Investors, Beware Exotic Investment Opportunities

It’s getting easier for the little guy to get into all sorts of exotic investments. That’s not necessarily a good thing.

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.”

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.

Easier access

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.

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Low odds of success

A common rule of thumb among venture capitalists is that out of every ten start-ups, four fail, four barely break even, and just two end up producing the type of gratifying returns you might read about. Harvard Business School lecturer Shikhar Ghosh maintains that the reality is far grimmer. He estimates that venture capitalists lose money on three-fourths of the deals they help finance.

Advocates of the new crowd-funding rules point out that buying stock in these start-ups might land you in a fledgling version of Google. “Where else can I invest $2,000 in a kindergarten Silicon Valley and maybe get a winner?” asks Bernhard Schroeder, a professor of entrepreneurship at San Diego State University. But supporters acknowledge that the process is likely to prove more attractive for the entrepreneurs raising money than for those who invest. “I hope that if I invest $100 twenty times, one of them is a winner,” says Schroeder.

Detractors of crowd funding fret that the market will be a magnet for miscreants, thanks to both the limited amount of disclosure and investors’ expectations that their money will be locked up for a while. The combination gives crooks plenty of time to raise money and disappear. “Because the JOBS Act will allow con artists to approach the market in a seemingly legitimate way, it will help them win the trust of investors,” says Peter Leeds, an expert on penny stocks—a market that’s rife with scams. “The less regulation and the less disclosure, the more likely you are to be throwing your money away.”

Trying to cut the risks

Well aware of the hazards, the SEC has suggested a series of rules on how crowd-funded shares can be bought and sold. Any issuer that wants to tap the general public would have to offer its shares through a broker or a crowd-funding “portal”—a new type of Web site that will be charged with providing investor education and taking steps to reduce the risk of fraud, among other things. A company making an offering would be required to disclose at least some basic information about itself, such as its financial condition and the experience of the people running the enterprise.

The SEC rules also would bar companies from selling more than $1 million in stock in any given year. And they would restrict the amount of these private offerings that small investors can buy. Individuals whose assets and annual income are both less than $100,000, for instance, would be barred from investing more than $2,000 or 5% of their assets or annual income in any given year. Investors with more than $100,000 in assets would be able to invest up to 10% of their net worth but not more than $100,000 in any one year. However, with the possible creation of dozens, if not hundreds, of stock-issuing brokers and Web portals, enforcing these limitations is likely to be difficult, if not impossible.

Indeed, since crowd funding for accredited investors—those with substantial income or assets—and charity projects launched a few years ago, dozens of Web sites have sprung up to cater to the demand. Sites such as Kickstarter and Indiegogo invite individuals to finance the development of a project, an artwork, a movie or a company by pledging relatively small amounts of cash—typically less than $100. The sites collect a fee­—usually 3% to 9% of the amount raised—for hosting and administering the distribution of the funds.

However, the Kickstarter and Indiegogo campaigns differ from equity crowd funding because the capital providers are not even expecting a return of their investment, much less a return on their investment. Instead, they get warm fuzzies from knowing that they’ve helped a friend or a cause, and the campaign promises to give them some sort of swag—a T-shirt or product sample, for example. Or, when financing a movie or a play, investors may be offered tickets to the show. What they don’t get is an economic interest in the company or project they’re funding.

With JOBS Act offerings, on the other hand, investors own a piece of the company (or project)—just as they do when they buy a traditional stock or invest in a limited partnership. There’s just no efficient way to sell the shares once they’re purchased.

A real estate deal in D.C.

Because sophisticated investors and wealthy individuals are already able to buy into private deals, their experience can give the average Joe an inkling of how buying stock through a crowd-funded offering might work out. Some do pay off—but investors have to be patient and have a high tolerance for risk. Consider Fundrise, a Washington, D.C.–based real estate firm that finances neighborhood developments. One of its first projects was the redevelopment of a dilapidated brick building in a “transitional” block of a gentrifying section of northeast Washington. When the offering for 1351 H St. NE was launched more than a year ago, Fundrise co-founder Benjamin Miller says, the project promised investors an 8% return. But Fundrise was able to lease the building to a popular eatery, so investors will soon get checks that represent a 15% return on their capital, says Miller.

However, the H Street deal paid out nothing in its first year, and that’s typical. Out of the dozen projects that Fundrise has financed through crowd funding, so far only two have distributed cash to investors. “Some of these are development deals, so you have to be prepared not to get any cash flow until the building opens,” says Miller. That can easily take two to three years.

Miller is a big advocate of crowd funding for financing real estate ventures. He says it can help investors have a say in the character of their community—and can help developers by getting the community invested in the success of a project. But he stresses that developing real estate is risky and that investing in it through crowd funding would be inappropriate for anyone who can’t afford to lose principal. “If you might need your money back anytime soon, don’t invest in this,” he says. “Don’t invest more in one project than you can afford to lose.”

Meanwhile, investors who were hoping to put their money on a football player may have to wait. Fantex has suspended the Arian Foster offering while he recovers from his injury.

What investors need to know

The JOBS Act altered securities laws in a number of ways. Here’s a summary of what it does:

-- Raises from 500 to 2,000 the number of shareholders a company may have before it’s forced to register its common stock with the Securities and Exchange Commission.

-- Allows private companies, including hedge funds, to advertise to investors. But the act allows companies to accept funds only from accredited investors—that is, investment professionals, those who earn more than $200,000 a year or those who have in excess of $1 million in assets.

-- Allows securities “crowd funding” through investment portals, but limits the amount that individuals with modest means can invest to a percentage of their annual income or assets.

-- Exempts “emerging growth companies”—those with total annual gross revenues of less than $1 billion—from some of the more stringent financial-reporting requirements of Sarbanes-Oxley, the 2002 law that rewrote accounting and disclosure rules for public companies.

-- Expands the ability of private companies to raise capital through limited stock offerings.

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