Mom-and-pop investors hoping to jump on the next hot tech start-up before it goes public may soon get their wish — and it could cost them.
In August, Jay Clayton, chairman of the U.S. Securities and Exchange Commission, spoke at a conference in Nashville, outlining plans that would make it easier for individuals to invest in private companies that haven’t yet gone public.
“We should also consider whether current rules that limit who can invest in certain offerings should be expanded to focus on the sophistication of the investor, the amount of the investment or other criteria rather than just the wealth of the investor,” Clayton said in his Aug. 29 prepared remarks at the 36|86 Entrepreneurship Festival in Nashville.
He also said that the agency’s staff is working on a concept release that will address the matter.
Under current regulations, so-called private placements — the sale of securities directly to an investor, rather than through a public offering — are only available to a small group of well-to-do individuals, known as accredited investors.
These individuals must have earned income that exceeded $200,000 in each of the last two years ($300,000 if married) and they must reasonably expect the same for the current year.
These investors must also have a net worth exceeding $1 million, excluding the value of their primary residence.
Consumer advocates warn that the current definitions don’t go far enough.
“The accredited investor definition is supposed to identify a population of investors who can fend for themselves without the protections afforded in the public markets — it clearly doesn’t,” said Barbara Roper, director of investor protection for the Consumer Federation of America.
“At least if you raised the financial threshold or you didn’t count retirement assets toward the threshold, you’d be dealing with a population that could better withstand the risks in this market and would be less likely to suffer devastating financial harm,” she said.
In 2017, state securities regulators conducted 179 investigations into private placements.
There were 66 enforcement actions, according to the North American Securities Administrators Association (NASAA).
Here’s what you need to know about these investments.
Private companies that are making their shares available to investors are exempt from certain registration requirements with the SEC.
The companies don’t have to register their securities offering with the SEC or with the states.
Prospective investors may receive a private placement memorandum, detailing the offering itself, the risk factors and other information about the company.
These documents aren’t reviewed by federal or state regulators, and the issuers may not be entirely forthcoming about the investment.
State securities regulators have warned that because these investments are exempt from registration requirements, they expose investors to greater risk.
“It’s an important segment of the market, it’s not very transparent and, by the time we see it, the damage has been done,” said Joseph P. Borg, director of the Alabama Securities Commission and president of NASAA.
He and other securities regulators in NASAA want to be part of the discussion as the SEC evaluates changes to the accredited investor definition.
“If they want to grow this side of the market, as part of the deal, they have to have some reforms in tandem that give regulators like us the tools necessary to redress fraud problems and the misconduct that comes up,” Borg said.
In an ideal scenario, you would identify the right private offering and multiply your investment over a period of years.
The reality isn’t always so rosy.
“The investors all hear the siren song of getting in on the next Google or Facebook, and 99 percent of these deals won’t be one of the big well-known tech companies that we’ve heard of,” said Andrew Stoltmann, an attorney in Chicago and president of the Public Investors Arbitration Bar Association.
“The parade of horribles and the risk associated with these private placements are legendary,” he said.
For starters, private placements may tout double-digit rates of return, but they’re illiquid. That means you have few opportunities to sell your stake if you needed to cash out.
Further, less disclosure and scant regulatory oversight of these private placements means investors must be on the lookout for fraud.
One notable private offering was Medical Capital Holdings, a medical receivables financing company that raised $2.2 billion from more than 20,000 investors through a series of private placement offerings of promissory notes from 2001 to 2009, according to Finra, the industry-funded regulator of the brokerage industry.
The company sold the notes through a group of broker-dealers.
Medical Capital made interest and principal payments to its promissory note investors until July 2008, when it ran into liquidity problems and ceased payments on some of the notes, Finra found.
The SEC charged Medical Capital with fraud in 2009.
Eventually, the company went into receivership.
Investors had net claims of $838 million and recovered $435 million, said Thomas Seaman, the court-appointed receiver of Medical Capital. The average investor lost $50,000, he said.
Company assets Seaman sold off to recover investors’ cash included a large yacht, a nuclear accelerator facility and a feature film.
“Most of these fraudsters circumvent the rules,” said Seaman. “They tell people that they’re selling only to accredited investors, but they in fact don’t bother to get the information or they turn a blind eye and let the people lie.”
“There is greed on both sides of the equation,” he said.
Even if you have the assets and the know-how to participate in a private placement, there is no guarantee that you won’t lose your money.
Henry Yoshida, a certified financial planner and founder of Rocket Dollar, a company that offers self-directed individual retirement accounts, has invested in start-ups as an accredited investor.
Each year, he and his wife allocate about $15,000 to $25,000 to one of these investments, which is about 25 percent to 30 percent of the money that the family earmarks annually for investing opportunities.
He works with accelerators — programs that weed through proposals and provide young companies with funding and mentorship opportunities — to select start-ups he’d like to invest in.
Projects that Yoshida has invested in through this manner include Liveoak Technologies, a tech company that manufactures application software for financial services companies.
Liveoak is still private and expects another round of financing in 2019, said co-founder and CEO Andy Ambrose. The company has inked commercial agreements with a number of banks and insurers, he said.
Accelerator programs vet these small businesses, examining their legal infrastructure and their boards of directors, as well as whether they have non-compete agreements and more.
“That’s my source of due diligence; otherwise you invest in people who are better presenters but aren’t necessarily running stable businesses,” said Yoshida.
Though the accelerators’ round of due diligence may keep him from investing in something fraudulent, it doesn’t minimize the possibility that he might lose his investment.
“Due diligence isn’t the same as risk,” said Yoshida. “You can still lose all of your money on any deal.”
Here’s what you should know if someone approaches you with a pitch to invest in a private offering, according to Borg.
If you don’t understand it, run away: Dig into the details of what you’re being offered. Do you know the founders and the industry? If there’s no documentation, consider it a red flag. Without the appropriate due diligence, you may give your life savings to people who may know how to put together a compelling PowerPoint presentation yet have no idea how to build a viable enterprise.
Don’t be lured in by promises of high returns: For every Facebook, there are thousands of failed ventures and a good number of scams. “If there is anything in the documentation that speaks to making a lot of money and cornering the market, then take it for what it is: hype,” said Borg.
Only invest what you can afford to lose: As with any investment, don’t put your whole nest egg on the line. This is a speculative bet, and even if your venture isn’t a fake, it could still fail.
Do your homework: Go beyond the offering document that you may receive from a start-up. See if they’ve filed anything with state regulators. Research the officers to make sure you’re not funding rip-off artists.
“You want to make sure that the officers weren’t convicted twice of securities fraud,” said Borg. “You are your own investigator.”