Originally published in The Street
By Douglas Fink
Regular mom and pop investors often complain that they cannot invest early in disruptive companies, and that by the time such firms sell shares to the public, the venture capitalists and hedge funds have gobbled up shares.
Take the case of WhatsApp, where retail investors never had a chance to invest. Famed venture capitalist Jim Goetz of Sequoia Capital invested in the messenger app in late 2012 and handled three funding rounds until Facebook snapped up the startup in 2014 for an incredible $22 billion. Sequoia’s $60 million became $3 billion without WhatsApp even selling shares to the public.
Since May 16, average individual investors for the first time have the ability to invest in what they hope will be the next big thing, just like venture capitalists. That’s when the latest stage of the 2012 JOBS Act took effect.
Created during the Great Recession to help capital-starved entrepreneurs, the latest rule under the JOBS Act, called Reg CF or Title III, allows small private companies to crowd-fund up to $1 million from non-accredited investors in exchange for equity.
However, as the SEC only allows crowdfunding via FINRA-registered platforms or broker-dealers, investors should still adhere to the basic rules of investing.
How much to invest? Startups should not be a large allocation for most individual investors. Investments in crowdfunded startups — pre-IPO shares in a company developing the next killer iPhone app or in a disruptive tech firm seeking $250,000 or perhaps $500,000 to get its idea off the ground — should only be a small portion of any portfolio.
Under the new rule, individuals can invest up to 5% of their annual income if earning less than $100,000 a year and 10% for those making more than $100,000 and the number of investors allowed in a deal is limited to 500. With deals limited to $1 million, that suggests many deals will be offered in shares of $2,000. Investors should speak with their financial adviser about how much to invest in this asset class, mindful that it should fit their overall investment strategy and their appetite for risk.
Diversify! Start-ups can now connect with investors via online portals, but before spending night after night trying to find the next Google or Snapchat, it’s worth remembering that history tells us that diversification is crucial among startups more than almost any other investment type. About three-quarters of venture-capital backed firms in the United States never return investors’ capital, according to a study by Shikhar Ghosh of Harvard Business School. Among 30% to 40% of U.S. start-ups, investors lose all their money and 95% of startups fail to hit their projected rate of return. That’s why big venture capital firms spread their money around and why you should too. Diversifying might mean not trying to pick winners and losers among startups via a portal but instead investing in a group fund that can pool money from non-accredited and accredited investors to invest in a variety of startups.
Expect higher fees. Investors are used to bargain basement fees for such instruments as ETFs, where annual fees can be just a few basis points. However, fees on more esoteric investments, such as startups, are significantly higher because of the amount of research required to assess everything from a company’s finances to its management team’s ability to execute, as well as track and even help guide the company’s development through board seats. Investors should expect fees that will be similar to what many hedge funds charge – 2% of assets managed and 20% of returns. That’s significantly higher than ETFs or mutual funds, but the payoff is much larger if a company hits it big.
The new rules of crowdfunding are democratizing the world of venture capital, offering an opportunity to 50 million unaccredited U.S. investors that has traditionally been the purview of investors with a net worth of $10 million or more. However, the average retail investor with $10,000 to invest should resist the urge to put all that money in just one startup.
Putting your money into a pooled investment vehicle that invests in a mixture of startups will still give you that Jim Goetz feeling when you have your WhatsApp moment without running the risk of completely losing your shirt when one startup goes down the drain.
Douglas Fink is the CEO of Group Capital LLC.