Before getting into our six tips for investing in startups in 2020, it’s best to dispel a big rumor out there about investing in fledgling businesses:
You don’t need millions of dollars to invest in a startup.
In fact, while there are millionaires and billionaires out there who do invest in startup companies, many investors are just like you and I — average people who are looking to get in on a business you believe in.
One thing to keep in mind: If you’re looking to build your retirement nest egg, investing in a startup company is not the best way to do it. Investing in startups can (and usually is) very risky. It’s a game of high-risk for high-reward.
There are a couple of reasons why you would want to invest in a startup:
- You really believe in the company and what they are doing.
- You believe in the people behind the company.
- You want to help the company achieve its mission — and make some money in the process.
If you are only looking for a way for your money to work for you, startup investing is not the avenue you want to take. Instead, you might consider more traditional investing, like stocks or mutual funds.
You have to keep in mind that a lot of startups fail, hence why if you are looking for retirement income, investing in startups is not for you.
But if you have a passion for a product, a strong belief that the people behind a startup truly have something special and some extra money, then investing in a startup is a good option for you.
Just What Is a Startup Company?
Before we get into how to invest in a startup, it’s a good idea to define just what a startup is.
It’s easy for owners or founders of a company to tell you they are a startup, but it’s not always the case.
Remember, startups are not part of a larger company and a lot of them are tech-related, but not always. They are also founded by a small group of people — former business associates or even friends — who are trying to take their idea to market.
If a company has been around for a couple of years, it’s not likely a startup. They may just be calling themselves that to attract investors.
Now that we have defined a startup, let’s get into our six tips for investing in startups.
1. Look Over the Legal
If you are planning to invest in a startup, it’s likely you’re no spring chicken when it comes to investing. However, regardless of your expertise, one of the biggest things you need to do first, before writing a check or hitting submit buy on your trading account, is look over the legal.
It’s easy to have a big idea if you are a startup, but if your corporate records house isn’t in order, your idea isn’t likely to get off the ground.
As a potential investor, you need to know things like how the company is incorporated, whether the shares are issued correctly and if all the company’s contracts are proper and ratified by a securities attorney.
Just like when investing in stocks, you need to take emotion out of the equation and look at this as if the company is trying to sell you, not that you are already sold on it.
Go into it with an open mind, but be inquisitive and try to get as much of an understanding of the company and its idea as you can before you hand over any money.
Think of it like buying a car or a house. You wouldn’t go into that kind of an investment blind, would you? Investing in a startup is no different. Do your homework and make sure your questions are answered.
That’s why looking over the legal is one of our six tips for investing in startups.
2. Meet the Owners/Founders
Another important thing to consider is that you aren’t just investing in a company when you invest in a startup, but you are investing in its people.
Most importantly, you are investing in the people driving the ship — its owners and/or founders.
You want to make sure those at the top of the company’s culture chain are 100% committed to making it work and are setting a positive tone both inside the company and out.
If they aren’t absolutely in love with their idea or product, how can you expect to be?
As the saying goes, if you don’t love it, don’t buy it. The same can be said here. If you, as the investor, don’t see the love and the passion of the owners of the startup, it’s best to walk away, no matter how much you love it.
You also need to make sure there is (and will be) honesty between the owners and the investors. Giving good news is easy; it’s giving the bad news that’s hard. If the owners/founders aren’t willing to give the bad news along with the good, it presents a trust issue for you, the investor.
That’s why meeting the owners/founders is one of the six tips for investing in startups.
3. Do the Math
Remember, when the owners tell you how much the company is worth, they are pretty much guessing. Some of it could be based on previous sales but a lot of it is based on emotion — how much they want the company to be worth. And remember, always take the emotion out of investing.
For you, it is important to verify what they tell you about the valuation. Is their valuation justified, or is it more pie in the sky? You might be surprised at what you find out.
When you are checking the numbers, it’s also important for you to know what stage of the investment game you’re in with a particular company. Are you one of the first investors or have the owners already raised significant capital? If it’s the latter, you might find investing in the startup a little easier.
In the end, you have to make sure the numbers add up.
That’s why doing the math is one of the six tips for investing in startups.
4. Understand the Risks
Remember when we said investing in startups was risky?
Here are some statistics we came across related to startups:
- Companies raise about three rounds of funding before they get to Series A (TechCrunch).
- Only two in five startups are profitable while one in three breaks even and one in three lose money (Small Business Trends).
- About 90% of startups fail (Failory).
- About 10% of startups fail in their first year (Failory).
- The No. 1 reason for a startup failing is misreading market demand — found in 42% of cases (CBInsights).
- The No. 2 reason for a startup failing is running out of funding and personal money — 29% of cases (CBInsights).
- In 2018, cash flow problems accounted for the reason 82% of businesses failing (Fundera).
We could go on, but the point here is most startups fail and, as an investor, you have to understand that before you invest.
So to be safe, it’s best if you are prepared to lose money when you decide to invest in a startup. It’s kind of like: Hope for the best but expect the worst.
That’s why understanding the risks is one of the six tips for investing in startups.
5. Know When to Walk Away
The key for you, the investor, is to see your way through the weeds to get to the heart of what you are potentially investing in.
There will be some instances where you start by loving a startup, but you find it is overvalued or its management is shoddy.
That’s why it’s important to know when to walk away from a potential startup investment.
If the business or its management doesn’t tick off all of your boxes, or if you get a whiff of something not being right, it’s ok to walk away.
Remember, this is your money we’re talking about and, again, if you don’t love it, don’t buy it.
That’s why knowing when to walk away is one of the six tips for investing in startups.
6. Look into an Online Investing Platform
If you don’t have a friend or family member starting their own business but you want to look for a startup to invest in, there are platforms out there that can help.
Here are websites that specialize in equity crowdfunding and startup fundraising:
- FundersClub — Started as an online venture capital firm in March 2012. They only invest in 1%-2% of the companies they review.
- Seedrs — This is a platform in the United Kingdom that allows three types of investment — equity, funds and convertible notes. Seedrs is not currently investing in U.S.-based companies.
- Wefunder — For as little as $100 you can invest in startups with Wefunder. According to its website, Wefunder has invested in 327 startups with $117 million.
There are many more options, so make sure to research and find one that works for you. Remember to check for any minimums or fees that come along with investing with any of these platforms (essentially, make sure you read the fine print).
These websites can go a long way to helping you find the right startup to invest in, as well as put you in a community of fellow startup investors.
That’s why looking into an online investing platform is one of the six tips for investing in startups.
An Option If You’re Uncomfortable
One possible option would be to make a business loan to the startup company rather than an investment.
A way to make it work for all parties involved is to make the payback based on revenue share — where you are repaid out of the business’ revenue each year.
This way, you are helping the business and limiting some of the risks.
But don’t misunderstand: There is still a risk, but it’s a lot easier to get your money back from a loan than an investment, especially with a startup.
But the key here is you have to be comfortable with the investment or loan because, at the end of the day, it’s your money.
So there are options for investing in a startup.
It’s Not Hard, But You Have to Put in Work
Because of the risk associated with investing in a startup, it is important to have all of your ducks in a row.
From looking over contracts, adding up the numbers and meeting the bosses, there is a lot you need to do before you’re comfortable in investing in a startup company.
You won’t get rich quick and you may not get rich at all, but you are investing because you love the cause, buy into what the company is selling or really believe in the owners of the company.
That’s why it’s important to understand these six tips for investing in a startup.
Want to learn how to invest in an exchange-traded fund? Check out our article on how to invest in an ETF.