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The best investors are always on the hunt for ways to generate greater returns while keeping their risk levels reasonable. Often times when newer investors think about how they can achieve this, they first look to stocks. With the rise of apps like Robinhood, it’s never been easier to buy and sell stocks. But oftentimes the best results come from thinking outside the box.
While startup investing was once reserved for only the ultra-wealthy, over the last decade it’s become substantially more accessible for the everyday investor. This is thanks to a number of innovations that we’ll discuss later. However, the takeaway is that this is now an option for the masses.
Given that small businesses and startups make up the backbone of the economy, it’s quite logical to think about investing in them. When you think about the number of different businesses you interact with in a day, it can be quite appalling. Even just to read this article, there are dozens of companies involved.
From the company that built the device you are reading on, to the company hosting this website, to the company providing your internet or cell service, the list goes on and on. And while many of those companies may be large and well-established now, they all started out as fledgling startups.
Here is everything you need to know about startup investing.
What is Startup Investing?
Before diving into the intricacies of startup investing, it’s worthwhile to define what we actually mean when we refer to a startup. Now, different people will have different definitions for the word startup depending on their background.
But for our purposes, we’ll refer to a startup as a young company that is working to bring something unique to the market. This could be a product, service, or idea that has yet to exist before. These companies are the disruptors that cause massive changes in our world and so getting a piece of them early on, has the potential to create significant upside for investors.
Types Of Startup Investments
When investing in startups, there are a number of different ways that investments can be structured. Depending on your goals, risk tolerance, and investing philosophies, different investment structures may be more appealing to you.
Broadly speaking, the two types of startup investments are equity and debt.
Investing in equity is likely the model that most people are the most familiar with. When you invest in equity, you exchange cash for ownership in a company. This is the same model of investing that happens in the stock market and why stocks are often referred to as equities.
However, investing in a publicly-traded stock and a privately-traded startup are two very different types of investments.
With a traditional stock, you’re able to place a purchase order any time from 9:30 am – 4:00 pm Eastern Time, Monday through Friday. Then, when you’re ready to sell, all you have to do is place a sell order and wait for a buyer to take it off of your hands. When it comes to startup equity, this is not the case.
Startup equity is far less liquid, meaning there are far fewer buyers and sellers in the market. This makes sense because startup investments are far riskier than stock investments and attract a smaller subset of investors.
With a startup, you run the risk of the entire company going to zero and losing your entire investment. The odds of a company like Facebook or Amazon going to $0 are far lower.
Investing in debt is generally a less risky way to get started investing in startups. However, with less risk generally comes less potential upside.
When you invest in startup debt, you are essentially making a loan to the startup. This loan will typically specify an interest rate and timeline for the investment.
After investing, the startup will make periodic payments to you, repaying their loan with interest. Once the loan reaches maturity and you are fully paid back, the investment is complete. A fixed interest rate means that you know from the start what your ROI will be, provided the company is able to pay.
The risk debt investors face is that at some point the company will no longer be able to make their payments. In that case, the company may file for bankruptcy, in which case it’s unlikely that you’ll be able to recover your investment. However, in the case of bankruptcy, debt investors do take priority over equity investors so you may receive a portion of your investment back.
How To Earn Money
In the stock market, you’re able to make money in two primary ways: capital appreciation and dividends. With startup investing, this is not the case.
Companies that pay dividends to their shareholders are typically very well-established and are no longer in growth mode. If their priority was growth, instead of paying out dividends they would reinvest that cash into their own business.
Startups on the other hand, typically operate in growth mode and will retain all of their earnings to reinvest back into their business. In fact, many startups operate at a loss and spend more money than they make. This is why they need you, the investor, to supply them with capital so they can continue to grow quickly.
Therefor, startup investors make money almost exclusively through capital appreciation. This is the “buy low, sell high” idea. Startup investors are constantly on the hunt for the next big thing. They want to find the next Uber or Spotify before it reaches the stage of market domination.
Back in 2011, Uber was 2 years old and valued at $60 million. For $6,000 an investor could have bought 0.01% of the company. Flash forward to today and Uber is now a $75 billion dollar company. As a result, that $6,000 would have grown to $7.5 million. For most people, $7.5 million would be a life-changing amount of money, especially to come from a $6,000 investment.
In order to make it as a startup investor, you really only need to be right a few times. A well-invested $5,000 could go on to become $5 million or more when placed in the right company. However, in most cases, you’ll never see that $5,000 again. This is because most startups fail.
Most Startups Fail
In 2019, the failure rate for startups was 90%. This means that if you invested $5,000 in 10 different startups, odds are 9 of 10 of those investments would end up worth $0. On top of that, there’s a good chance the 10th one wouldn’t go anywhere either. As a result, diversification is very important for startup investors.
