TL;DR - Unless you can stomach high levels of risk and have loads of experience in early-stage investing, it's probably best to avoid direct involvement in this space.
Over the last couple of weeks, I’ve run into an increasing number of individuals that want to invest in startup companies. Perhaps I shouldn't be surprised since I've been attending a lot of startup and venture events. The truth is, though, it's been a bit startling and even though I don’t usually engage at this level (it's just not in my professional wheelhouse) I wanted to address the question, "Are you sure...?"
But it is intriguing that an increasing number of individuals want to get involved in this space, so I decided to memorialize my views on the subject. Besides, it’s been a while since I posted on this blog and it needs refreshing.
Why invest in startups?
There are a lot of reasons to invest in startups and early-stage companies, but it’s important to recognize that this activity also carries a lot of risk – usually more risk than investing in public markets. Some of the reasons investors choose to put money into startups include the potential returns, a belief in the idea (or product), a strong belief in the founder or team, to make an impact, and to diversify your investments.
However, the risks involved with early-stage investing are considerable and generally fall into three categories: investment risk, security risk, and business risk.
By and large, failure risk is the biggest risk early-stage investors face. When this happens, you can lose your entire investment; this happens more frequently than you imagine. The fact is, the vast majority (up to 90%) of startups fail. There is a vast literature on why this is the case, and we would encourage you to research it carefully before jumping in.
Liquidity risk is another factor you should consider carefully. Even if they are successful, it is likely to be three to seven years before you see a return.
Can you invest in startups?
The first step is to determine whether or not you are an accredited investor or not. An accredited investor meets the following criteria:
Earned income of $200,000 (or $300,000 filing jointly) in either the past two years and expect to do so again in coming years; and
Have a net worth of at least $1,000,000 either individually or jointly with a spouse; or
Hold a financial professional license (Series 7, 65, or 82).
Even if you meet the accredited investor threshold, very few individuals have the resources to manage the investment process on their own. (Keep in mind that the SEC may limit the amount that non-accredited investors can invest in any given year, so you’d be wise to consult with a lawyer before doing anything.) The process – which looks simple but is not - can be summarized as follows:
Sourcing Deals: Finding early-stage entrepreneurs and meetups for up-and-coming tech companies
Due Diligence: vetting company founders, creating financial models, and a thesis for specific companies, industries, or verticals
Financing: How will the financing ultimately take shape, and how will you monitor underlying performance?
Finally, it’s really important to consider what you are bringing to the table in addition to cash. Most startups need more than just money! They also need expertise in specific areas and functions. Can you provide that? Even if you can, this can be an enormous time-suck unless you either have lots of time on your hands, or have a team that can help manage this element of early-stage investing.
This flow chart will help you evaluate if you are ready to invest in start-ups:
If you have never invested directly into startups as an angel investor, we strongly suggest that you consider using a platform as your vehicle for investment. For most people, this is going to be the most appropriate way to access private markets – but keep in mind that you will still be bearing all the risk!
A quick Google search will turn up the platforms with the best SEO, but in our experience, the following list is a good place to start. It isn’t comprehensive by any means and is, quite frankly, very US-centric. While this isn’t an endorsement on my part – I can’t speak for the quality of the platforms or the investments available through them – it’s a good place to start looking:
AngelList – Accredited Investors
Propel(x) – Accredited Investors
Another way to get started is to join an Angel investor group. Most reputable Angel associations require investors to be accredited – but not always, so check with them. A good place to start researching your area or region is the Angel Capital Association. Start here, and work your way through the list.
It’s also possible to invest in startups and early-stage investments indirectly by accessing the public markets. There are a lot of publicly traded funds available to all investors. They are normally categorized as SBICs (Small Business Investment Companies), BDCs (Business Development Companies), and PE firms (Private Equity). Some of the biggest ones out there include Hercules Capital, Horizon Technology Finance Corporation, Apollo Global Management, The Blackstone Group, The Carlyle Group, and KKR & Co. (Note: I am not in any way approving or suggesting you invest in these companies!).
There are heaps of ways for beginners to invest in startups, but it’s not for everyone. You’ll need to consult with your advisors (accounting & legal) before making any decisions, but no matter what you do… be cautious! It can be an immensely rewarding activity, but it can also be extremely risky.