By Craig Tompkins
In 2012, the Jumpstart Our Business Startups (JOBS) Act was passed by Congress with the goal of expanding the potential pool of investors from which small businesses can raise capital. While the final rules governing how this new game will be played are still pending, what is known, is that the average investor is now more likely than ever to be offered investments that were previously only available to the very wealthy.
Private placements are a type of investment that were previously only made available to “accredited investors,” with an exception allowing a small number of non-accredited investors to invest in each particular company offering a private placement investment. The fact that these investments are not registered with the SEC makes private placements very risky. When a company is not registered with the SEC, there is no requirement on that company to file detailed financial reports, making it very difficult to determine how the company is performing.
But lack of transparency is only one of many risks inherent in private placements. These types of investments are frequently used as vehicles for scams, and are often pushed on unwitting investors by stockbrokers hoping to score a big commission.
The sales pitch for private placements usually includes mention that you are being given the opportunity to invest in a quickly growing company before its shares become publicly available, and once the company has its Initial Public Offering (IPO), you’ll be able to sell your shares over a stock exchange for a large profit. However, it is important to know that nobody can guarantee that any business will ever even have an IPO. This means you may have an investment that could be impossible to sell.
The JOBS Act has made two changes to the laws governing private placements that affect the average investor. First, companies are now allowed to advertise their private placement offerings to the public at large. While the law states that firms may only seek accredited investors through mass advertising, there is a risk that many more non-accredited investors will become aware of these investment opportunities. This makes it increasingly likely that an individual will be roped into investing in a private placement that is not a suitable investment given their investing knowledge and goals.
The second major change brought on by the JOBS Act is the legitimization of “crowdfunding” as a means of selling an ownership stake in a business. Crowdfunding allows business to sell small ownership stakes to large amounts of individuals. It’s important to remember that crowdfunding investments carry many of the same risks as private placements. It is difficult to determine the financial health of a crowdfunding investment, it may never become a public company and you may never be able to resell your ownership stake.
Your first line of defense in protecting yourself from being duped into a bad investment in a private company is to ask: Why me? If you can answer the question of “Why me?” with an answer that makes sense, investigate the person who is trying to sell this investment to you. Use FINRA’s BrokerCheck to verify that they are properly licensed to sell securities. FINRA also recommends checking to see if the person offering you investment securities has served time in federal prison. Time served could be a very good indication that you are dealing with a con-artist.
If the person selling you the investment checks out, do some research on the company you would be investing in. Read the offering materials in full and search the web for information about the company.
Finally, never invest more than you can afford to lose. Even legitimate private placement offerings, sold by legitimate dealers, are highly risky investments. You could do everything right, and still lose your entire investment.