I’ve never invested in a startup so I was keen to get Max’s input with this article on how to invest in startups. Tim
Whether you hit the startup lottery or lose your money, you want to be intelligent in where you choose to invest. If you invest in the proper startup, you may be able to retire when the company goes public. You may also lose 100% of your investment. Here’s a guide on how to invest in startups.
What is a Startup?
Finding a standard definition for a startup can be difficult and depends on who you ask. A several-year-old and profitable business can be referred to correctly as a startup. A company that has not earned a dollar in revenue can also be considered a startup.
There are also differences between types of startups. A seed-stage venture will look very different from a series E and above. Each company targets various industries and has other end goals.
A startup can fall into any number of these categories but would most likely be a company pre-profit.
Who Are Angel Investors?
Angel Investors are the individuals who provide funding to a startup in exchange for an equity stake in the company. When Angel Investors (or venture capitalists) invest in a company, they become part owners in the venture and the founders.
The popular TV show, Shark Tank, can give you a face to some of the world’s most well-known and best angel investors.
Many startups and early-stage companies are on a journey to find a high-profile investor to open up opportunities for other angel investments and give outside investors some social proof in their idea or business.
Once a startup has initial funding, this typically attracts more investors to provide additional capital.
Why Add Startups to Your Investment Portfolio?
The fastest way to understand what may be happening in the future is to be involved with a startup. Founders and investors of startups have a knack for knowing what will happen before it happens. If the future pans out as the company is planning, the investors are paid back, and the money at risk was a good investment.
While investing in startups, an investor is taking an approach that tomorrow is bright. Instead of taking guaranteed returns of a blue-chip company or treasury bill, their investment strategy is a high risk, high reward.
Who Can Invest in Startups?
Nate Nead, Managing Principal at Invest.net, encourages individuals to do extensive research and understand the startup clearly before investing in any startup company.
Startup investing is a double-edged sword for individual investors. To be truly successful at it [investing, they should either have great advisors or be able to perform the market analysis and company due diligence that most institutional venture capital firms are accustomed to doing, which is typically extensive. It is [not advised] that individual investors directly invest in risky ventures like startups unless they are comfortable losing all their investment capital.
Let’s consider what factors to consider when potentially investing in a startup.
Factors to Look for When Investing in a Startup
Before adding startups to your investment portfolio, you must look at several factors.
Darren Hazan, a Crowdfunding Expert at DarrenHazan.com, gives three considerations you should consider before investing in startups.
- Is the startup building something based on a trend (say smart toilet seats) or a long-term movement (environmental awareness)?
Suppose the startup is primarily raising capital due to a popular culture moment that is a reason to tap the brakes on your investment. Cultural trends come and go.
Thankfully, you can still buy this Baby Yoda Chia Pet and send it my way. Thanks in advance.
When you make startup investments, you want to make sure the company will be around to give you a return on your money invested.
- Have the CEO, Founder, Directors, etc., created a startup before, and do they have a track record of success? Have they successfully exited?
Alice Neuhauser, CFO at Seismic Capital Company, echos this sentiment saying you must scrutinize the personnel and previous success (or lack thereof).
…individual investors should be on the lookout for detailed profitability projections [and] a breakdown of what the startup has achieved thus far.
Growing a business is one thing. Understanding when to exit is critical for you as the investor to see a return.
If this is the founder’s first time with a startup, that could be a reason to think twice about the particular company.
Investment opportunities based solely on projections without previous success are very high risk, and no security is offered.
- Is the company weatherproof and evergreen?
If the Federal Reserve (Fed) or Securities and Exchange Commission (SEC) changed legislation, would this critically affect their business? (weatherproof)
What assumptions are the business is based on.
Will people spend money on this product or service regardless of the economy (evergreen)?
Do they need to put out new services or products to stay afloat continually?
Companies like Airbnb and Uber did so well for so long because they had disrupted an industry with no government red tape or bureaucratic regulation.
Think about things that people need no matter what is happening in the economy. When a company is unaffected by regulatory agencies and people spend money on their product regardless of the economy, the startup can bring big rewards to its investors.
Is it Risky to Invest in Startups?
90% of startup companies will not make it to an initial public offering (IPO). An IPO is not necessary to earn a return on investment. A company will often stay private and make the Founders and investors a profit.
Startups have unique risk factors that do not apply to Blue Chip companies. Whenever something is new and exciting, it may disappear as quickly as it came onto the scene.
Remember the most critical rules on investing.
The first rule to investing is to never lose your principal. The second rule is to never forget rule number one! -Warren Buffet
How Do I Invest in Startups?
Brian V. Folmer, Founder at FirstLook.VC says individuals have multiple ways to become an investor in startups.
…It’s easier now to raise than ever. I think the music will stop once the economy pulls back, and we slip into a recessionary period. New companies have sprouted up over the last few years, like FirstLook’s “Shark Tank in a Box” model and Republic’s crowdfunding platform. These companies provide new and more efficient ways for individuals to become investors in startups. When the economy pulls back, so do most qualified investors. They are legally obligated to deploy capital (as it’s already in the bank), so funding options will still be there.
Your best bet as an individual investor is to do research and due diligence on the startups on these investment platforms. When using a crowdfunding platform, you can invest as little as $100. A diversified portfolio is a great idea, especially when starting with startup investment opportunities.
What Effects Startups
Jake Hare, CEO, and founder of Launchpeer, says changes in the tax code could negatively affect startup investments.
…one of the changes that may impact is the new potential updates to the capital gains tax. If Biden’s changes are enacted, it means that there would no longer be preferential tax rates for those that make over $1 million on the sale of their shares post-IPO or as part of an acquisition. Many investors know it’s a “buy and hold” game with startup investing; exiting their investment usually takes long enough for them to benefit from long-term capital gains tax. Under this change, they may be limited to the amount of upside they can convert to preferential capital gains tax depending on their income levels and when they sell. Investors may not see startup investing as ideal and instead move to other investment forms since the tax benefit is not as strong anymore.
Even if the specific industry does not have much government regulation, taxes are always a risk to consider when adding anything to your portfolio.
Thanks to crowdfunding, you can invest in startups with a small amount of money. You can make a decent return on your investment. Before investing any cash, complete your due diligence and understand the company thoroughly to know you are making a sound investment.
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This post was produced by Wealth of Geeks and was syndicated by Tim Thomas / Timothy Thomas Limited.
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