tier, so it's rather renting some server space because the land only exists virtually.

    You might really own some intellectual property, but that might be very restricted when depending on SL environment or Linden Scripting Language.

  • LeaPatrizia

    Personally I don't agree with the simple "It's all a game"-statement from Skip Oceanlane (Carmen Dubaldi), but the analysis of the exchange is just too simple.

    There are companies which define investors' rights differently and actually grant them a share of the company and there are measures by some companies to prevent fraud.

    So in the first line the exchange is the trading platform, which actually has not many means to control companies, except setting rules and enforcing them. On a sidenote CAPEX exchange has improved its service and stability under Skip's management,

    Basically the companies "exist" independently from the exchange and several of them have survived various exchanges.

    Just to give one example have a look at a company like FED and what they did to improve company structure and guarantee rights to shreholders.

  • http://www.hypergridbusiness.com Maria Korolov

    Oh, and a post-script. Here’s what I would do if I wanted to scam folks out of a lot of money (see if any of this sounds familiar — if it does, you may be in for a ride):

    * I’d buy a small, unprofitable SL business with an okay reputation from someone who was tired of it and wanted to get out of SL. I’d get the avatar, as well, so that I’d have “creator” rights to their objects.
    * I’d make a big publicity splash for the company, get folks jazzed up about it and my plans for expansion. They don’t have to be good plans, just plausible.
    * I’d make up financial returns to show that the company has turned around and is growing.
    * I’d list the company, and get the money from the IPO.
    * Now I’d use some of the IPO money to pay out dividends, and pocket the rest. Meanwhile, I’d put out a steady stream of press releases about new developments, new products, income improvements, etc… Before each new positive announcement, I’d sell more stock.
    * I might play with this for a while. Put out a negative announcement, buy up some cheap stock, then have a miraculous turnaround and sell stock again when it goes up. Easy to do, with no checks against insider trading. And I’d keep paying out big dividends to keep everyone happy.
    * Use alts to post happy customer reviews, shill for the stock, keep prices pumped up.
    * Then: oh, no! Market downturn! New competitors! Customers fleeing in droves! Can’t make our dividends this month. Maybe next month things will turn around.
    * Financials looking even worse, have to sell off assets, close down sims, all that money we invested in technology and staff and marketing — all lost! (Not that there was any such investment.)
    * The alts now pile in, blaming the owner for his incompetence — or defending him, because it wasn’t his fault the market turned against him, he tried his best.
    * Eventually, the company shuts down and is delisted — or is “sold” to another “CEO” who has a new strategic vision, and a great new plan for turning it around.

    • Pamela

      Hello
      First I would like to thank you for this post. I am a student studying International business and uses of IT is the area of studies, as of the moment. A question posed to the class :

      What are challenges are likely to occur in business and politics, as Information Technology transforms from a support role to a partner role in business?

      In the chapter of the book we were to study the case, and answer 1-3 of the discussion questions. I read the case and most of all the chapter and I found no reference as to guide me on how to answer this question fully especially the impact or challenges on politics. I could imply my on opinion about this topic, such as creation of jobs, how to regulate "the virtual company, however in upper level class , opinions alone don't count. Don't worry this is not an exam questions, and I know that my book is not the only source of research on the topic. As so far in my reading I have to do all the thinking anyways and my head hurts. OK! back to the topic. I am wanting to ask your ideas on the challenges political challenges, that an organization who is full speed on exploiting the uses of IT to their advantage, competitive strategies etc. Please what is your concept of the question at the top. In the political sense what challenges do you believe political challenges may occur with the Virtual Company. I read your post here and thought it to be insightful and would like your opinion on what is being discussed here.
      Thank you

  • http://www.hypergridbusiness.com Maria Korolov

    Lea —

    Yes, it's risky for a company to rely on just one platform. Similarly, it's risky for an app developer to, say, just rely on Apple. But that's a known risk. Investors can plan for it (by valuing the company at a lower amount). And there are ways to hedge those risks — design your company so that it can work in mutliple platforms, for example, (Utherverse, OpenSim, etc…) or make sure all your intellectual property is backed up off-line, and you have real-world contacts for your top customers in case you lose connection to them in-world.

