How can I invest in startups if I’m not rich?
For more than a decade, millions of people around the world have tuned into “Shark Tank” to watch as celebrity venture capitalists invest in early-stage companies. If you’re like many, you’ve dreamed of the opportunity to tap into similar investment opportunities.
But can an average Joe who isn’t a celebrity or a multimillionaire become a startup investor?
Believe it or not, you can. More and more average investors are venturing away from the stock market and joining angel investors and venture capitalists in startup investment opportunities.
Can I Invest in a Startup if I’m Not Rich?
Yes, you can invest in a startup, even with only a modest amount of capital. You don’t have to be an accredited investor or high net worth individual to invest in startups anymore, although you did in the past. Today, anyone can invest in private companies, primarily through equity crowdfunding, but the space is still largely dominated by venture capital groups.
Moreover, just because you can invest in these opportunities doesn’t necessarily mean you should.
Most startup companies that the average Joe can access are in extremely early stages. Many of them have nothing more than the idea their hopes and dreams are built on. These investments are very high-risk, high-reward propositions.
How Investing in Startups Became Possible for Everyone
The U.S. Securities and Exchange Commission (SEC) was created just after the Great Depression. Since then, the regulatory agency has been charged with protecting investors, which sometimes feels more like limiting than protecting.
Startups were one of these limitations for decades.
In the past, if you wanted to invest in early-stage companies, you had to be an accredited investor. That means you had to have an income of at least $200,000 per year for two consecutive years or a net worth of at least $1 million.
That all changed in 2012 with the JOBS Act.
Part of the JOBS Act was changing regulations meant to protect smaller investors from making risky investments in small businesses. Under new regulations, individual investors in the United States who are over the age of 18 and have a job can invest in startup companies.
There is one caveat. The amount you can invest annually may be limited. Unless you’re an accredited investor, you can only invest between $2,200 and $107,000 per year in startup companies. The amount is based on your income. The rule was designed to ensure low- and middle-income households don’t bet the mortgage payment on a speculative startup investment.
Notwithstanding these limits, the SEC has significantly increased access to startup investments for investors of all wealth and experience levels.
How Startup Investing Works
When you invest in a startup, you provide the cash flow (or part of the cash flow) the company needs to move into its next stage of growth. In exchange, you receive shares of the company you fund.
The shares act like traditional shares of stock. They represent your ownership of a small percentage of the company and your right to claim against assets in the event of a bankruptcy — that is, if there are any assets left.
Considering how risky these investments are, you should learn everything you can about the company before investing. You should only invest in startups as:
- Diversification Tools. High-risk investments can comfortably fit into just about any investment portfolio, but they should be used as diversification tools, and you should only allocate a small percentage of your portfolio to them.
- Long-Term Investments. Startup shares are generally illiquid. You should only invest money in a startup that you won’t need immediate access to. If things go well, your investment may pay off big time in the long run. Conversely, if things go poorly, you may lose your entire investment.
Here’s how to get started investing in startup companies:
Step #1: Get to Know the Startup Investment Strategy
The first thing you should look for is growth. Sometimes startups haven’t started selling their product or service yet, making sales growth nonexistent. If the company is pre-sales, ask questions to learn about the progress they’ve made since inception.
Consider the results of the work they’ve done in the time the company’s been around. Has the company been growing quickly and working hard to bring its vision to life? Or has it just been sitting around hoping to collect investment dollars?
You also want to consider value. It’s hard to pinpoint a fair market valuation on companies that are in the early stages, so you need to be a haggler.
Don’t just give the startup the valuation it’s asking for. Consider the size of the market, the amount of competition, and how much of the market the company is likely to capture, and use that information to come up with a valuation you’re comfortable with. Then negotiate with the startup to try and get as close to that number as possible, but don’t fold. You can do so by reaching out to the owners of the business and making an offer you think is reasonable.
Remember, you’re the one taking the risk here, and the risk is significant in most cases. So, you need a low-valuation entrance to make the risk worthwhile.
