Investing is a game of risk and reward, and nowhere is this truer than in startup investing. When you invest in startups, you’re running a much higher risk for, presumably, a higher earning potential than you would with conventional stocks. Unless you know what to look out for, however, you’re bound to get burned along the way.
If you like a high-risk, high-reward investing style, startup investing might be for you. Those who are light of heart, on the other hand, should stay far away from this asset class.
Globally, over US $104 billion was invested in startups in 2019 alone, marking an all-time high. Although startups aren’t for everyone, they clearly have a time and a place in many investors’ portfolios.
Given the steep rise of startup investing and the runaway success of many venture-backed companies, there must be something appealing about them to investors. In this article, we’ll go over the fundamentals of startup investing, its respective pros and cons, and touch on how to get started if you think these assets are right for you.
What Is Startup Investing?
Gone are the days when regular investors were limited to public equities. In today’s digital economy, equity crowdfunding and do-it-yourself (DIY) angel investing are often easier than investing in publicly-traded companies. This is the essence of startup investing—using digital means to buy shares in small companies looking to raise capital.
Real-life startup investing isn’t exactly how it’s depicted on television. Whereas hit TV shows like ABC’s Shark Tank and CBC’s Dragon’s Den portray intense back-and-forth negotiating and cutthroat deal-making, this is a far cry from the reality for most startup investors.
Although their potential for growth is high, startups carry significant risks. After all, a 2018 report by the Enterprise Research Centre found that 45.3% of startups never make it to their third year. Given their failure rate, the element of risk is always present when investing in startups, albeit it can be managed by following measured and responsible investing guidelines.
Why Invest in Startups?
Again, startups are a high-risk, high-reward investment – so there are just as many reasons to avoid them as there are to invest in them. But if you can get comfortable with the risks, and understand what you’re getting into, there are a few key reasons why startup investing can be a smart move:
- Innovation. Startups are, by definition, innovative; they’re creating new products, new services, and in some cases, completely new industries. That’s why big companies like Google and Apple are always on the lookout for startups to acquire – they want to get their hands on that innovation.
- Opportunity. With a startup, you have the opportunity to invest early in a company that could potentially become the next Google, Facebook, or Amazon. If you invest in a startup that takes off, your return on investment could be massive.
- Diversification. Investing in startups is a great way to diversify your portfolio. Startups are typically high-risk investments, so investing in them can help to balance out your less risky investments. (This isn’t to say that all startups are high-risk – there are definitely some lower-risk startups out there. But it’s still important to do your research before investing in any company.)
- Passion. If you’re passionate about a certain industry or type of company, investing in startups is the perfect opportunity to get in on the ground floor. You’ll have a front-row seat to watch the company grow and succeed, and you might even be able to help shape its future.
Additionally, there are plenty of examples in recent history where startup investors have made a fortune. Just look at the founders of Uber, Airbnb, and Pinterest – they all became billionaires by investing in startups.
So, should you invest in startups? It depends on your risk tolerance, your investment goals, and your knowledge of the startup landscape. But if you’re comfortable with the risks, and you’re prepared to do your homework, investing in startups can be a smart move.
Startups vs Public Market Stocks
In general, startups are what we call private companies, while market stocks are public companies.
Public companies have to disclose their financial information quarterly and annually to the Securities and Exchange Commission (SEC), which then makes that information available to the public. Anyone can buy and sell shares of a public company on an exchange, such as the New York Stock Exchange or NASDAQ.
Private companies, on the other hand, are not required to disclose their financial information. This is because they’re typically smaller and less well-known than public companies. As a result, private company shares are not traded on an exchange. Instead, they’re typically sold to investors in a private placement deal.
There are pros and cons to investing in each type of company. Let’s take a closer look:
Public Company Startup Investing
Public companies are generally more established and have a longer track record than private companies. This makes it easier to assess their financial health and predict their future performance. Public companies also tend to be more transparent, meaning they disclose more information about their business operations.
However, public companies also come with a few downsides. They’re typically more expensive to invest in, and their stock prices can be more volatile (meaning they can rise and fall quickly). Additionally, they’re subject to more regulation than private companies, which can make it difficult for them to make changes or take risks.
Private Company Startup Investing
When it comes to private companies, there’s more uncertainty around their future performance, because they have less of a track record. Some startups do eventually go public, but others stay private for many years or even indefinitely. This makes it more difficult to know what you’re getting into when you invest in a private company.
On the plus side, private companies are typically cheaper to invest in than public companies. And since they’re not subject to as much regulation, they may have more flexibility to make changes and take risks. Investors also tend to receive distributions (or payouts) from private companies rather than simply relying on stock price appreciation.
