Investing In Future IPOs: With SEC Changes, Investors Get Ready To Invest In Startups

Late last week, the Securities Exchange Commission (SEC) unanimously voted to propose rules for investing via crowdfunding platforms and portals, like my firm, OurCrowd. Though it will take some time for the SEC to craft the actual rules, this sets the stage for investors to get access to early-stage, private companies. These changes all stem from the JOBS Act of 2012, which intended to provide a catalyst to job growth in the U.S. by encouraging investments in small and medium companies (SMBs). Investing in private companies bodes to become as commonplace as investing in stocks, mutual funds, ETFs and IPOs.

Why private companies are so hard to evaluate

As it appears likely that individual investors will soon be able invest in private companies, it’s imperative to get educated on what makes a successful startup investment candidate.

When it comes to early-stage investing, education is especially important for the following 2 reasons:

Lack of transparency: Unlike publicly traded stocks which disclose their financials quarterly, the inner workings of private companies are somewhat opaque. Also, many startups are young enough that they don’t have significant cash-flow or earnings to be materially analyzed.

Risky investments, high payoff: The National Venture Capital Association reckons that 25-30% of venture-backed businesses fail. With a risky asset class like private equity, it’s important for investors to employ sound risk management. Investors should have a real process to sift through various opportunities — you don’t need to swing at every pitch. 

The dream of most entrepreneurs and those investors that back them is to reach the big show, IPO’ing the company. Here’s the methodology that we use at OurCrowd to size up the invest ability of startups applied to some of the more exciting, recently-floated companies:

5 things investors should look for when investing in private companies

Invest in experienced entrepreneurs: Entrepreneurs are the life-force of any startup and strongly determine its fate.  So, investors should pay close attention to who’s behind the company.  One study from Harvard Business School found that the success rate for first-time entrepreneurs was only 17.7%, while even failed serial entrepreneurs performed better, with a predicted success rate of 19.8% in later ventures. Entrepreneurs with successful track records had predicted success rates of almost 30% in new endeavours. Newly IPO’d, SFX Entertainment (NASDAQ: SFXE) was founded by Robert F.X. Sillerman (yes, those are his middle initials). From founding a greeting card company while he was a teenager to creating a marketing consulting firm while in college, Sillerman has been creating businesses around the music industry for decades. He founded what was eventually to become Live Nation (NYSE: LYV), the largest concert promoter in the world. SFXE is his second-time around, this time focusing on tours, live events, and festivals in Electronic Dance Music (EDM). 

Place bets on easy-to-understand businesses: This is a core tenet of Warren Buffett’s and should hold true for investing in startups as well. With simple businesses, it’s easy to understand their profit levers and markets. It’s also easy for simpler businesses to raise money in subsequent rounds. Sprouts Farmers Markets SFM is one of those businesses. Freshly floated in August, SFM is a health-food chain with 163 stores in 8 states. Talk about easy to understand — Sprouts offers high quality, natural, organic products at attractive prices and may very well be the next Whole Foods. Earlier this year, its IPO rocketed up almost 123% on its first day of trading.

Invest in companies with traction: This may be a no-brainer but when you look at early stage companies, many are still very early in their maturation cycles. They’re sexy, going after huge markets, but haven’t demonstrated any traction yet. Instead, look at companies that have already validated their markets with early sales or partnerships. Rocket Fuel FUEL exemplifies a young growthy company, racking up huge growth and sales numbers. The programmatic advertising platform went IPO in September after having experienced 139% Y/Y revenue growth (hitting $106.6M in 2012). Sales increased in H1 2013 at almost the same rate and shares have climbed over 100% since they floated.

Look for startups with strong sponsorship: It takes a lot for a startup to succeed. To help a startup navigate the startup ship, it needs to have a strong extended family, namely good investors and advisors. Investors looking at startups should take a look at the other investors in the company and see if these individuals (or funds) can provide value beyond just the capital they contribute (though, that’s important down the road). The data show that startups that have groups of smart investors (called, angel groups) or venture capitalists do perform better over time, like Wix.com, which has recently filed its S-1 to go public. It’s a do-it-yourself website builder, playing in a $20B market. Founded in 2006, Wix.com has 37M registered users. Importantly, the young Internet firm is backed by Benchmark Capital (early investors in EBAY, OPEN, Z) and Bessemer Partners (invested in YELP, LNKD), 2 investment firms experienced in bringing young companies through to IPO. 

Invest in companies targeting a large market: Given the riskiness of early-stage investing, investors should look to target firms that address large markets — we’re talking in the billions of dollars. It takes time and money for startups to exit, so the payday has to be significantly large enough to compensate investors for the risk and dilution they take when new investors come in along the way. One interesting recent IPO is Alcobra Pharma ADHD, an Israeli biotech firm focusing on — wait for it — the ADHD market (a $2.8B market in 2008 and expected to reach $4B by 2014). ADHD is the most rapidly growing segment of central nervous systems diseases.

The playing field is changing for investors. As the JOBS Act of 2012 gets implemented, investors should get unprecedented access to private equity deals — deals they were previously shut out from. It’s conceivable that in a few years, private companies become an asset class sitting in investors’ IRAs and 401(k)s, as common as stocks, mutual funds, and ETFs. But, to get there, people — and the institutions that service them — will need to get serious about investor education.