Step #2: Determine How Much You Can Invest
Startup investments are high-risk and should be part of a well-balanced portfolio rather than your entire investment portfolio. Considering this, an effective rule of thumb to follow is that you should never invest more than 5% of your portfolio’s value in a single high-risk investment or group of high-risk investments.
Don’t worry, even if you only have $50 to invest in a startup, there are opportunities out there for you. We’ll touch on those a bit later.
Step #3: Find Investment Opportunities
Let’s face it, startup owners don’t go knocking door to door and giving presentations worthy of “Shark Tank.” Instead, you’ll have to do a little digging for opportunities.
One option is to consider reaching out to friends and family members to find startup businesses in need of funding in your area. Doing so means you’ll be investing in your local community without third party involvement that usually comes with fees.
If you have under $5,000 to invest, however, you’ll likely need to use an equity crowdfunding website. Equity crowdfunding platforms securitize startups and sell shares to multiple members of the investing community. Although it may be more difficult to haggle the valuation of a startup down when you go this route, it’s easier to find a diverse group of opportunities.
Step #4: Do Your Due Diligence
Chances are there’s not going to be much information online about the startup you’re considering investing in. However, business owners know their business and can help you understand what they have going on.
If you’ve found a startup in your area, you’re one step ahead. You likely already have direct access to the founder or management team. However, most equity crowdfunding platforms offer a way to connect with the business to ask questions. Ask as many as you can think of and form a complete understanding of the business before you invest.
Moreover, due diligence isn’t just about the business and business model. It also includes gaining an understanding of the market the company is part of.
Do some research to determine how big the market is and how much competition the company faces. The goal is to find a mass-market product or service with little competition. If the market is small, the business won’t earn enough money to make the investment worth it. If it’s already saturated with competition, chances are the company you back will never make it through the weeds to become a leader.
You’re looking for a needle in a haystack that addresses a massive market with a unique product nobody can compete with.
Step #5: Make Your Investment
You’ll likely have to go through the steps above several times before you land on a company you believe has significant potential at a discounted valuation, but they’re out there. Once you’ve found your needle in a haystack, make your investment.
If you’re working with an equity crowdfunding company, the process is simple. Submit payment and receive shares.
The process is more involved when working directly with the startup you’re investing in. Never just hand cash over on someone’s word that you own a piece of the company. Make sure you’re working with someone who’s a registered representative of the company and that everything you agree on is put in writing.
For example, if you’re investing $1,000 for a 1% stake in the company, you should ensure these details of the deal are included in a written agreement. If you’ve attached a royalty to the deal, your royalty payments should also be clearly stated in the contract.
Even if you’re working with a family member or friend, get everything in writing. Humans aren’t equipped with the best memories, and disagreement over money has a history of getting between loved ones. A written agreement could save your investment and your relationships.
Pros & Cons of Startup Investing
Startup investing is exciting. If it wasn’t, millions of people wouldn’t tune into a television show about it to watch the art of negotiation. As exciting as it might be, there are a few drawbacks you should carefully consider before you invest.
There are several benefits of investing in early-stage companies, aside from the sheer excitement of becoming a small-scale Mr. Wonderful. You can help make someone’s dreams come true while you make your retirement more comfortable.
- An IPO Could Make You Rich. If the startup you back early on makes it to an initial public offering or is acquired by a larger company, your original investment will likely seem like peanuts compared to the valuation of the company at this stage. Successful startup investments could turn thousands of dollars into hundreds of thousands or even millions of dollars over the long run.
- Portfolio Diversification. A well-diversified investment portfolio includes assets of all risk levels. High-risk investments take a smaller allocation. Nonetheless, high-risk, high-reward investments are a healthy part of a quality investment portfolio.
- Extremely Low Valuations. Most startup companies you invest in won’t have very much to show by way of sales or earnings. That huge risk is generally reflected by a seriously low valuation, which is often discounted, giving you plenty of room for long-run growth.
- The Feel-Good Effect. Startup investors are often called angel investors because they’re the angels that keep small businesses alive through growing pains. When you make a startup investment, you’re supporting small businesses, helping someone’s dreams come true, and helping the economy.
