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. Choosing from Acorns vs. Robinhood on the initial stage seems to be less illusive.

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 Korolov