How to lose money like a millionaire

You may not have been one of the select few who were close enough to Motionloft founder John Mills to be solicited for a seed investment, but new securities rules coming down the pike make it increasingly likely that a friend (or friend of a friend) will ask you to buy their company’s stock. As a recent TechCrunch story about Motionloft illustrates, that’s not necessarily good news.

In fact, while some proponents gush that the Securities and Exchange Commission’s upcoming rules on so-called equity crowdfunding will give average investors the ability to buy into the next Facebook or Google at pennies a share, others contend that the law will teach small investors a hard lesson – how to lose money like a millionaire.

Back in 2012, Congress passed the Jumpstart Our Business Startups, or JOBS Act, which aimed to boost employment and economic growth by making it easier for small businesses to raise capital. Yet while small businesses are widely believed to be an engine of economic growth, business owners say it’s been difficult to get loans to grow in today’s still-tight credit environment.

Responding in part to these concerns, Congress decided to make it simpler for small businesses to sell stock to the public without going through the trouble and expense of becoming public companies.   Public companies list their shares on stock exchanges, making it easy to buy and sell the shares. But they are subject to strict auditing and disclosure rules.

By contrast, private companies are not listed on exchanges. Their shares are purchased directly from the company and are often sold back the same way, if they can be sold at all. However, private businesses don’t have to hire auditors to check their books and records, nor report their financial results to regulators and the public.

The JOBS Act loosened existing securities laws to let small private companies sell shares to as many as 2,000 individuals before having to formally register the shares with securities regulators or a stock exchange. It also allows private companies to publicly solicit investments in their stock through the web, newspaper and broadcast advertisement. In the past, private companies were limited to selling to shares only to sophisticated investors and to up to 500 “friends and family” members. They could not publicly advertise for investors.

Concerned that the new rules would open a Pandora’s Box of fraudulent securities offerings, the regulators set limits on how much capital could be raised under the new rules. Small investors won’t be able to invest more than a set percentage of their annual income or net worth; and so-called crowdfunding “platforms” will have to vet offerings and make sure that investors get at least a basic information about the company and who is behind it. 

These rules are subject to a public comment period and possible revision before becoming effective. The comment period ends Jan. 23. It's unclear whether the SEC will immediately implement the rules or make additional changes.

Still, implementation of the law is inevitable in the relatively near future and what the changes mean to small investors is that you will have the ability to do what venture capitalists and so-called “angel” investors have done for years – finance fledgling companies long before they become household names.

So what's the problem? Being a venture capitalist requires patience and the ability to tolerate a complete loss of principal. For every Facebook (FB) – the social network that made its early venture capitalists a fortune – there are three companies that failed or lost money for their early investors, according to Shikhar Ghosh, a Harvard lecturer who recently completed research on startup returns.

Moreover, if you’re investing because you need to finance a particular goal – retirement, a kid’s college, or a new house or car – it's important to realize that private financings are notorious for their “illiquidity.”

Translation: You can put your money in, but it’s difficult and sometimes impossible to get your money out. With no public market for the stock, the only way individual investors can get their money back is if the company gets sold to a third party or if the company itself (or its management) buys back your shares. That nearly eliminates the possibility of cutting your losses when a company is in trouble – or getting your cash quickly when you are.

“If you break your hip and need your money back, you’re out of luck,” said Heath Abshure, the Arkansas securities commissioner.

Despite these concerns, expect to hear a lot about these new investment opportunities in the months ahead. If you’re willing to invest in them like you invest in a Kickstarter crowdfunding campaign – as, say, a donation for a feel-good project you want to finance – go for it. But if you’re hoping to earn a return on your money, beware of friends peddling stock.