A startup is a new or young company founded by one or more entrepreneurs to develop a unique product or service and “push” it into the market. Usually, the typical startup is a shoestring operation with initial funding from the founders and/ or families as well as friends.
Though investing in startups can be lucrative, it comes with many risks. There are a lot of unknown elements which can come into play even if thorough research is performed. The vast majority of startups fail so you could end up with nothing in the end. To minimize the probability of failure, here are some tips which can be used in deciding whether you should invest in a startup.
Ordinary folks can invest in startups via crowdfunding sites. The platforms offer a wide and curated selection of companies which require a minimal amount for investing. The big boys in the crowdfunding startup space are Wefunder, SeedInvest, StartEngine and Republic.
Platforms For Investing In Startups
Investors can start investing for a little as $100 though some crowdfunding sites require a bigger amount. SeedInvest requires an investment of at least $500 while AngelList only accepts accredited investors with minimal incomes of $200,000 ($300,000 if married) or with a minimal net worth of $1 million, excluding their primary residence. Minimal buy-ins are at least $1,000.
How Much Can You Invest?
According to SEC guidelines, non-accredited investors should take note that there may be a maximum amount you can invest in crowdfunding ventures during any 12-month period.
Eg. If your annual income or net worth is less than $107,000, you can invest up to the greater of $2,200 or 5% of the lesser of your annual income of net worth. However, if your annual income and net worth are equal to or more than $107,000, you can invest up to 10% of annual income or net worth, whichever is lesser. This amount cannot exceed $107,000.
A general rule of thumb to wise investing is that one should not go all in due to risk elements. The right amount for investing should be no more than what the investor can comfortably lose if the startup takes a long time to reach profitability or goes bankrupt.
Experts also recommend making several small investments in a few different startups to diversify the risk and maximize the returns compared to investing a huge amount in one startup only.
How To Make Money From Investing In Startups?
When you invest in startups via a crowdfunding site, you enter into an investment contract with the company. In general, there are 4 different types of investment contracts and thus, 4 different ways to make money from your investment:
This contract treats your money like a loan that earns interest. It may give a fixed return such as 2 times your investment or a variable return. When you receive the interest payments depends on how the business performs over time.
2. Convertible Note
This serves as a form of debt that converts into stock shares when a startup archives certain goals like new rounds of funding. The money on your investment is made when the startup goes public or once it is purchased by another company.
This only happens when startups in the later stage allows you to buy stock shares in the company, pretty much the same as when you would buy stock shares of a publicly traded company. However, the stock shares of startups cannot be sold and to make money, you will need to wait till the startup goes public or once it is purchased by another company.
Startups who have become successful in the later stage offer investors the ability to buy stock shares that pay annual dividends.
Why Should You Invest In Startups?
Investing in startups gives you the insider seat to solutions for real world problems or the development of new technologies so here’s why you should invest in them.
1. Growth Potential
Large cap stocks in the Standard & Poor (S&P) 500 are far less risky than startups but there is not much room for exponential growth. With startups, the sky’s the limit and they can scale pretty quickly. This possibility of exponential growth should be what an investor should be buying into.
2. Belief In A New Idea
Investing in startups may appeal to many people because it means pursuing new ideas and/ or technologies. People often invest in what they want to see in the world and especially if it is something that resonates with them – whether it is about using cool technology or about more sustainability. There is no better opportunity to show your support and that is when investing in startups helps investors realize their “secret dream”.
3. Personal Connections
Maybe your best friend or brother is launching a great new product and/ or service. It seems like an innovative idea and of course, you would want to support them by helping to finance part of the project. Many people invest in startups because they are in a network and are being supportive of what they know.
4. Sense Of Fulfillment
For some investors, investing in startups is something they do for the good feelings they receive. Helping someone start a business makes them feel fulfilled because they are watching the birth of a company, learning about different industries or getting hands on into something wildly exciting.