    The bigger problem is, unless you sign real contracts with a real legal entity, is that your investment doesn't actually exist. So your risk is 100 percent. That's the case with the "virtual companies" on the CapEx. There are no legally binding contracts with legal entities because no legal entities are involved.

    Does FED have a legal entity behind it? Do its investors get real legal contracts with the owners — say, partnership stakes? That's the only way to guarantee rights to shareholders. You could also issue options to investors (the way dot-com startups used to do for employees they couldn't afford to pay). Either way, you need real lawyers to draw up real agreements, and get them signed by real people.

    There are plenty of companies operating in Second Life that are run that way — with real partnerships between real people. Yes, those companies can still go under, but their partners are dealing with actual business risks, risks they can plan for, and get the rights to review real financial documents — the kind of documents that you go to jail for falsifying.

    With anything else, there's too much opportunity for abuse. Or, if not actual abuse, then wishful thinking. A "virtual company" may fully intent to share profits with "virtual investors" but then, once money starts rolling in, can suddenly realize that there are no actual legal obligations for it to do so. Or it may be acquired by new owners, who simply ignore all the previous promises made, since they weren't legally binding. Or any number of other things could happen that cause the actual company owners to change their minds. (Doctor bills. College tuition.)

  • http://www.hypergridbusiness.com Maria Korolov

    Dubaldi just told me that the CapEx has systems in place to catch just the kind of scams I spelled out above.

    That might well be the case, but my original point stays the same.

    All disbursements and dividends, board meetings, financial statements, etc… are completely voluntary. At any point, the CEO of a “virtual company” can decide that they’re tired of playing the CapEx stock market simulation game and go home. And they’re perfectly in their rights to do so – the exchange clearly labels itself as a game. None of the companies listed on it are real companies. The financial reports they’re submitting, the news releases, everything — they aren’t real. They’re all part of the game.

    I’m not saying that anyone is particular is lying in their financial statements. I’m not saying that Dubaldi himself is lying in his financial statement.

    I’m saying that the financial statements ARE PART OF THE There are no “real” financial statements inside Second Life. There are no accounting standards. No audit firms. No securities regulators. Nothing.

    Of course, a company inside Second Life can have ACTUAL financial statements — the statements that they file with the IRS (or the tax authorities of their country). The IRS randomly audits these returns, and there are penalties for providing incorrect information. Other countries have their own safeguards.

    Even a company that loses money can file a Schedule C – Profit or Loss from Business. These are real statements. Denominated in real currencies. Backed by actual financial statements from bank accounts, PayPal transactions, and Linden dollar conversions, as well as receipts and invoices from vendors and suppliers.

    So if you want to invest in a company doing business inside Second Life — go out and invest in that company. Buy a partnership stake, or shares, depending on its corporate structure.

    If you just want to learn how the stock market works, there are a lot of free-to-play fantasy stock trading games online. You can follow real companies, and learn to read real, audited financial reports.

    If you want to gamble, go to Vegas or anywhere else that has gambling commissions, so at least you’ll know your odds of winning before you put your money down.

    With CapEx, there are no odds of winning. There is no exit strategy. A listed company could, in theory, get big, incorporate and, out of the goodness of its heart, hand out real stock certificates to its virtual investors. But it’s under no obligation to do anything of the sort — and does anyone really believe that this would happen?

    The only other exit strategy for an investor is to try to sell his shares to someone else. And, at the end of the day, someone is going to be stuck holding the worthless shares — and be reminded that it was all a game, that they shouldn’t have expected anything different.

  • angmalu

    Thank you so very much for doing this article, Maria. I've tried explaining this in SL soo many times much to no avail. It's great you took the time to clear this all up. This is now on a notecard in my SL Inventory, I hope I own. ~ Angèlle Marquette in SL-Angèle Lubin in RL

  • iliveisl

    ditto on what Maria said! (nice post btw) =)

  • Smoovious

    > There is one way for the CapEx to
    > become fully, 100 percent legal and
    > compliant with the Second Life terms
    > of service — if the Linden dollars
    > traded on the exchange are purely
    > fictional.

    The Linden dollars, according to SL’s own ToS, are already purely fictional.

    — Smoov