• How to be an early stage investor
  • Can everyday investors replace venture capitalists?
  • What to expect from a private investment research service

Dear Reader,

Welcome to our weekly mailbag edition of The Bleeding Edge. All week, you submitted your questions about the biggest trends in technology. Today, I’ll do my best to answer them.

But before we get to today’s mailbag, we have to put yesterday’s market action in context.

The Dow fell nearly 10% in one trading session. It was the worst one-day decline for the index since the “Black Monday” crash of 1987. In fact, it was the fourth-worst decline in the last 100 years… That’s how unusual it was.

These types of moves can be incredibly distressing. The market is certainly responding irrationally to the latest developments surrounding COVID-19.

These kinds of gut-wrenching moves with the market seeming to fall off a cliff are exactly what market bottoms feel like.

And they don’t make any sense this time around. The moves are all short-term, fear-based market activity.

This is a perfect example of “behavioral finance”… when asset prices are trading not at reasonable valuations but at values driven by collective behavior. This will all pass, and I don’t believe we’ll have to wait long.

Why? A few reasons.

The large economic markets in the northern hemisphere have pretty much shut down. Schools are closed… events large and small are being canceled… and people are staying close to home and working remotely when possible.

While these precautions are extreme, they will certainly help slow down the further spread of COVID-19.

And we have already seen the spread slow to a crawl in the affected parts of Asia.

China’s new cases have pretty much come to a halt, and more than 70% of those infected there have already fully recovered. The recoveries grow significantly every day.

North America and Europe are witnessing nearly identical exponential growth curves of confirmed cases, and the recoveries will come just as quickly as they did in China.

And finally, we’re seeing some rational analysis of COVID-19 from the medical community.

Dr. Neil Fishman, chief medical officer at the Hospital of the University of Pennsylvania, who is an infectious-disease specialist, recently stated, “I think what we’re seeing with COVID-19 is what influenza would look like without a vaccine.”

And Dr. Anthony Fauci, an immunologist and a director at the National Institute of Allergy and Infectious Diseases, recently published research in the New England Journal of Medicine, where he stated clearly that the mortality rate of COVID-19 “may be considerably less than 1%.”

This is consistent with the data coming out of South Korea… with a rate of 0.65% and dropping as more testing is completed.

This is not what we hear in the mainstream media, is it?

With much of the northern hemisphere focused on slowing the spread of this influenza-like virus and warmer weather already on its way, I believe we’re going to be looking at a lot more positive news in a couple weeks’ time.

We should also remember that consumer spending continues to be strong. Interest rates are near record lows, which is driving growth in the real estate market. And unemployment remains at all-time lows.

And while conferences and industries like travel, hospitality, and entertainment are having their day of reckoning, other industry segments are booming amid this crisis.

As I shared yesterday, semiconductor and electronic components used for 5G wireless infrastructure continue to have strong demand.

Remember, 5G networks aren’t a “nice to have” technology. They are a critical part of the world’s wireless infrastructure. The 5G rollout is moving full speed ahead regardless of what happens with COVID-19.

After all, governments wouldn’t stop building essential infrastructure like bridges, canals, or roads just because of a virus. The same goes for 5G.

And because consumers are using the internet more than ever to work remotely and entertain themselves, the servers and all the components needed to manufacture them have seen an increase in demand.

We literally need to increase the size and scale of data centers to handle the increase in traffic.

Imagine that. The markets are going to snap back strongly once people understand the commonsense and fact-based approach to COVID-19 that experts like Dr. Fishman and Dr. Fauci are presenting.

This may be an uncomfortable start to 2020, but I’m confident we’re going to finish the year strong.

In the meantime, be sure you keep reading The Bleeding Edge. I’ll keep you up on the latest developments. But for now, let’s turn to our mailbag.

If you have a question you’d like answered next week, be sure you submit it right here.

Early stage investing: Better than pre-IPO?

Earlier this week, I reported news on the early stage investing front. The Securities and Exchange Commission (SEC) is considering raising the investing cap on crowdfunding deals like Regulation A (Reg A) and Regulation Crowdfunding (Reg CF).

For a full recap of that development, go here.

But here’s the key insight: The new regulations from the SEC would raise the cap on Reg CF deals from $1.07 million to $5 million. That means early stage companies could raise up to $5 million from both accredited and nonaccredited investors.

And amount like this for an early stage company would allow it to forgo a traditional venture capital-backed round and conduct a Reg CF with normal investors.

I suspect many early stage companies would find this option attractive. They could raise capital on far better terms than they could with a venture capital firm.

And that could give everyday investors several opportunities to invest in private technology companies while they are just getting off the ground… when the return potential is the highest.