Cons Of Investing In Startups
Investing in startups is not suitable for everyone especially investors who want low risk and consistent income. There are a few disadvantages and these should be taken greatly into consideration.
1. Huge Risk
It carries a huge risk because 90% of all startups fail, either due to a lack of marketability, advertising problems, poor teamwork or other issues. They are only considered a good investment if you are prepared to lose 100% of what you are investing and make returns at the end of the day. The vast majority of your investing should ideally be in index funds and exchange-traded funds (ETFs) or even individual stocks.
2. Illiquid Investment
In normal circumstances, if you bought a stock today and want to sell it tomorrow because you changed your mind, you could probably sell it easily. However, not the same can be said for startup investments. They are highly illiquid and when you invest, you should expect your money being tied for a minimal period of 3 to 5 years, if not more. The investment might take years to mature and materialize.
3. Patience Is Key
It takes time to see results so even if a startup succeeds, it could still take years before seeing physical returns on your investment. Patience is key to giving the portfolio companies to grow.
How To Decide If The Startup Investment Is Good?
A general rule of thumb to all investors, be it amateurs or experienced investors, is that you should always invest within your means. Experts recommend doing tons of research before putting your money on the line. Before making an investment in startups, you need to ask yourself and ponder these questions carefully.
1. What Do You Know?
How much do you know about the startup? Is it a field, product, service or industry that you are familiar with? It is advisable to invest only in things you understand.
2. Is The Team Passionate?
You might have the most experienced team but if they do not have passion about making it work, even a no-miss idea can fail. Be it communicating with clients, developing strategies or prototypes, passion is essential to becoming a successful entrepreneur.
3. Does The Startup Have Domain Expertise?
The startup should know the ins and outs of the business, meaning they are people who have the necessary knowledge, experience and skills. If the founders are first timers in the industry, the probability of failure is much higher as they still need to learn the fundamentals while experienced competitors are able to set up and operate more quickly.
4. Is The Market Big?
Having a large and growing market is important and critical to success. The product and/ or service can be niche but ultimately, consumers must be willing to pay to obtain it. The marketability needs to be high if not many resources would be spent educating consumers and yet, no results can be seen.
5. Is It Workable?
You need to know whether this product or service is workable. If it is, why now and whether it has been tried before? If the answer is yes, why did it fail and if the answer is no, what is the probability of success? What makes the startup uniquely capable of achieving success?
So Should You Invest?
Whether you should really depends on your financial circumstances. Nobody can guarantee the chances of success, even for seasoned investors. So what you can ask yourself is that are you struggling to make ends meet, living from paycheck to paycheck or are you consistently hitting your savings targets? If you should decide or are keen to invest in a startup, you are most likely ready when your answer to the following principles is a resounding yes.
1. Talk To Your Financial Advisor
Your financial advisor is someone who knows your financial circumstances like the back of his/ her hand and will not usually recommend such high risk investments so you will need to start the ball rolling. He/ She will be able to help you plan better and advise on the suitable amount for investment with the long term protection of your interests in mind.
2. Invest Within Your Means
Always start small especially for newbie investors or for industries you are not familiar with. Due to the high volatility, it is advisable to invest no more than 5% of your portfolio. If you have more money to work with, you can invest several small amounts in different startups to diversify the risks and maximize your returns.
3. Be Prepared To Lose It All
Investments always have risk elements and when you invest, you must be prepared to lose it all. The monies you use to invest should not be your emergency fund or the money you have earmarked for your children’s education. They should be “extra money” that you have nowhere to spend on meaning if you lose this investment, it should not cause you to lose your house or future etc.
In conclusion, investing is not a “get rich quick” scheme especially investing in startups. It is only suitable for people who have huge risk appetites or have money to spare with the mindset of waiting for returns patiently and/ or preparing to lose it all should the startup fail. A diversified portfolio is a wiser way of investing and we wish you all the best in startup investing!