So, which is better: public companies or private companies?
That’s a tough question to answer because it depends on your individual investing goals and preferences. If you’re looking for stability and transparency, public companies are a good choice. But if you’re willing to take on more risk and are interested in early-stage startups, then private companies may be a better option – so long as you’re ready to do the research to understand them.
Risks of Startup Investing
Perhaps one of the biggest concerns when investing in any asset class is the risk of losing money. This is certainly true when it comes to startup investing, which can be incredibly volatile and risky.
Take the classic example of Theranos, the blood-testing technology company which was backed by some of Silicon Valley’s top investors. The company was valued at $9 billion in 2014, but it all came crashing down in 2016 after it was revealed that the technology didn’t work as promised. Investors lost millions of dollars on the deal.
Or Jawbone, the promising fitness tracker brand that attracted the attention of investors like Kleiner Perkins Caufield & Byers and Andreessen Horowitz. Despite raising hundreds of millions of dollars, the company was never able to corner its market and ended up filing for bankruptcy in 2017.
Of course, these are incredibly high-profile cases – but considering that 9 in every 10 startups fail, it’s not just Silicon Valley investors who are susceptible to these kinds of losses.
So, what are the risks associated with startup investing?
- Volatility: The biggest risk is that your investment could become volatile – in other words, it could go up and down in value very quickly. This is especially true with early-stage startups, which are often unproven and have no track record.
- Lack of liquidity: Another risk is that you may not be able to sell your investment when you want to. Lack of liquidity means that there’s no market for the investment, meaning you may not be able to sell it at all (or you may have to sell it at a significant discount).
- Lack of information: Without knowing all the facts about a startup, it can be difficult to gauge the risk and potential return of an investment. Early-stage companies aren’t always forthcoming with information, and it can be difficult to get a clear picture of their business.
- Risk of failure: The biggest risk of all is that the startup you invest in could fail completely. Some companies do not set themselves up for success, whether due to poor management, a flawed business model, or simply bad luck. If your investment is in one of these companies, you could lose everything.
So, how can you mitigate these risks?
Mitigating Startup Investing Risks
The old adage to “Never invest more than you can afford to lose” rings especially true for startup investing. In effect, this is the single most important guideline you must adhere to if you want to protect your wealth whenever you’re investing in early-stage companies.
There are, of course, many other important considerations you should keep in mind if you want to mitigate the risks of startup investing. Below, we’ve listed some of the top investment criteria to help manage risk in a startup investment portfolio:
- Think Long-Term: Don’t invest money you need back in the short term. The median time to exit is 8.2 years for an IPO and 5 years for a buyout or M&A, so you should have a long-term outlook when investing in startups.
- Note Original Management: Consider privileging companies that have a dedicated core of founders who have remained with the company since its inception.
A fragmented leadership team with evident turnover could signal managerial disharmony, especially if the company is still in its early stages. Your best bet is to invest in a company that is being run by people who have a long-term vision for the company and are passionate about their product.
- Do Your Homework: Thoroughly research the industry, sector, and market conditions of any startup you’re thinking of investing in. Take note of metrics like burn rate, customer traction, and user growth; if any of these numbers are concerning, it might be wise to steer clear.
- Diversify: Spread your risk by investing in a number of different startups rather than putting all your eggs in one basket. This will help to minimize your exposure to any one company’s potential failure.
It’s also best to avoid singling out one asset or sector as your only focus; if the startup investing market takes a downturn, you’ll be glad you have other holdings to fall back on.
- Use Caution with Early Stage Companies: The majority of startups will fail, so always be cautious when investing in early-stage companies. Remember that these businesses are typically unproven and have a high risk of going under.
- Set Limits: Decide in advance how much you’re willing to lose on any given startup investment and stick to it. This will help keep your emotions from clouding your judgment and ensure that you’re not over-invested in any one company. Otherwise, you may find yourself in a difficult position if things go south.
By following the above tips, you can help minimize the risks of startup investing and safeguard your wealth for the long term.
Online Equity Crowdfunding Platforms
If you have ever invested in a product or idea on Kickstarter or Indiegogo, you have participated in early-stage startup funding – but this is not quite the same as startup investing. With Kickstarter, for example, you are not buying a stake in the company; you are simply pre-ordering a product or service.
However, there are now a number of online platforms that allow people to invest in early-stage startups in exchange for equity. These platforms use crowdfunding techniques to raise money from a large number of investors, and they have the potential to provide entrepreneurs with much-needed capital while giving investors the opportunity to participate in the growth of exciting new businesses.