Expert startup investors recommend investing in no less than 100 startups. Knowing that there is a 90% failure rate, they do so with the expectation that 90 of them will go to $0. Their hope is that the 10 that don’t fail more than make up for those that do. One single “unicorn” (a company worth over $1 billion) could easily make up for all of those losses.
Startup Investing Example
Say a startup investor allocates $5,000 into 100 different startups throughout their life, a $500,000 total investment. From there, 90% of them go bust throughout the next 10 years. Now their portfolio is worth only $50,000.
However, of those that succeed, 6 of them experience a 2x return. Bringing their total portfolio up to $80,000. Still a very sizable loss over 10 years.
Then, 2 others experience a 5x return, which brings the portfolio up to $130,000. The 9th winner returns 10x bringing the portfolio up to $180,000. At this point, we have accounted for 99% of their investments and they have lost $320,000 over the span of 10 years.
However, this startup investor got lucky, and one of their investments went on to become a unicorn and return 2000x. This brings the investor’s portfolio from $180,000 up to $10.18 million. A single unicorn is able to more than make up for all of the losses and leave the investor with greater than a 20x return over 10 years.
But, had the investor not struck gold with a unicorn, the story would have had a less exciting ending. Being left with over a 50% loss across a 10 year investing timeline would not get many people very excited about startup investing. So if you’re going to invest in startups, you have to maximize your odds of choosing correctly.
How To Invest In Startups
When it comes to the process of investing in startups, there are a number of different options. In the past, your only real option was to be connected to venture capitalists or founders. Then from time to time one of them may float a deal past you that you could decide whether or not to invest in.
While these deals are still quite common in large startup hubs, for those of us that are not so conveniently located or connected, there are a number of different options. The options you have at your disposal will largely depend on whether or not you are an accredited investor.
Accredited Investor Requirements
The SEC created the accredited investor rules to prevent smaller investors from investing in risky investments. When you don’t have a significant amount of knowledge or resources, investing in risky assets can be analogous to going to the casino and betting it all on black.
So the accredited investor rules are meant to be a quick way to determine whether you have the resources or knowledge necessary to make these kinds of investments.
There are a number of different ways to qualify as an accredited investor. However, the four most common are:
- An individual has a gross income of over $200,000 in the previous two years
- A married couple has a combined gross income of over $300,000 in the previous two years
- An individual or married couple has a net worth of over $1,000,000 excluding their primary residence
- An individual holds the FINRA Series 7, 62, or 65 license
If you do not meet one of these four criteria, you will not qualify as an accredited investor. As a result, you will be unable to participate in many startup investments. However, today there are multitudes of options available to non-accredited investors as well.
Startup Investments For Accredited Investors
By qualifying as an accredited investor, you will be eligible for virtually any type of startup investment. The primary type of investment that you’ll need to be an accredited investor to participate in are individual investments. These are investments where you are investing into one specific company and receiving equity.
Other types of startup investments include crowdfunding arrangements which will be open to both accredited and non-accredited investors.
Individual Investment Platforms
Most individual investment platforms allow users to invest in startups using something called a SAFE. SAFE stands for Simple Agreement for Future Equity and is essentially an agreement between a company and their investors. In the future, this agreement will ideally convert to equity if the company is able to raise a larger funding round down the line. These are the industry standard when it comes to investing in early stage startups.
Some other platforms that offer the ability to invest in startups that are further along will use more complex investment vehicles. However, for the most part you want to make sure you understand whether you are making a debt or equity investment, as well as how you will generate returns.
The EquityBee platform is one of the best for investing in well-known startups. While many of these companies already have significant traction, it does give you the opportunity to invest at a discount. This is due to the way EquityBee investments are structured.
With EquityBee, you’re able to provide liquidity to early startup employees who want to exercise their stock options. In some cases, these employees need millions of dollars to execute their options. By supplying them with the funds to do so, you are able to receive exposure to the startup at a significant discount.
InvestX has a strong track record of investing in companies like SpaceX, Uber, Pinterest, and Spotify to name a few. Through the platform, you’re able to invest in off-market startups before they hit the mainstream.
Due to their strict vetting process, InvestX typically only has a few open deals at any given time. This means that investors can have confidence that any deal they see on the platform has undergone significant due diligence.
Startup Investments For Non-Accredited Investors
As a non-accredited investor, you’ll be somewhat limited in the types of startup investments you’ll be able to make. Most of these are covered under Regulation CF that went into effect on May 16th, 2016. Prior to this piece of legislation, it was next to impossible for non-accredited investors to allocate money to individual startups.
Regulation CF brought about the Crowd SAFE, an investment vehicle that non-accredited investors are able to access. Crowd SAFEs also typically come with a lower minimum investment, making them even more accessible to the masses.
Crowdfunded Investment Platforms
Most of the platforms that are open to non-accredited investors take advantage of crowdfunding and Crowd SAFEs to give non-accredited investors access to startup investments. Similar to Kickstarter, the projects on this platform state their mission, set funding goals, and potentially include tiered rewards for backers.
