We love investing at The Motley Fool. We also embrace the powers of cooperative learning, innovation, and entrepreneurship. Ultimately, we strongly believe that a wisely regulated free-market economy will drive our standard of living ever higher.
Investing is risky, however. This point especially requires emphasis in light of new rules that expand opportunities for ordinary investors.
Investing like a venture capitalist
Prior to the amendments made to Regulation A in June 2015, very few companies used that Regulation to raise capital. The “old” Regulation A limited such offerings to only $5 million and had required more cumbersome disclosure and compliance with state securities laws. The “new” Regulation A makes equity crowdfunding efforts possible, thereby opening such investment opportunities up to non-accredited investors. Now, investors with assets worth less than $1 million or with less than $200,000 in annual income can invest in private companies before they go public. Such companies will get much-needed funding – up to $50 million – via a less cumbersome, mini-IPO process.
This is a pretty exciting new opportunity for ordinary investors. Early stage investments promise tremendous gains over the long term. But they often carry considerable risks that can be different from, say, a diversified mutual fund or shares of a public company. Consider:
- Of all startups, only about 35% survive to age 10.
- About 75% of venture investments fail to return their investors’ capital.
Investors need to know that the overall hit percentage for early stage investments is quite low. Your returns are very likely to be earned in just a few, headline-worthy successes. Venture capital firms tend to manage this risk by taking a “basket approach” to making their investments. They spread out their investments across many companies in order to minimize the damage from one poor investment, while also increasing the odds of discovering a gem.
Additionally, investors in venture funds usually are large institutions that have extremely well-diversified portfolios. For these institutional investors, a loss in one or even a few investments can be easily tolerated.
We suggest you take a similar approach.
You have bills to pay, a retirement to fund, and perhaps a family to feed. The last thing you need is a plummeting portfolio that will drag down your entire financial future along with it. You must always align your investments with your own tolerance and capacity for losing money.
It all starts with building a solid financial foundation. Here are a few steps to consider before making an early stage investment in a private company:
- Pay off high-interest debt before investing. We’re talking credit cards and anything with double-digit interest rates.
- Make sure you have a cash cushion of three to nine months’ worth of living expenses. The more other people rely on your paycheck — and the more unpredictable that paycheck — the more you should have in cash. You can keep your cash in CDs, money market funds, or even just a traditional savings account.
- Contribute to your retirement plan at work. Employer-sponsored retirement accounts – such as a 401(k)s, 403(b)s, and SEPs – come with powerful tax advantages. Plus, you might receive a matching contribution, which is free money your boss puts in your account as an incentive for you to save. Remember, free money can’t be beat.
- Once you’ve taken full advantage of the match, consider setting up a Roth IRA if you’re eligible. The investments in a Roth grow tax-free (as long as you follow all the rules) and IRAs offer far more investment choices than your typical retirement plan at work.
- Build a diversified base of investments. The mix of assets will largely depend on your investing time horizon and tolerance for risk. But here are some guidelines.
- A decent rule of thumb has you first subtract your age from 110. That amount is the percentage of your portfolio you should have invested in stocks. So if you’re 30 years old, you would have 80% in stocks and 20% in cash and bonds.
- Buy stocks only with money you DO NOT need for at least five years. We say that because in the short run, stocks are volatile. Do you remember 2007 through 2009, when at one point the S&P 500 had lost more than half its value? It eventually recovered, but it took a few years.
- The quickest and easiest ways to invest in stocks or bonds are via index funds. History shows their low costs and tax-efficiency (relative to other types of mutual funds) are hard to beat.
- If you’re looking for a prudently diversified portfolio of cash, bonds, and stocks (both domestic and international) all in one mutual fund, check out target date
- Protect what you’ve already accumulated. See a qualified estate planning attorney to get a will, durable power of attorney, advanced medical directive, and other legal documents that will protect you and your family if you die or become temporarily incapacitated. Also, get some life insurance and maybe disability insurance if others rely on your ability to earn income.
Now You’re Ready
Once you have your financial house in order, you’re ready to consider investing in individual companies, including early stage ventures.
The amount you should invest in any single business depends on several criteria, including the riskiness of the company and how much you can afford to write off as a total loss. But as a general guideline, we suggest that you don’t invest more than 5% of your portfolio in a stock of a well-established, publicly traded company. From there, you can scale down the stake according to riskiness of the company, perhaps limiting no more than 0.5% of your portfolio to an early stage company. Even better, devote no more than 5% of your portfolio to a collection of at least 10 early stage companies.
Today’s greatest companies, and most profitable investments, were once just a gleam in an entrepreneur’s eye. It can be very exciting to help such visionaries turn those gleams into reality, while making a lot of money in the process. But history tells us that betting too much of your future on too few startups is quite perilous. By following the guidelines we’ve set out above – and even more in The Motley Fool’s 13 Steps to Investing Foolishly – you can prudently benefit from the incredible power of capitalism and innovation.