In light of this, I floated the idea of finding a way to recommend these companies to my readers. We received a flood of responses. Today, I want to share some of my favorite questions.

Hi, Jeff. What would be the average holding period until the exit for the Reg CF new service? Would you expect prices to be less than pre-IPO after the lock-up period? If so, why not wait until after the IPO and lock-up (similar to your early stage service)?

– Brian S.

Thanks for writing in with your questions, Brian. These are precisely the sort of things investors should be asking themselves before they commit to investing in early stage tech companies.

Yes, the share price, or valuation of the company, would be dramatically lower than pre-IPO share prices as well as after the lock-up expiration.

The reason for this is that a “normal” Reg CF deal typically happens around the seed stage of a company. The seed round is what follows immediately after a pre-seed raise or even a “friends and family” raise.

Most companies raising a Reg CF have only been around for a year or two and have limited or no product/service revenues. That naturally means that the valuations tend to be very low.

As for the average holding period, it really depends. I’ve experienced exits within a year, and I have investments that I have held now for 10 years. But here’s the thing…

As long as the companies are growing, we want to hold them for a longer period. That’s where the biggest gains come from.

For example, one of my early stage investments was acquired by Square last year. I more than doubled my money in a short period. Sounds great, right?

Not at all, actually. As early stage angel investors, we’re not interested in doubles. We are interested in companies that can deliver 10x or 100x returns. We don’t like to see our portfolio companies getting acquired so early. We know they are worth much more.

And there is something else that is important to consider. In the U.S., the Internal Revenue Service has a special code, section 1202, which is designed specifically for investors who are willing to invest in early stage private companies.

In short, for investments that have been held for five years or longer, all capital gains are tax-free.

You read that right. This is a major benefit that we receive for taking on so much risk to help small private companies create jobs and wealth.

My point… As an angel investor, we want to be holding a company for five years or more because we keep everything on a successful exit. This is an important mindset for investing in early stage private companies.

Bypassing the onerous venture capital requirements…

Next up is another great question about investing in early stage technology companies.

Jeff, by bypassing the venture capitalists (VCs), would this eliminate the 20% carried interest that VCs typically get with investing in a deal?

– William S.

Thanks for writing in, William. Another great question.

And the answer is yes.

Limited partners in venture capital funds (who all need to be accredited investors or institutions) give up 20% of the profits of the venture capital fund and they have to pay a 2% annual management fee. These are the typical terms in the industry.

It is practically a losing proposition. And research has shown over decades that the majority of venture capital funds vastly underperform the market.

Regulation CF deals are structured differently. They are raised individually, not as part of a fund. They are typically raised on a crowdfunding platform, and the costs to the company are typically less than 5% to the platform. And investors often only have to pay a small fee to facilitate the investment.

Under a successful $5 million Reg CF offering, both the company and the investor win. That’s so much better than a typical VC-led round.

How much should we invest in early stage deals?

And let’s conclude with one more question about early stage investing…

Hey, Jeff, I would be interested in getting a little more information on the early stage investments. I’m currently subscribed to two of your other services, and I was just wondering if the anticipated format would be the same (monthly buy/sell alerts, etc.).

Also, I was wondering what the initial capital investment would be. I’m currently spread out between the other services, but not having any previous baseline, it would be somewhat a leap of faith.

– Ken M.

Hi, Ken. First, let me thank you for being a subscriber. Happy to have you on board.

As for your first question, the format of the research service would likely be different than my other services that focus on publicly traded companies.

For starters, we wouldn’t have sell alerts. As I mentioned above, these early stage private investments would basically be illiquid. Investors would typically hold shares in the company until there was an exit.

Buy alerts would be entirely driven by when I find exciting investment opportunities that are raising a Reg CF or Reg A deal. So this wouldn’t be a regularly scheduled monthly research service. I might have one recommendation one month and three the next.

As for the amount to invest, this is up to the individual investor. I can give some general guidance, however. Investors should invest around 10% of the amount they would normally invest in a publicly traded stock.

For example, if the average investment in publicly traded companies is $10,000, then a private early stage investment would be $1,000. If the normal investment size is $5,000, then the private early stage investment would be $500.

And the great thing about Reg CF deals is that the minimum investment size tends to be very low. I’ve seen them as low as $50, and they usually tend to be around $100.

This means that just about every investor can participate. The key is to determine proper position sizing and be consistent with investment amounts for these kinds of private early stage investments. It’s also important to build a portfolio of these companies – at least 30 – so that the numbers work to our advantage.

That’s all the time we have for this week. If I didn’t answer your question, then feel free to write me right here. I’ll do my best to get to it next week.

Regards,

Jeff Brown
Editor, The Bleeding Edge

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