A Level Playing Field for Investors

Editorial Note: Today, we’d like to share a piece Adam wrote for our friends at Investment U about the massive growth opportunities coming from the startup investing space. In just two months, Title III of the JOBS Act will give anyone the chance to buy into exciting young companies – for as little as $100. Read on for Adam’s advice on how to get started.

The first startup company I worked at went up against Wi-Fi… and lost.

The year was 2003, and we had a unique solution to wiring buildings for Internet. Instead of ripping through walls to install Ethernet cabling, our solution used existing electrical wires to transmit Internet.

It’s hard to imagine the idea getting funding today. But you have to remember that, at the time, Wi-Fi wasn’t the pervasive tech that it is today. To put things into perspective, it would be another seven years before Starbucks offered free wireless Internet at stores.

The hardware was working, the software was improving, and patents had been granted. Speed was a little slower than traditional fiber-optic cable, but the installation cost was lower.

Our technology was dubbed “powerline communications.” At the time, it was pretty groundbreaking stuff.

Our solution was more secure than Wi-Fi. It didn’t require cabling through walls and hallways.

It was revolutionary! Or so we thought…

High Hopes and Stock Options

I was the seventh full-time employee hired at Telkonet. My duties included sales, database management, marketing and product installation. We all wore many different hats on the job, as do most employees of startups and small businesses.

At first, we targeted the hospitality industry. Nationwide hotel chains had recently implemented deadlines for all hotels to provide guest Web access. It was a great catalyst for us.

We made good progress in hospitality. And for a while the Navy was interested in our technology for retrofitting warships for Ethernet.

It was an exciting time. And it got better when I was granted stock options.

You see, Telkonet was a publicly traded company at the time. It was small, with a market cap of about $15 million when I joined.

However, around this time, a piece of legislation called Sarbanes-Oxley (SOX) was passed. It was a reaction to the scandals at WorldCom and Enron. Politicians told us it would prevent such crimes from happening again.

But, from a small-business perspective, the new rules made it more costly to be a public company. Reporting and audit requirements were more extreme under SOX. In essence, it became a heck of a lot more expensive to be a public company. Especially one with limited cash flow.

I remember, back at Telkonet, our CFO Barry complaining about SOX. He told me many times how much of a pain in the neck it was for a small company like us.

At the time I didn’t realize just how dramatic the effects of SOX would be on the markets. It was the beginning of a shift away from small, publicly traded growth companies…

And toward a market where almost all small company growth took place in private markets.

The End of One Era…

To be clear, I’m not blaming SOX for Telkonet’s failure. Wi-Fi eventually did our core business in. But the new and confusing reporting requirements certainly didn’t help.

I’m telling this story because it hints at how we got to where we are today. And if you’ve been paying attention to the markets for the last 15 years, you’ve probably noticed what I’m talking about.

Today, small companies (especially fast-growing ones) wait as long as possible to go public.

Here’s one of my favorite examples. When Microsoft (Nasdaq: MSFT) went public in 1986, it was valued at around $500 million. Over the next 10 years, the stock rose more than 6,000%.

Compare that to Google – now Alphabet (Nasdaq: GOOG) – which went public in 2004 at a valuation of $24 billion. Over the next 10 years, its stock rose around 950%. Certainly an admirable performance, but it doesn’t hold a candle to the return that Microsoft investors saw.

Because Microsoft investors got in earlier. And companies simply don’t IPO as early as they used to. Luckily, things have changed in the last few months. But I’m getting ahead here. Let’s hammer this point home first…

There are countless examples of this phenomenon. In the chart below, you can see the overall trend, which is toward larger and less frequent IPOs.

IPO_Offering_Size_vs_IPO_per_Year-550The end result is public market investors getting left out. Excluded from participating during a company’s “peak growth period,” as I call it.

But that’s all about to change.

… And the Beginning of Another

Thankfully, 10 years after SOX, lawmakers realized something was wrong.

Small businesses were not getting access to the capital they needed to grow and thrive. And importantly, investors were being left out of mega-growth investment opportunities. All the good stuff was happening in private markets, where only wealthy and connected insiders had access.

The JOBS (Jumpstart Our Businesses) Act was passed in 2012. This new set of rules allows everyone, not just wealthy “accredited” investors, to invest in private, early-stage companies.

And finally, after more than three years of waiting, the first deals are now live. Many more will be soon.

This is the beginning of a level playing field for all investors. The JOBS Act isn’t perfect; don’t get me wrong. But it’s a darn good start.

There are two types of investment opportunities from the JOBS Act that we’re interested in.

Title IV (also known as Regulation A+)

  • Companies can raise up to $50 million
  • More established companies
  • Lower costs vs. traditional IPO
  • Called “mini IPO” or “IPO lite”
  • Deals are live today

Title III (also known as Regulation CF, or “equity crowdfunding”)

  • Companies can raise up to $1 million per year
  • Very early-stage investments
  • Limited operating history and financial reporting
  • High risk and high reward
  • Launches in May 2016

The first Title III deals will go live this May. For me, this is the most exciting part of the JOBS Act.

Title III offerings will give anyone the chance to buy into exciting young companies – for as little as $100. We’re talking about true “ground floor” opportunities.

In the traditional private funding world, deals of this stage are considered “seed” financings. In other words, it’s very early in a company’s journey.

For example, Facebook’s (Nasdaq: FB) “seed” round valued the company at around $5 million. Needless to say, those who recognized the opportunity were rewarded for the risk they took.

Obviously, for every Facebook there are many failed startups. But there are thousands in between as well. Investing this early requires discipline, diversification and due diligence (the four D’s).

My advice is to start slow and invest small amounts across many different opportunities (20-plus is ideal). And, please, don’t put everything into the first deals you come across! They may all look like winners when you start out.

Also, no matter how promising an opportunity may seem at the time, never invest for fear of “missing out.” Invest when you believe a company is solving a big problem and can do so profitably. Look for startups with notable co-investors, especially when you first begin.

I was lucky enough to find this advice before I started investing in startups, so I’m more than happy to pass it along.

Three years ago, I set a goal to build a portfolio of 50-plus startup investments. As of today, I own equity in 61. So far, three have failed. Twenty-one have gone on to raise money at higher valuations. You can see many of the companies in my portfolio here.

One of our primary goals at Early Investing is to help readers avoid common mistakes. Like investing at a place with poor-quality “deal flow.” Or not diversifying.

To that end, we’ve worked with our friends at Investment U to develop something special. Our brand-new guide, “Startup Investing 101,” is now available in the Investment U Bookstore.

Here’s a peek at what we cover in this 25-page report:

  • Where to find high-quality deals
  • Red flags to watch for
  • How to research early-stage investments
  • How to evaluate your “co-investors”
  • And more.

It’s packed full of actionable information and insider tips for finding the best opportunities in these new markets. If you’re thinking about investing in this new asset class, this guide will serve you well. And at just $19, it could pay for itself many times over if you avoid just one bad deal – or find a great one.

Take a look here.

Good investing,

Adam Sharp
Founder, Early Investing

P.S. I’ll be speaking at two upcoming Oxford Club Private Wealth Seminars in Stowe, Vermont, July 18-19, and Chicago, Illinois, September 7-8. Among the topics I’ll be discussing: equity crowdfunding, angel investing and pre-IPO investing. My friends at The Oxford Club know how to put on a classy event, so I highly recommend going to at least one of these unique gatherings. It will be quite the experience. Click here for more information, including the full lineup of speakers.