The Securities And Exchange Commission recently voted to implement Title III of the Jumpstart Our Business Startups (JOBS) Act. This means that starting in January 2016, average Americans no longer need to be accredited investors to be able to invest in future or current private startups.
If your income is $100,000 or less, you’re allowed to invest up to 5% of your income. Those earning more than $100,000 can invest up to $10,000. Accredited investors who earn more than $200,000 or $300,000 per couple, and have a net worth over $1M excluding their primary residence, can invest what they wish.
I’m pro Title III because everybody should be able to have the freedom to invest in what they wish. A significant amount of new capital will now go towards startups that in the past might have never had a chance to get off the ground. As a result, crowdfunding platforms like Kickstarter or GoFundMe should swell in interest.
PRIVATE INVESTORS BEWARE
With millions of Americans now being able to invest in private companies, I’m a little worried about the potential outcome. The $5,000 – $10,000 investment caps seem appropriate because investing in private companies is much riskier than investing in a publicly listed company. Here are three things to highlight about investing in private companies.
- Most startups fail. Paul Graham, the founder of Y Combinator, said that 94% of his incubator class ends up failing or becoming zombie companies with never a potential for an exit. YC only accepts about 5% of applicants, so imagine what the failure rate is for everybody else without mentorship, funding, and instant connections? Let’s forget about internet/tech/mechanical startups. Notice how much turnover there is on your favorite retail store street. Staying in business is tough thanks to ever increasing rents, mercurial customers, changing trends, and competition.
- Private investment money is illiquid. Unlike buying shares of Apple Inc., where you can buy and sell shares in a second, you better prepare to invest for 3 – 10 years before potentially seeing any type of return. In fact, given the high failure rate, it’s a good idea to kiss all your startup investment money goodbye as soon as you deploy your capital.
- There’s a higher chance of getting scammed. Sure, there are massive public equity scams such as Enron and wealth managers like Bernie Madoff. But there are many more private company scams than public listings. The reason is, in order to be a publicly listed company, you’ve got to go through auditors and SEC listing requirements. There are many more people carefully scrutinizing your books. A private company doesn’t even have to give quarterly investor updates. If they choose not to, very little has to be disclosed.
If you want to invest in startups or private companies, it’s a good idea to limit your exposure to no more than 10% of your investable assets e.g. $500,000 in the S&P 500 index, $200,000 in a bond ETF, and $50,000 in private companies. However, I guarantee you there will be a point when you wish you had your private investment money back.
WHY YOU SHOULD NOT INVEST IN STARTUPS
I don’t recommend anybody angel invest, unless you have lots of money to burn. All the really good deals have already been shown to the best investors and venture capitalists. What you and I are left with are usually the rejects. The companies might all sound promising, but they weren’t promising enough to get funded by the elite.
If you insist on investing in private companies, you might consider investing in a syndicate run by an established private equity investor on a site like Angelist.co. You can invest alongside people worth over $100M if you wish. You’ll have to give up some of the upside, but your chances of actually making a return increase much more.
Back when I was making a steady paycheck, I invested $75,000 in a college friend’s startup. The idea sounded good at the time (they always do) and the company, despite the financial crisis, is still around today. The founder is a great salesman, with a tremendous amount of energy and hustle. He is relentlessly competitive, which is a necessity in founders.
Despite growing my net worth by several fold since I first made the investment nine years ago, I still find $75,000 to be a ton of money. With $75,000, I could buy three Rhinos (my sexy 2015 Honda Fit EX) and have $15,000 left over to travel around the world for a month with a friend. Unfortunately for me, I have not received one penny in return from my investment.
If I had just plopped the $75,000 into the S&P 500 instead, it would be worth more than $120,000 by now. Not only is investing in the S&P 500 more liquid, it’s so much safer as well.
I’ve mentally written off my $75,000 investment that I hoped would one day turn into $750,000. For a couple years, I was at peace with my decision until I found out on Facebook the founder recently purchased a ~2,000 square foot loft in the West Village of Manhattan!
After doing a quick search online for similar sized properties in the area, I discovered they are going for ~$5M+! The founder makes less than $150,000 a year, and there’s been no huge exit. How the hell does he afford a $5M dollar apartment? Even if he found the steal of a lifetime at only $2M, something weird is going on here.
When I asked him, he coyly said, “I’ll never tell.”
With this new information, I’m no longer at peace with writing off my $75,000 investment in my friend’s company. I’m now annoyed the founder is living the life of a deca-millionaire when he hasn’t returned any money to shareholders. I can’t help but wonder whether he siphoned some of the company funds to help pay for his apartment. My “hope” is that the Bank of Mom and Dad bought it for him, which is why he won’t ever say.
Nothing annoys me more in the financial world than when people brag about their unearned financial success. Bragging about your new home, car, or whatever when your parents bought the items for you is low class.
DON’T EXPECT ANY MONEY BACK
If most private companies fail, you’ve got no business investing in private companies. I know people who have invested hundreds of thousands of dollars in some of the hottest companies in Silicon Valley. Although they are worth a lot on paper, they haven’t come close to gaining back their initial principal. At least with public companies, it’s easier to see the writing on the wall before they go to zero.
10 years is a long time to hold onto a private company that may one day go public. As I just wrote, I’ve been holding on for nine years with no returns so far. The people who are getting liquid are the founders, who are selling shares at each funding stage to Venture Capitalists hungry to take as large an equity stake as possible with their limited partners’ money.
Don’t ever forget companies like Secret, which raised millions of dollars from VCs, cashed out $6M between the two founders, and then closed its doors less than twelve months later. With private companies, minority shareholders get screwed the most because they have no idea what’s going on.
If you want to invest some money in your friend’s hot new idea, go ahead. Think of the investment as a charity donation, because chances are high that money is never coming back.
Most everyone is much better off just investing in a mix of stock and bond index funds or letting a low cost digital wealth manager automatically invest for you. Just keep on contributing to your investment funds over time and you’ll be surprised at how much you’ll accumulate.
Related: Just Say NO To Angel Investing
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Updated for 2018 and beyond