By Andy Gordon on May 23, 2014 Dear Early Investor,
Last week, I sat down with a founder of a company that was disrupting the retail sector in a way I never thought possible.
Yet I was skeptical. The tech didn't seem that special to me. So I bombarded Adam, the founder, with questions. I wanted him to admit he had no business asking for my money.
Didn't happen. He did pretty well. Especially when he showed me his app. It performed so smoothly, I felt all my zeal to reduce him to a puddle of sweat slip away.
The startup has several more hurdles to clear before I recommend it. Though, given its revenue run and valuation, I think it could be worth twice as much as it is now in about a year.
But unless you make at least $200,000 or are worth $1 million or more (excluding your primary home), you can't invest. Why?
The government is sitting on the enabling regulations for less wealthy investors.
Washington, it seems, is getting cold feet.
The New York Times ran a blog yesterday that cast fresh doubt on the proposed rules the SEC issued last October. It gleefully quoted Barbara Roper, director of investor protection at the Consumer Federation of America, saying, "The proposed rules are terrible."
The problem? "The S.E.C. proposal maximizes the risk of unaffordable losses because most companies will fail."
Say What?
Roper needs to brush up on her investing fundamentals. It's very easy to have more losers than winners and still make a nice profit. Here's an article on our Investment U site that explains it. Basically, all you have to do is cut off your losses early. And then let your winners ride.
It's a little different for startups. For every 20 holdings, you aim for two big winners. The others will be a mixed bag. Some will be 2X. Some 4X. Some less than 100%. And a few could go under altogether.
You still should come out ahead, because in the startup space, big winners aren't defined by making 50% to 100%.
Rather, you can make 5X to 30X your stake.
That takes care of the "most companies will fail" part of her concerns. How about the "unaffordable part"?
Bear with me here. I'm going to get technical on you for a minute.
For investors whose income plus savings total $100,000 or less, the rules proposed in October let you invest 5%, or $5,000, at the most. If their earnings plus savings add up to between $100,000 and $200,000, the max percentage is 10%. The most you can invest is $20,000.
Listen, no loss is easy to take. But $5,000 is about 20% down on a cheap new car these days. It's a long weekend in Hawaii. It pays for the textbooks of your college-aged child for one semester. It's not unaffordable.
A $20,000 loss is more substantial. I'd compare that amount to a large healthcare expense, which, according to a Wells Fargo study, 40% of the middle class says is "their greatest fear in retirement." But remember, this group of investors earns between $100,000 and $200,000, above Wells Fargo's definition of middle class.
(I don't want to be as glib as Roper. So let me spell out how Wells Fargo defines middle class. If you're 25 to 29 years old, you qualify with income of $25,000 to $99,999. But your investable assets have to be less than $99,999. For 30- to 75-year-olds, your household income should be $50,000 to $99,999. And your investable assets would have to be between $25,000 and $99,999.)
Again, don't get me wrong. $20,000 is a tough loss. But unaffordable? That's a stretch.
This isn't the first time The New York Times has gone after equity crowdfunding. My colleague Adam Sharp wrote about this back in April. His article, "We're All Adults Here," quotes former U.S. Car Czar Steven Rattner saying in the Times, "Picking winners among the many young companies seeking money is a tough business. Buy a lottery ticket instead. Your chance of winning is likely to be higher."
(Editor's Note: Rattner has settled two investigations out of court by paying $6.2 million to the SEC and $10 million to the New York State Attorney General's Office. He began his career as a journalist for - you guessed it - The New York Times.)
And, in a March 29 Sunday editorial titled, "How to Harm Investors," the Times said that "The proposed crowdfunding rules need to be thoroughly reworked."
I guess we know where the Times stands on the issue of equity crowdfunding.
To top it off, this past Tuesday, it was reported that the SEC is thinking of raising the minimums required for accredited investors. Income would be raised to at least $250,000 from $200,000. And the net worth threshold would go from $1 million to $2.5 million.
Equity Crowdfunding Is DC's New Political Football
Equity crowdfunding is clearly under attack. But why?
Why is something that held so much appeal just a couple of years ago now looked upon with such disdain?
Well, it's not the emergence of scams. As I wrote to you last week, so far, so good. "Reward-based crowdfunding has been around for more than half a decade and it's been free of scams to date," I said.
Nor has equity crowdfunding seen any scams of note.
What this is all about is... (what else?) politics.
Opposing the new equity crowdfunding rules is the powerful and staunchly Democratic American Association of Retired Persons (AARP). Also in opposition: the Consumer Federation of America, the Council of Institutional Investors, and Americans for Financial Reform.
Washington is curling into a fetal position on several issues as a new presidential election cycle comes into view. You can chalk crowdfunding up to yet another job-creating initiative caught in the crosshairs of warring Democratic factions.
And let's not forget the poor ol' New York Times. It must be frustrating talking about how dangerous startup investing is without being able to point to any actual scams. The first sniff of a scam is going to cause a whirlwind of bad publicity. The media will have a field day pointing fingers at Washington's crowdfunding enablers.
The SEC knows this. And it's running scared. Much safer to smother everyday investors with protective measures than allow them the freedom to invest in exciting, young companies.
In the same Wells Fargo study cited earlier, 52% of middle class respondents say they don't invest in the stock market, because "I am afraid to lose my nest egg in the ups and downs of the market."
If that's how they think about investing in general, then early investing isn't for them.
Conservative investors and those sensitive to risk will self-eliminate themselves from this investing space, at least to the extent that they can.
What they might not know is that many mutual funds are investing more and more in these private, small companies, getting in at a better price rather than passively waiting for them to IPO.
Can't say I blame them.
Whether the SEC or the Times likes it or not, equity crowdfunding isn't going away.
Believe it or not, I have found a manufacturer that does a better job than the wealthiest VC investors at picking startups that go on to enjoy great success.
How this company does it - and how you can copy its strategy - is the subject of my next e-letter to you.    
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