How To Invest In Startups
Investing in startup companies can be a risky business, but it can also be a highly lucrative one. With the rise of today’s technology and many avenues of innovation, entrepreneurship is at an all-time high. Don’t let yourself be fooled into thinking that only tech companies are considered startup companies worth investing in.
The key feature when answering how to invest in startups is that every startup company needs to have is the potential for rapid growth. Granted, there are other components that go into a successful startup. Things like having money available, a committed team, momentum, good marketing, good timing, sound business and financial models, etc., need to be considered. With so many moving parts and unknown variables, the chance that any given startup fails within its first few years of operation remains 90%. The risk of losing your initial investment is, therefore, high. But when these startups do make it, however, their investors make money… a lot of money.
The Basics of Early-Stage Startup Investing
To maximize your gains with minimum investments, you need to be there at the very beginning of a startup. But unless you are a founder, family member, or close friend a founder, chances are you won’t be investing in early-stage startups. Likewise, if you’re not a high net worth accredited investor, you’ll likely not be able to participate as an angel investor, either.
Most individuals investors can, however, devote some of their personal finances to private companies via private equity. Simply put, private equity funds specialize in venture capital funding and allow for indirect startup investments. These are shares that represent ownership in an entity and are not traded publicly on the stock exchange. There is, however, an additional option for a startup investor to diversify and increase their investment portfolio, aside from equity funds, real estate, or investing in the stock market.
Equity crowdfunding has gained a lot of popularity in recent years and has become a favorite for startup investments. It’s the most common type of crowdfunding where a startup company is raising money and where investors receive a percentage of the company’s equity in return.
This has only been possible since the 2012 JOBS act and its Regulation Crowdfunding, which provides some exemptions from the registration requirements for securities-based crowdfunding. As such, companies can offer and sell up to $1.07 million of their securities per year without having to register with the US Securities and Exchange Commission (SEC).
The Risks and Rewards of Early-Stage Startup Investing
investing in early-stage companies is a high-risk, high-reward endeavor. While some of these startups can offer an exponential return on investment, many more will go bankrupt. As such, there are several risks and rewards that should be acknowledged before investing any amount of money from your personal finances.
Risks of Startup Investing
- Losing Your Initial Investment – If the startup fails for whatever reason, and you are not able to get any real money out of it before that time, you’ll also lose your initial investment.
- Your Startup’s Equity Represents Illiquid Investments – Be it in the form of shares or stakes, your startup’s equity represents illiquid investments. This means that they cannot be easily sold or exchanged without a significant blow to their value and, by extension, to your savings account.
- Unavailable Information – A critical aspect of investing in startups is due diligence. This means that you need to analyze all the documentation and other aspects of the business to lower your risk and maximize your investment. But while every company needs to report its 10Qs,10ks, and Form-C to the Exchange Commission after it goes public on the stock market, private companies only have to offer Form-C. In some cases, a startup investor has limited information about the company. KingsCrowd can help you gather as much data as possible and make an informed decision.
- Some Potential of Fraud – Since equity crowdfunding is a relatively new form of investing, there is always a potential for fraud. Using an investment platform like WeFunder, StartEngine, or SeedInvest can help mitigate this risk.
The Rewards of Investing in Startups
- Investment Portfolio Diversification: The general rule of thumb when investing in stocks is to never put all your eggs in the same basket. The same thing applies to your entire investment portfolio, for preferred stocks, bonds, real estate, etc. These private investments can be a great addition to your investment portfolio, but due to their inherent high risk, they shouldn’t make up more than 10 percent.
- Good Investment Opportunities Mean a Lot of Money: While the failure rate is high, investors make money with startups with equity crowdfunding, more so than most people think. The rewards can be enormous, sometimes offering a 4,000% ROI or more.
So, How Can I Invest in Startups and Earn Money?
In most cases, you’ll have to hold on to your investment for up to five years or more before seeing meaningful results. Since an equity investment is not liquid, its valuation will go up with every funding round. There are, however, certain times when you have the opportunity to liquidate and exit your investment preferably with more money than you originally put in. These exit events will include the following:
- Mergers & Acquisitions (M&A) – Many large organizations are on the lookout for private companies to buy. Almost every successful startup receives offers to merge or sell off. For a startup investor, this is often the quickest way to make a profit on their investment. Investors offer cash or new stock, or a combination of both.
- The Startup Goes Public -Though this happens less often than M&A, private companies can go public on the stock market and offer exponential returns to their shareholders. Think of the huge ROIs that Facebook’s private shareholders got when the company went public.
- Paying Dividends – Some founders may want to continue their vision of a standalone business and decide not to get bought or IPO. Usually, when this happens, they already have a lot of money to play with and are on an upward trajectory. In this case, investors receive part of their cash flows in the form of ongoing dividends.
Earning money by investing in startups is easy if you understand the ins and outs of the process. By doing your due diligence, you will be well on your way. But again, investing in startups is a high-risk, high-reward operation, but that’s where KingsCrowd comes in. We help you make the best decisions with your money, all while aiding budding entrepreneurs and educating you on the startup environment. Subscribe today for more in-depth information!