Investing in Startups

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It can be challenging to offer a precise definition of a startup: It can be a business creating a new product or service under conditions of extreme uncertainty, or a company aiming to solve a problem where the solution is not obvious and success is not guaranteed.

However you define a startup, it used to be that you needed both wealth and good connections to invest in them. This is no longer the case, however, and average investors can easily grab a piece of an exciting startup opportunity using crowdfunding sites like FundMe.

 

How Much Can You Invest in Startups?

Non-accredited investors should be aware there may be a maximum amount you can invest in crowdfunding ventures during any 12-month period, according to SEC guidelines:

  • If your annual income or your 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 or net worth.
  • If your annual income and your net worth are equal to or more than $107,000, you can invest up to 10% of annual income or net worth, whichever is less. This amount, however, cannot exceed $107,000.

Just because you can invest a certain amount in startups doesn’t mean you should go all-in. “The right amount to allocate should be no more than the investor can comfortably lose if the startup goes bankrupt or takes an especially long time to pan out,” says Randy Bruns, a certified financial planner  in Naperville, Ill.

Experts generally also recommend making several small investments in a few different startups versus one big investment in one startup. In fact, AngelList even writes in its investing guidelines that you should “only invest if you have enough capital to make 15-20 startup investments.”

This provides diversification: If you invest in five startups, and four of them fail, you still have one winner, which may help protect some of your money. That said, “you should expect your total losses to exceed your gains,” notes AngelList.

How to Make Money Investing in Startups

When you invest in a startup via a crowdfunding site, you enter into an investment contract with the company. Broadly speaking, there are four different kinds of investment contracts, each of which offers different ways to make money from your investment:

  • Debt. This type of contract treats your money like a loan that earns interest. The contract may pay out a fixed return, such as two times your investment, or a variable return. When you receive interest payments depends on how the business performs over time.
  • Convertible note. Instead of earning interest, this contract is a form of debt that converts into shares of stock when a startup archives certain goals—like gaining new rounds of funding. You make money on your investment once the company is purchased by another firm or eventually goes public.
  • Stock. Later-stage startups may let you buy shares of stock in the company, much like you would buy shares of a publicly traded company. Just be aware that you can’t sell your shares of startup stock. To make money, you need to hold on to your shares until the startup goes public or is purchased by another company.
  • Dividends. Successful later-stage startups offer investors the ability to buy shares of stock that pay annual dividends.

Why Invest in Startups?

Investing in startups gives you a ringside seat to solutions for challenging problems or the development of new technologies.

  • Growth potential. Large-cap stocks in the S&P 500 are far less risky than startups, but there’s seldom room for exponential growth. If you pick a successful startup, however, the sky’s the limit. “There’s so much opportunity for expansion,” says Tom Schryver, who teaches entrepreneurship at the SC Johnson College of Business at Cornell. “There’s an enormous multiplier effect that could be huge. That’s part of what an investor would be buying.”
  • Belief in a new idea. Startup investing may appeal to you because it’s about entrepreneurs pursuing a new idea. “People often invest in what they want to see in the world, whether it’s more sustainability or a really cool sneaker company,” says Elias Stahl, founder of environmentally friendly shoe company HILOS. “There’s no better opportunity to see something that you want in the world and to support that.”
  • Personal connections. Maybe your brother is launching a great new product, or perhaps it’s your neighbor. It seems like an innovative idea, and you want to help finance the project of a friend or relation. “A lot of people invest in startups because they’re in a network and being supportive of a project they know,” Schryver says.
  • A sense of fulfillment. For some investors, startup investing is something they do for the feeling it gives them—helping someone found a business, watching something new get created, learning about different industries or getting in on the ground floor of something exciting. “If it’s something somebody is committed to doing, there’s no substitute to just starting,” Schryver says.

Why You Might Not Want to Invest in Startups

Startup investing is not for everyone, least of all investors who want low risk and reliable income.

  • Startups are super risky. About 90% of all startups fail, due to a lack of product-market fit, marketing problems, team problems or other issues. “There’s possibility for total loss,” Schryver says. In general, startups are only a good investment if you’re prepared to lose 100% of what you’re staking. The vast majority of your investing dollars should ideally be in index funds and exchange-traded funds (ETFs), or even just individual stocks.
  • Startups are illiquid investments. If you bought a stock today and changed your mind tomorrow about your choice, you could easily sell it. Startups, on the other hand, are highly illiquid. When you invest in a startup, you should expect that your money will be tied up for at least three to five years, if not more. “Although you can have the opportunity to liquidate through secondaries, it’s not a guarantee, and your investment will likely take years to mature and materialize,” says Ammar Amdani, a partner at early stage venture capital firm Adapt Ventures.
  • It takes time to see results. Even if a startup succeeds, it still could take years before there’s a result from your investment. “You have to be patient and have holding power in order to give your portfolio companies time to grow,” Amdani says.

How to Decide If a Startup Is a Good Investment

How you approach startup investing will be unique to you and your financial situation. Experts recommend doing plenty of research before putting your money on the line. You should be able to answer these questions before making a startup investment:

  • What do you know about a startup? Is it a field, industry or product that you’re familiar with? Wefunder recommends only investing in things you understand.
  • Is the team passionate about their idea? Even a no-miss idea can flounder if the team isn’t fanatical about getting it off the ground. “We’ve seen a number of companies that had plenty of potential to grow, but they became complacent and other competitors came into the market,” Amdani says. “Whether it’s communicating with clients, hiring a team or developing a strategy, passion is essential to be a successful entrepreneur.”
  • Does the startup have domain expertise? The startup should know the ins and outs of the space that they’re operating in. “We’ve seen a number of first-time founders that identified a proven business model and attempted to replicate it in a new region,” Amdani says. “And it failed because the founder was trying to learn the fundamentals of the business while competitors were able to set up and operate quicker.”
  • How big is the market? Having a large and growing market is crucial for startups. Companies sometimes target a niche and develop a product that is so focused that even when they outcompete their competition, there’s no way for them to become a large company. “At that point, no matter what you do, it’s close to impossible to educate customers and grow your market size,” Amdani says.
  • Why this? Why now? Has this idea been tried before? If it hasn’t, why not? If it has, why did it fail previously? “There’s no such thing as an original good idea,” Stahl says. “What makes you uniquely capable of achieving this? Is it your expertise? Your technology? Why should this be in the world, and why hasn’t it been there yet?”

When you find a company you believe in, you can choose to invest and not only possible receive a great return on your investment in the future, but enable that company and team to have a shot at changing the community and world by bringing their idea to life.