Risk, Reward, and the Disruptive Potential of the JOBS ACT
The article below is an updated and expanded version of a Legion M byline originally published August 5, 2016 on FinanceMagnates.com. You can read the original article here.
Every savvy investor understands the relationship between risk and reward. Bonds are safe but stocks are sexy. IPOs have home-run potential; blue-chips ensure you won’t strike out.
Thanks to new rules enabled by the JOBS Act, the game has changed. If the stock market is the world’s biggest casino, the SEC just introduced a new table.
It’s called equity crowdfunding, and it’s not really new–it’s just new to you. The wealthy have been doing it for years.
At its core, equity crowdfunding is about allowing the general public to participate in early stage PRE-IPO investing, a domain that for the last 80 years has been the exclusive purview of venture capitalists and high-net-worth individuals.
Let’s say your neighbor is a Mark-Zuckerberg-type with a new startup cooking in his garage. It’s a great idea, but he needs cash. You’ve got a little money stashed away and want to invest. This could be your chance to get in on the ground floor of the next big thing, right?
Wrong. Prior to the JOBS Act, most of the population was forbidden from investing in PRE-IPO startups. Unless you had a net worth north of $1 million (not counting your home) or an annual salary of more than $200K, you were excluded. People like Peter Theil and Mark Cuban had the chance go after legendary Silicon Valley returns, but the rest of us had to wait until after a company went public, and invest with much more mundane expectations.
To give you an example, as of this writing Facebook’s share price is $160, representing a 4.2x multiple of its $38 IPO price. Meanwhile Peter Theil, one of Facebook’s early investors, reportedly had a return of over 2000x on his initial $500K investment.
A cynic would say the game is rigged. The system clearly favors the wealthy elite by giving them access to opportunities not available to rest of us. After all, there is no test for intelligence, education, or understanding to determines who can invest—only personal wealth.
Others would argue the system protects you. After all, the example above is great when your neighbor really IS the next Mark Zuckerberg, but what if he’s not? Aren’t venture capitalists and high net worth individuals better suited to sort the visionaries from the wannabees? Are they better equipped to survive potential losses?
This may have been true back in the 1930s when many of our securities laws were written, but today we have access to more information on our smartphone than J.D. Rockefeller had in his entire lifetime. Technology has leveled the playing field and the JOBS act has brought the SEC into the 21st century. It’s not a free-for-all (i.e. companies using the JOBS act need run background checks on founders, provide annual public reporting, etc.), but now ALL of us have the chance to invest like the 1%.
RISK vs. REWARD
Before you invest in a startup, it’s critical to understand what you are getting into. Early stage investing is an extreme illustration of risk vs. reward. If you are fortunate enough to get in on the ground floor of the next big thing, there is the potential for staggering returns. But early stage investing is, by nature, about long shots. The vast majority of startups fail, and when they go down they usually take all the investment capital with them. For every Facebook and Google there is a Pets.com and Webvan—plus thousands of others small companies that went under before we had a chance to learn their name.
Our advice to anyone considering investing in an early stage startup is to imagine losing your ENTIRE investment. If that thought is too much to bear, don’t write the check. Or write a smaller one.
Because while most startups fail, those that succeed often change the world. If you don’t mind bearing the risk, why shouldn’t you be able to swing for the fences? After all is there anything more noble than investing in the people and ideas that shape the future? At the very least you’ll have the satisfaction of creating jobs and fueling innovation. And if you get lucky, you might just be in for the ride of your life!