Startup Investing
This week's post is inspired by a conversation I had with a good friend at work about private equity investing. He's looking to eventually retire at some point and the reality is you need to do more than just invest in a 401(k) if you want to do that. Taking the right approach in terms of diversification and taking smart risks is an important part of securing your retirement and investing in startups is one tool you have in your toolbox. In this post, I'll cover Regulation C/F which opened up private company investing to everyone, what it takes to be an accredited investor, some platforms I have used for private investing and an overall strategy to apply to investing in private companies.
Regulation CF
Before the Jobs Act in 2012, you had to be an accredited investor to invest in startups. Title III (Regulation CF) of this law took effect in 2016. It allows early stage companies to raise funds from all Americans with a few requirements. This is great for allowing early adopters, customers and others participate in the early growth stage of a company. Here are the key requirements:
Capital raise is limited to $5M
Conducted online
SEC/FINRA registered broker-dealer must conduct the capital raise
Company must file a Form C with SEC before starting
Minimum 21 days for offering to be open (gives investors time to think about their investment and cancel)
Accredited Investor
There are basically four ways you can qualify as an accredited investor:
Net worth (not including your primary residence) equal to or greater than $1M
$200,000 annual earned income with expectation that it will be substantially the same now and in the future ($300,000 annual income including spouse)
Hold a Financial Professional License (Series 7, 65, or 82)
Trust with assets equal to or greater than $5M, directed by a "sophisticated person" (i.e., someone with financial / investing expertise
Interestingly, the SEC is actually looking at a rule change to make it harder to qualify as an accredited investor, as noted in a recent Time Magazine article:
T
he Securities and Exchange Commission is pushing for significant changes in how private funded companies operate and who can invest in them, the agency said this week. The proposed changes probably won’t benefit rank and file American investors but will likely help people who are already rich get even wealthier.
While the details remain unclear, the SEC says it wants to increase the financial transparency of large companies which raise money away from the public markets. In addition, the regulator wants to limit the ability of people with less than $200,000 in annual income or $1 million in net worth to invest in non-public companies. In short, the current system, which already excludes the vast majority of Americans, could get more restrictive. In turn, the changes could widen income inequality, something which the Biden administration says it wants to reduce.
Needless to say this isn't great news and if anything they should be making it easier for the average person to invest in private companies. The article goes on to say:
Those accredited investor requirements rule out most of the U.S. population from investing in private companies funded by private equity or Silicon Valley venture capitalists. That’s because the median household is far too low at approximately $67,500 in 2020, according to government data.
This barrier to investing means that most Americans cannot participate in the superfast growth generated by some startups in Silicon Valley or elsewhere in the private markets. A case in point is the spectacular growth of Meta (formerly known as Facebook) during its ultra-high growth period. The first investment of $500,000 occurred in 2004 when the company was valued at around $5 million. In 2012 the company went public with a value above $100 billion. That’s at least a twenty-thousand-fold increase in value in less than a decade. But only people who were already well-to-do could participate in such gains. Compare that to returns on the S&P 500 over the same period – that wouldn’t have even doubled your money.
That two-tier investing system – one of potential humongous gains for the elite and one of more subdued increases for everyone else – has attracted criticism. “The intent of the American capital markets should be to make them more inclusive,” Haslett says. “Yet, the majority of value appreciation in technology companies is not finding its way into the pockets of your average American.”
I call this the SEC's way of saying "have fun staying poor." We will need to keep an eye on this and hope it doesn't have much traction. Better still, they should open up private company investing to more Americans by lowering the accredited investor requirements.
Platforms
There are four startup investing platforms that I have used in the past and below is a quick summary of each:
Great app
Good variety and quantity of companies
Also does accredited deals if you qualify
Won't transfer investments made in your name to revocable trust for estate planning purposes (have to setup payment for trust and invest directly)
Some novel investments like music NFT's, tokenized litigation settlements
Companies are vetted and tend to be a little more established than other sites (i.e., revenue generating)
Good website
Will transfer to revocable trust after completing a request form if desired
Good variety of companies, not as many as Republic
Also has accredited deals if you qualify
Easier to handle multiple investing entities (i.e., trust)
Companies tend to be much earlier stage and many are pre-revenue, which can have higher upside and also downside
Vetted, similar to Republic
Haven't used as much as the other platforms
A lot of odd offerings like collectibles (rare trading cards), wine
Companies on platform tend to be really small compared to Republic
Typically smaller investment minimums than the other sites
Angel.co:
Accredited only
Need to be invited by someone to join a syndicate
Syndicates typically formed with Special Purpose Entities to pool investor money and then purchase equity in startup, so you don't own the equity directly like the other platforms (although the other platforms may use these vehicles for some of their accredited deals)
High quality startups that can have big name Venture Capital funds involved, higher chance of success
Investing in Special Purpose Entities are a little more complicated from tax standpoint (K-1's)
Strategy:
Overall approach is to "spread the table" and invest small amounts in several different startups. This approach is inspired by the book Little Bets, where I learned that it's best to take a portfolio approach to new ventures and not put too much in one deal. You have to expect a high failure rate (maybe as much as 90% of your investments), but the 10% that are successful should do really well and should more than offset any losses you incur on the deals that don't work such that your overall return far exceeds what you would get by simply investing in the stock market. You can do as much due diligence as you like, but generally you would do more work the more money you are investing and limited due diligence if the amount invested is small.
Here are some things you can look at when you are vetting a startup that I have learned:
What problem are they solving? Is it compelling?
What is the market size (total addressable market)?
What is the quality of the team - have they done this before, what is their industry background?
What is the product?
What is the business model (i.e., business to consumer, business to business)?
What is the insertion point (where do they fit in the industry)?
What is the traction / momentum (typically look at trailing 12 months revenue growth as one example)?
What is competition?
What is defensibility of the business model (are their patents, unique business model that can't be easily replicated)?
Any other concerns?
Financing needs (i.e., what is the cash "burn rate" and prospects for raising additional funds before money runs out or the business can be cash flow positive; what is potential for dilution of your investment through future fundraising rounds)?
In conclusion, as I have written before, a diversified portfolio is very important to weather the market storms that seem to happen more frequently and with more intensity in recent years. An important part of this strategy is incorporating an appropriate percentage of private company / startup investments in your portfolio.
Not financial advice, only for information and entertainment, do your own homework. I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2022. To see all my books on investing and leadership, click here.
Always remember: freedom, health and positivity!
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