Pros and Cons of Crowdfunding Investing
There are pros and cons to using online equity crowdfunding platforms. On the plus side, these platforms offer entrepreneurs a way to raise money without giving up equity or control of their company. They also provide investors with an opportunity to invest in early-stage startups, which can be risky but also has the potential for high rewards.
However, there are a few downsides to using these platforms. For one, the process can be time-consuming and complex, so it is not ideal for everyone. Additionally, the success of a crowdfunding campaign depends on how well the company is able to market its product or service, so some startups may have an advantage over others.
Overall, online equity crowdfunding platforms offer a great opportunity for both entrepreneurs and investors. They provide a way for startups to get the capital they need to grow their business, and they give investors the chance to participate in the potential success of some of the most exciting new businesses around.
Choosing a Crowdfunding Platform
There are a number of crowdfunding platforms to choose from, and they each hold appeal for different reasons. Figuring out which one to use can be tricky, but it’s important to do your research in order to make the most of your campaign. Let’s take a look at some of the most popular crowdfunding platforms and their features:
In 2010, AngelList was founded with the goal of helping startups connect with top-tier, high-end investors. Now, however, it allows startups to raise money from a much broader group of people – so you can invest right alongside the top VCs with a low minimum investment of $1,000. This platform has the advantage of a long track record, too.
However, do note that this platform has relatively high fees compared to others (1-2.5% management fee, 0.15% admin fee, 20%+ carry), and only accredited investors can participate.
Not all investors want to spend thousands of dollars right away, and Wefunder caters to that group of people. With a minimum investment of just $100, Wefunder democratizes startup investing and makes it possible for anyone to invest in the next big thing. There are also incredibly low fees (2% – 3.5%) and non-accredited investors are welcome.
The downside is that this platform doesn’t have the same level of prestige as AngelList, so your company might not get as much exposure. There’s also limited history to look back on – so using Wefunder is one of the riskier options.
Having funded over 500 offerings, and with more than $500 million raised, StartEngine is another major player in the crowdfunding space. It has a minimum investment of just $100 and charges a fee of 3.5%. This platform is also open to non-accredited investors.
The main disadvantage of using StartEngine is that it isn’t ideal for people who want a short-term gain – investors can only sell their shares after a one-year holding period.
A common problem with these types of platforms is that they are non-vetted, which can be great for startups but also risky for investors. SeedInvest takes a different approach by only allowing vetted startups and investors to join its platform. This means that there is less risk for investors, but it also limits the number of startups that can raise money through SeedInvest.
SeedInvest is open to both accredited and non-accredited investors and has a minimum investment of $500. It charges a fee of 2%, which is a competitive rate. However, investors should expect to wait around 5-7 years to see a return on their investment.
How To Choose
These are just four of many prominent platforms in the crowdfunding space. When it comes time to choose a platform, it’s important to weigh the pros and cons of each and decide which is the best fit for your startup. Consider the following factors when making your decision:
- Are you accredited? If not, you will need to use a platform like Wefunder or SeedInvest.
- How much money do you want to invest? Some platforms have an incredibly low minimum investment, while others require a higher commitment.
- What is your timeline? It’s important to look at each platform in terms of its holding period – the amount of time you’ll have to wait before you can sell your shares.
- What is your risk tolerance? Choosing a younger platform with less history is a riskier move while using a platform with a longer track record comes with its own set of risks.
Once you’ve answered these questions, you should be able to make an informed decision about which crowdfunding platform is right for you.
Risks of Equity Crowdfunding Sites for Startup Investing
Most startups listed on an equity crowdfunding platform are those that couldn’t secure funding from conventional sources such as venture capital firms or high-net-worth angel investors. This is especially true of tech startups. Therefore, you should naturally proceed with caution whenever you find a tech company listed on one of these platforms.
Investing in IPOs: A Crash Course
When startups or other privately-owned companies have moved through funding rounds A to D, and they reach a point where their valuation has grown so large that it is time to offer shares to the public, the company undergoes an initial public offering (IPO).
An IPO can be a great opportunity for investors. For example, Facebook’s IPO in 2012 raised $16 billion and made many early investors very wealthy.
However, there are also risks associated with investing in IPOs. For one, the stock may not perform as well as expected after the IPO. Additionally, companies that undergo an IPO are subject to greater regulatory scrutiny and must comply with more stringent reporting requirements. For this reason, these types of investments may be better suited for younger investors with long horizons and very high risk tolerances.
Who Can Invest?
It’s important to note that IPOs are not typically open to the general public. Most of the time, the startup’s broker-dealer will only allow certain investors, such as institutional investors and high-net-worth individuals, to participate in the IPO.