If the projects reach their goals, they are funded and investors hope for the best from the company. If on the other hand, they do not reach their funding goal, the investors’ money is returned and the project is not funded.
While many crowdfunding platforms focus on high-growth startups, NextSeed focuses specifically on local businesses. Think of the coffee shop down the street, your favorite restaurant, or your local pilates studio. NextSeed lists these businesses on their platform and investors can allocate money to their local business owners.
Clearly, it’s unlikely that your local pizza shop will turn into the next Dominos, so most of these investments are structured as debt. This means that instead of owning a small piece of the pizza shop, you’ll be lending money to the business owner. From there, the business will take that cash and use it to expand their operations or possibly open a new location. Then you as the investor receive monthly payments throughout the course of the loan.
Investments on the Miventure platform are some of the most accessible to newer investors. With a $25 minimum investment, it’s extremely easy for novice startup investors to dip their toes in the water.
Each listing on the platform comes with a 1-2 minute pitch video from the founders explaining the business and the vision. As a result, you’re able to get a better feel for who you’re investing in as well as what they’re hoping to do.
Plus, due to the crowdfunding model, if the project doesn’t hit its’ funding goal, you receive all of your money back.
Why Invest In Startups?
The decision of whether or not to invest in startups is highly personal and will depend largely on your personal circumstances. For many people, adding startups to their investment portfolio will be a smart move. However, for many individuals, this investment won’t be a good fit.
To start, we’ll outline three of the most compelling reasons why a person may choose to add startups to their investment portfolio.
1. Upside Potential
As outlined earlier, startups have some of the greatest potential of any asset class. There aren’t many other asset classes that have the potential for a 1000x gain or more.
The name of the game when it comes to startup investing is making a lot of smart bets and hoping that a few of them pay off. Those few payoffs have the potential to more than make up for all of the losses you’re bound to experience as a startup investor. This is because the magnitude of your gains has the potential to far outweigh your losses.
Any well-experienced investor knows the importance of diversification. With investing, your objective is to generate high risk-adjusted returns. This means that for each additional unit of risk you take on, you’re able to achieve a disproportionately greater return.
When solely investing in stocks, your risk-adjusted are quite limited. This is because your investments will likely be highly correlated and move together.
However, when you begin to introduce other asset classes like startups, the correlation between your investments begins to decrease. This means that he some of your investments are falling in value, other investments will be holding steady or rising. As a result, your portfolio is better balanced and able to achieve higher returns on a risk-adjusted basis.
Now while there is potential to create an impact through investing in stocks or other asset classes, the impact you can generate through startup investing is typically much greater. With the rise of startup crowdfunding platforms, you can use your dollars to support local businesses or bring new projects into existence.
Investing in larger companies usually does not offer this level of impact as the company already likely has access to billions of dollars. You’re unable to make as big of a dent with only a few thousand dollars.
Why Not Invest In Startups?
That being said, there are certainly reasons to avoid startup investing. As with any asset class, there are situations when it makes sense to add to a portfolio and others when it does not.
1. Extremely Risky
As far as all asset classes go, startups are perhaps one of the most likely to go to $0. When you invest in a startup, there is roughly a 90% chance that you will lose your entire investment. In order to invest in an asset with those odds, an investor must have very high risk tolerance.
Additionally, startup investors typically need to have a substantial overall portfolio. This is because it’s not ideal for startups to make up too large a portion of a person’s investments. Most experts tend to recommend 10% or less of your investment portfolio going towards startups.
So, if you wanted to follow the strategy of investing $5,000 into 100 different companies, you’d need an overall portfolio of at least $5 million! Fortunately, many of the newer startup investing platforms come with minimum investments as low as $25 or $100 to accommodate smaller portfolios.
Unlike stocks which can be bought and sold immediately on any weekday, startup investments are highly illiquid. There is not typically a large number of buyers looking for shares in specific privately-traded companies. Further, the startups that do have a list of investors lined up and ready to buy, are likely startups that you don’t have access to.
Even with the rise of startup investing platforms, many deals still require connections. Fast-growing startups with impressive teams have among list of investors ready and willing to give them money. Unless you’re in Silicon Valley and have connections with venture capitalists and founders, there’s a good chance you’ll never get the opportunity to invest in those deals.
However, that’s not to say it’s impossible to find deals without connections. Many platforms like EquityBee allow everyday investors to gain access to well-known startups. But, you likely won’t be getting in from the ground floor as you potentially could if you knew the right people.
Final Thoughts: How To Invest In Startups
By now, you should have a solid grasp on investing in startups and be prepared to make a decision about whether it’s right for you.
If you plan on investing in startups through an online platform, check out all of our startup investing platform reviews.
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