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