The main reason for this is that IPOs are typically very risky investments and are sometimes considered highly asymmetric investments. The company’s management team has a lot of discretion when it comes to how they allocate the shares being offered in the IPO. And if the stock price falls after the IPO, it can be difficult for smaller investors to sell their shares without taking a loss.
What Happens to Common Stock in a Privately Held Company After an IPO?
Many investors are naturally drawn to the big-risk, big-upside potential of early-stage startups. In particular, the prospect of an initial public offering (IPO) is one of the main reasons why startup investors are interested in this type of asset – but as mentioned, not all investors are permitted to invest in IPOs.
Once the company goes public, however, common shares in the company are traded on the open market, and anyone can buy or sell them. This tends to happen fairly quickly, so everyday traders don’t have to wait long to get their hands on some hot new stock.
The thing to remember is that, while common shares may experience a pop on the first day of trading, they may also fall in value if the company doesn’t live up to expectations. It’s important for investors to do their homework before buying into a newly public company.
Do I Need to Be An Accredited Investor to Invest in Startups?
As mentioned in a previous section, accreditation is not essential on certain crowdfunding platforms. Accredited investors are simply labeled this way because they meet particular net worth criteria set by the SEC.
Therefore, if you can find a broker-dealer or a platform that does not require your net worth to meet the SEC criteria, you are free to invest along the following guidelines set out by the SEC.
SEC Guidelines for Non-Accredited Investors
Non-accredited investors must abide by directives set forth by the U.S. Securities and Exchange Commission. These conditions stipulate the extent to which regular retail investors can invest in startup crowdfunding initiatives within a 12-month period.
- For those with an annual income of less than $107,000, you can invest up to the greater of $2,200 or 5% of the lesser of your net worth or annual pre-tax income.
- For those with an annual income of $107,000 or greater, you can invest up to 10% of the lesser of your net worth or annual pre-tax income; this figure cannot exceed $107,000.
Startup Investing, IRAs, and 401(k)s
In the world of investing, there are certain accounts you can use to invest in startups that come with special tax benefits. The two most common types of startup investment accounts are:
- IRAs (Individual Retirement Accounts). These accounts are opened up by the individual investor and can be used to invest in any type of company, not just startups.
- 401(k)s (which are employer-sponsored accounts). These accounts are opened up by the employee and can only be used to invest in certain types of companies, including startups.
Both IRAs and 401(k)s offer tax benefits to the investor. For example, in an IRA, you can invest in a startup and not pay taxes on the profits until you withdraw them from the account. This is a major advantage over investing in a startup through a regular brokerage account, where you would have to pay taxes on any profits you make each year.
The benefits of using a 401(k) to invest in startups are even greater. In a 401(k), you can invest up to $18,000 per year in a startup and not pay any taxes on the profits. This is a huge advantage over investing in a startup through a regular brokerage account, where you would have to pay taxes on any profits you make each year.
How to Invest in Startups Today
Now that you know the basics of startup investing, which method of investing should you choose? Here are your options:
- Angel Investing: Angel investors are individuals or groups who provide money to startup businesses in exchange for a piece of the company. They are often friends or family members of the founders and are typically more forgiving when it comes to potential failures.
- Crowdfunding: As discussed, you can use platforms like AngelList to invest in startups. This is a great way to get started with startup investing, as you can spread your investment across many companies.
- Venture Capital: If you have a lot of money to invest, venture capitalists are the people you want to talk to. They are professional investors who put money into high-risk startups in the hopes of earning a large return.
- 401(k)s: A growing number of 401(k)s offer startup investing as an option. This is a great way to diversify your portfolio and invest in something with high potential returns.
- IRA: If you have opened an IRA account, you can invest in startups through a venture capital firm. This will allow you to spread your investment across several companies and reduce your risk.
No matter which method you choose, it’s important to do your research first. Read up on the companies you’re considering investing in, and make sure you understand the risks involved. Startup investing is a high-risk, high-reward venture, so it’s important to be smart about your choices.
If you’re interested in making a startup investment via IRA, take a look at our self-directed IRA company reviews page to get started.
To invest in startups, you do not need to be accredited. However, there are regulations that limit how much non-accredited investors can invest in a startup.
The set minimum investment will depend on the startup and the stage it is in, as well as the platform or firm you are using to invest. Typically, the investment will be lower when investing in an early-stage startup and increase as the startup grows.
Yes, startup investments are considered high-risk. However, there is potential for high rewards if the startup is successful – so many investors consider the risk worth taking.
When investing in a startup, make sure the team is experienced and has a good track record. Also, look at the product or service the startup offers and how it compares to others in the industry. Finally, be sure to do your research on the startup’s financials.