How to Crash Investors' Private Parties

BOSTON ( TheStreet) -- Are you upset you didn't get in on the LinkedIn ( LNKD) and Pandora ( P) IPOs? Not just because you passed on their public offerings, but because you didn't have a horse in the race before they went public?

For the most part, private investing in pre-IPO companies has been an exclusive and expensive club, mostly limited to financial and venture capital firms or very wealthy individuals. Facebook, for example, announced earlier this year that it was offering up to $1.5 billion of securities to clients of Goldman Sachs ( GS), provided they invested at least $2 million and pledged to hold the shares until 2013.
For the most part, private investing in pre-IPO companies has been an exclusive and expensive club.

Increasingly, however, smaller investors are looking for ways to hop the fence and join the party, especially given the hot prospects of several well-known, Web-based and social-media focused companies.

Doing so is easier said than done.

The whole reason these shares have been traditionally out of reach of the average investor is because they are deemed high risk and keep much of their financial information closely guarded, unlike publicly traded companies that have a legal requirement to open their books.

It is with the intent of protecting investors that the SEC has put rules and regulations in place limiting such securities to qualified institutions and people with a net worth of $1 million or more or with income of more than $200,000 in the current year and each of the preceding two years ($300,000 for couples). Pre-IPO shares cannot be advertised to the general public.

The simplest, though watered-down, way to get around this restriction and place bets on upstart companies is to find a mutual fund that invests in them. It may not be the same as personally wrangling Facebook shares, but you may gain diversity and downside protection in exchange for bragging rights.

For just a $2,500 minimum investment, Fidelity's Advisor New Insights funds have a smattering of private, Web and social-media related companies in the mix, among them Ning, Digg and, of course, Facebook.

Morgan Stanley ( MS) has also added a dash of private company stock -- notably, once again, Facebook -- to its Focus Growth funds. Unlike other Morgan Stanley funds with such holdings that have a high buy-in basically limiting them to institutions and wealthy investors, a $1,000 minimum buy-in is enough to get you started.

T. Rowe Price ( TROW) has sprinkled private shares into several funds. In April, it went public with its $190 million investment in Facebook, shares bought via a private offering of employee-owned stock that was authorized by the social media giant.

The T. Rowe Price Global Technology Fund ( PRGTX) and its Science and Technology Fund ( PRSCX) may be top-heavy with well-known, public companies such as Apple ( AAPL), Microsoft ( MSFT), Google ( GOOG) and H-P ( HPQ), but also under the hood are hot pre-IPO companies including Facebook, Angie's List, Zynga, Twitter and Groupon. Be aware, however, that the T. Rowe Price funds still only have less than 1% of their holdings in Facebook, so Mark Zuckerberg isn't going to get to know you on a first-name basis.

Taking a cue from T. Rowe Price, one approach to buying private stock is to find a willing (and authorized) seller.

Even those with enough personal wealth to not worry about SEC restrictions can find it hard to crack into the exclusive club of private shares. As such, a variety of exchanges have emerged -- SharesPost and SecondMarket among them -- to match up buyers with sellers (which often include early VC investors and past or present employees with stock options).

As of July 26, SecondMarket had completed $268 million in private company stock transactions. Since its start in 2008, it has completed 650 transactions for about $750 million.

Far and away, for Q2 of 2011, the hot industry has been consumer Web and social media, for 87.6% of SecondMarket's completed transactions. Retailing and commerce accounted for 5.1% and "business products and services" commanded 7.3% of transactions.

What's hot? According to the company, the most-watched companies on its site are Facebook, Twitter, Groupon, Zynga, Foursquare, Yelp, Dropbox, Gilt Group and LivingSocial.

There is a possibility it will soon be easier for individuals to buy private shares.

In an April 6 letter to U.S. Rep. Darrell Issa, R-Calif., chairman of the Committee on Oversight and Government Reform, SEC Chairman Mary Schapiro responded to his concerns that regulations were stifling investment and, in turn, stalling IPOs.

Among the regulations that could be reconsidered are traditional restrictions and an easing of a requirement that once a company has 500 shareholders it register with the SEC and disclose financial information. (Various loopholes, such as the defined difference between the reporting of a "holder of record" and a "shareholder" have allowed some companies to skirt that requirement.)

Until the rules change, investors need to be leery of any pitch to buy pre-IPO securities directly.

Recently, Finra, the largest independent securities regulator in the U.S., issued a warning that "social media has become the latest hook on which con artists can hang a scam." The regulator warns that "fraudsters dangle the promise of wealth from the sale of 'pre-IPO' shares," pointing to a 2010 federal prosecution against a self-employed securities trader who, claiming he worked for Goldman Sachs, bilked more than 50 U.S. and foreign investors out of more than $9.6 million in a series of pre-IPO scams spanning eight years.

Even the legitimate sale of unregistered shares in private transactions -- often called "private placements" -- can be "fraught with risk, including the fact that you can't be certain the company being touted will actually complete an IPO," the advisory says.

"This means you cannot be sure whether you will ever be able to sell the shares you purchased and ... the fair market value of your shares may be based solely on speculation," Finra adds. "And privately purchased shares typically come with restrictions, such as lock-up periods that prevent you from selling your shares for up to a year even if the company goes public in the interim."

As for fraud, a "promoter might be offering shares he doesn't have or that he acquired in a questionable transaction" and pre-IPO offerings "that target the general public -- especially those that are publicized through 'spam' emails -- often violate the federal securities laws."

At the very least, check on the seller's credentials; a legitimate seller of investments must be properly licensed, and his or her firm registered with Finra, the SEC or a state securities regulator.

-- Written by Joe Mont in Boston.

>To contact the writer of this article, click here: Joe Mont.