OK, it’s great to feel like an angel and even better to make money doing it, but it’s not all sunshine and rainbows in the startup arena. There are also significant drawbacks to consider.
- Many Startups Fail. Early-stage startups are extremely risky businesses. According to EmBroker, about 90% of startups fail. You may never see a return on investment, or worse, you could lose your entire investment.
- Illiquid Investments. Liquidity refers to how quickly you can turn an asset into cash. Stocks of publicly traded companies are generally highly liquid assets because there’s just about always someone ready to buy them from you. However, there are far fewer buyers for risky startups. In most cases, you won’t be able to exit your investment until it matures, making it more of an all-or-nothing binary investment. That means you’ll have to wait to find out if the company goes belly up or makes it to the big time.
- Little Historical Data to Rely On. Startups are young, private companies, meaning there’s little historical data to base your investment decisions on. Instead, you have to rely on your understanding of the company, what the business owner or management tells you, and data from the wider market.
- Did We Mention the Failure Rate? Not to sound repetitive, but it’s important that this sinks in. Nine out of 10 startups fail. That means if you blindly buy 100 startup companies, only 10 will ever make it far enough to pay you any money back; the rest will be busts. Never invest money in startups that you can’t afford to lose. Research is more important than ever when making these investments.
How the Average Person Can Invest in Startups
Once you know the risks, you’re confident in your ability to research and understand the business and the market it services, and you’re ready to get started, here’s how to invest in startup companies:
Ways to Invest in a Startup
First, you’ll have to decide which of three ways you’ll make your investment. You can invest through a private equity fund, an equity crowdfunding platform, or an angel investing group.
Private Equity Funds
Private equity funds work like mutual funds. They’re funds that pool money from a large group of investors to make investments in multiple private companies, generally startups. When you buy shares in a private equity fund, you own a small percentage of every investment the fund makes.
This is the easiest way to invest in early-stage companies because the private equity fund makes all the investment decisions for you.
Equity Crowdfunding Platforms
Equity crowdfunding platforms also pool money from large groups of investors to make investments in startups, but the fundraising process is a bit different. When you work with a crowdfunding platform, you make your own investment decisions, choosing which investments you want to participate in.
Crowdfunding platforms tend to come with low minimum investments, so you can make a startup investment with as little as $50 in some cases.
Some of the most popular equity crowdfunding investment platforms are SeedInvest, Wefunder, StartEngine, and Fundable.
Angel Investing Groups
You can also choose to invest with an angel investing group, but be prepared for large minimum investments. In most cases, you’ll have to shell out at least $5,000 to get started, but there are some rare exceptions to the rule. Some of the most popular angel investing groups include AngelList, Tech Coast Angels, and Golden Seeds.
How to Decide Which Startup to Invest in
Now that you know where you’re going to invest, it’s time to pick the investments you want to make. If you’re working with a private equity fund, you don’t have to pick the startups you invest in; the experts make the investment decisions for you.
Otherwise, if you’re selecting startup companies to invest in, look for:
- Growth. Consider how long it’s been since the entrepreneur started the business and how much the business has grown since its inception. It may not be profitable, but it may already have a product awaiting manufacturing runs, intellectual property, and a plan for commercialization.
- Valuation. You should always get a low valuation when you invest in a startup. Keep in mind that you’re taking substantial risks with your money. You should be compensated for those risks through a discounted valuation.
- Market Size and Competition. Look into the size of the market the company plans on entering and the competition in that market. If the market is too small or the competition’s too steep, there’s a strong chance the company will fail.
- Business Model. Research the company’s business model. Does it seem like the company is on the right track to success? If not, it’s time to turn and run.
There’s no question that investing in early-stage businesses is risky, but a single investment in the next Facebook, Tesla, or Google could make you a very wealthy person.
The key here is realism.
Be realistic about the risks and don’t invest anything you can’t afford to lose. Also, be honest with yourself about the company you back. It’s easy to get excited about the next best product or service and fail to do your research to find there’s already tons of competition.
However, being honest with yourself about the risks will help ensure you do the required research to make educated investment decisions.