In an era of multimillion-dollar sports contracts, taking a financial interest in the future earnings of pro football star Arian Foster may seem like a safer bet than putting money into the stock market. But careful investors should think twice before buying into the Arian Foster “tracking stock.”
See Also: Problematic High-Yield Investments
Never mind Foster’s back injury, which put the Houston Texans’ 27-year-old running back on the injured-reserve list midway through the 2013 season. The prospectus for the tracking stock’s initial public offering lists other troubling concerns. Among them: Your prospects for making money on the deal hinge on Foster earning more than he’s ever made in the past.
Moreover, once you buy the stock, you may be unable to sell it. The stock also gives you an interest in the financial health of Fantex, the newly formed brokerage firm behind the offering. So far, Fantex has done nothing but lose money.
Such is the challenge of a variety of new investment options made possible by the Jumpstart Our Business Startups Act—better known as the JOBS Act of 2012. Many promise mouthwatering yields or the potential to get in on the ground floor of the next Facebook or Google.
But the fine print offers a more sobering message: Don’t invest more than you can afford to lose. The new law creates “a disaster waiting to happen,” says Chicago securities lawyer Andrew Stoltmann. “Congress and President Obama made the conscious decision to accept a wave of burned investors in the hope it would result in more jobs.”
A boost for small firms
The idea behind the JOBS Act was to spark job growth by providing a boost to small businesses, which are considered an important engine of economic growth. Because small businesses complain that their growth is frequently hampered by a lack of affordable financing, the law attempted to streamline securities rules to give small firms easier access to public securities markets.
But determining exactly how the JOBS Act will change the investment landscape is complex because regulators were left to interpret how to revise the existing securities laws that the legislation altered. The Securities and Exchange Commission has since been issuing new rules aimed at carrying out the law piece by piece. The bulk of the revisions are technical in nature. However, some are likely to make it much easier for rank-and-file investors to get into risky private stock offerings.
Two of those changes have already gone into effect. One boosts the number of investors a private company can enlist before it must go public. The other allows private companies and hedge funds to openly solicit sophisticated investors through advertisements on television, in newspapers and on the Internet.
The most controversial piece of the law addresses “crowd funding.” Regulators recently issued proposed rules that are expected to win approval and go into effect in the spring of 2014. The crowd-funding rules, as currently designed, would allow small investors to buy securities in privately held firms that are exempt from many of the stringent disclosure requirements that apply to publicly traded securities. Although that’s been possible in the past on a limited basis—basically, by firms selling shares to sophisticated investors, friends and family members—the new rules throw public financing of private ventures wide open. That makes it possible for even a novice investor to be tapped for the type of financing deals that used to be solely the purview of professional investors and multimillionaires.
For businesses, the change holds the promise of easy money—the lifeblood of entrepreneurs. But for investors, it may prove to be a Pandora’s box.
The reasons are myriad, but they start with a simple fact: Most small businesses fail. Roughly one-third are still operating ten years after their launch, according to government data. Worse, even a successful company can prove to be a miserable investment when it’s offered via a private deal—the type of financing that the JOBS Act opens up. And the companies that sell shares via JOBS Act rules will essentially remain private companies.
Moreover, crowd-funded shares are likely to be the investment world’s Hotel California: You can buy in, but good luck getting your money out. Without the benefit of an exchange or a broker willing to buy the stock when an investor wants to sell, it will be difficult to unload the shares. “If you break your hip and need your money back, you’re out of luck,” says Heath Abshure, Arkansas’s securities commissioner and a critic of crowd funding.
Abshure frets that investors will be lured in by the promise of big potential returns but will be unprepared for the risks. “The dirty secret that apparently no one is willing to say is that privately placed and crowd-funded securities are extremely speculative and risky,” he says. “Even professional investors, who are trained to evaluate these things, lose more often than they win.” (For more, see Find Seed Money Via Crowd Funding.)
Indeed, the fortunes that venture capitalists earn when selling their shares in hot newly public companies, such as LinkedIn and Twitter, make for big headlines. But what’s often overlooked is that these sophisticated investors didn’t make that money overnight. The National Venture Capital Association estimates that typical early-stage investors have money locked up in a fledgling business for seven to ten years before they can cash out in a public stock offering (assuming the firm is strong enough and substantial enough to go public).
And the JOBS Act could make the waiting period to earn a return on a private company’s stock stretch even longer. That’s because it quadruples the number of investors a private company may enlist before it must go public, from 500 to 2,000. A proposed JOBS Act rule that allows private companies to raise up to $1 million a year through crowd funding means these businesses could remain private for decades before succumbing to the inconvenience of going public and the stringent requirements that entails.