How to Invest in Startups for Individuals

kid jetpack | investing in startups for individuals

Imagine if you were one of the very first investors in Facebook, Apple or Uber. If this seems crazy,  remember that every company needs startup capital, and individual investors can now participate in startup funding easier than ever.

Investing in startups for individuals now has many options, including online startup companies that match investors with entrepreneurs, angel investing, and venture capital investing through funds.

While, now, almost anyone can legally invest in many of the internet startup companies, there are more options for those with a net worth of $1 million or more to invest in startups, as I’ll explain below.

Investing in startups for individuals is what I’ll be writing about in this post because it is a new and promising alternative investment. That doesn’t happen often!

Startup investing has flourished since 2016 as a result of legislative changes which had a profound affect for both innovative entrepreneurs and alternative investors looking beyond traditional investing in stocks and bonds.

Before you proceed, please be aware that startup investing is high risk due to the extremely high failure rate of startups. This is addressed throughout this article, but I wanted to clarify this early on. Diversification becomes more important than ever with startup investments as I cover in more detail below.

How do Investors Make Money from Startups?

Let’s begin with the most important reason for investing: making money in a way that enhances and provides your desired lifestyle.   So, how do investors make money from investing in startups, exactly?

You may have seen new entrepreneurs getting startup funding through recently popular crowdfunding which gives investors a product or reward, and no return on investment (ROI). This is the structure for many startup investment offerings.

However, equity crowdfunding is alive and well now, along with the other methods below to invest in startups. Equity crowdfunding gives the investor equity (some ownership) in a company while reward based crowdfunding gives a reward, such as a product.

Usually, startup investments are made with the goal of huge capital gains. Sometimes, an income component will be added too, which is ideal for those living off investments. (Click here to read my article on How to Live Off Investments.)

Another option for startup investing is lending, as opposed to equity startup investments. With startup lending, you make a loan to a startup and get paid interest for your loan.

As you can see, there are different ways to make money from startup investing, but the most common goal is to make back your original investment many times over with a nice big capital gain. This is what most startup investors envision.

How to Get Income from Startups

Investors, then, usually choose between investing in startups for high capital appreciation or, less often, for income, by choosing between equity startup investing or making loans to startups. You can equate this to choosing between stocks for growth or bonds for income, only it applies to extremely small companies at a very early stage.

Sometimes, however, there is a combination of income and capital growth. Kevin O’Leary, Mr. Wonderful on Shark Tank, likes to structure deals with an income component.

An example of a startup loan platform that matches investors seeking to make loans with entrepreneurs seeking to get loans is Lending Club. On their website, they have posted interest rates of over 6% to over 27% paid to the lenders, signaling that this is not a low risk investment.

One thing I see that I really like is that Lending Club has evaluated the small businesses seeking loans into investment safety categories. This allows an investor to lower their risk by lending only to lower risk, higher quality businesses. Alternatively, an investor can go for higher yielding, higher risk businesses. (Click Here to Read My Post on Retirement Income Planning.)

I see from their website that IRA investors are allowed for loans through Lending Club, too, but you’d want to confirm this with your CPA or your own research.

Investing in Startups for Beginners

In the past, investing in a private company was illegal unless you were an accredited investor, as defined below. Believe it or not, between 1933 and 2016, it was illegal for non-accredited investors to invest in private companies. (1)

Then the rules changed opening a new opportunity for individual investors.

Finally, after many adaptations of earlier legislation, in 2015, the Securities and Exchange Commission adopted rules that, beginning in May 2016, made it legal for investors with any level of wealth to invest in startups. The name of the law was the JOBS Act. (I know, this doesn’t really make sense as a name for startup investing rules but you’re about to see why the name was chosen.)

JOBS stands for Jumpstarting Our Business Startups, which no congressperson would want to vote against, hence the name.  1.

The JOBS Act changed previous rules and made it easier for companies to raise funds both publicly and privately. This led to the recent rise and availability of equity crowdfunding as we are seeing now.

“Funding portals” that were registered with the government became allowed on the internet. This fueled the birth and subsequent rise of online startup companies that match investors with entrepreneurs.

Limitations for Investing in Startups

In this new legislation, however, there was a limit on the amount an individual could invest in these startup offerings in relation to their net worth or income.

As of this writing, for people with net worth or earnings over $107,000, the limit you can invest is the lesser of 10% of your net worth or 10% of your annual income. You cannot invest more than $107,000 as per Regulation Crowdfunding.  2.

For people earning, or with a net worth under $107,000 the limit is the greater of $2,250 or 5% of your net worth or income.

Even given the limitations, this is still a big break for non-accredited investors who had previously not met the rules to invest in startups, and the entrepreneurs seeking funding.

This new legislation seems to put the responsibility of startup investing more into the hands of investors, and less the government. It also seems, to me, like a good and healthy move to stimulate innovative new products and technology.

Many of the online startup offerings, however, are still only available for accredited investors. In other cases, the number of accepted non accredited investors is limited.

How to Know If You Are an Accredited Investor

All of this means that the first step for investing in startups is for individuals to determine if you are an accredited investor. Knowing this will tell you what your options are for finding startups to invest in beyond your nephew’s app.

♦ Wealth Building Tip ♦ Every investor should know if they are Accredited or Non Accredited. Click To Tweet

In simple terms, if your net worth is over a million dollars excluding your home, you are accredited. But if you’re not a millionaire yet based on net worth, you can also qualify based on your income, as explained below. (Note the power of adding the word “yet” to this statement.)

Here are the official rules the SEC has put in place to determine if you are an accredited investor.

An accredited investor is anyone who has:

  1. Earned income over $200,000 for an individual, or $300,000 with a spouse, in each of the two preceding years, and expects to do the same for the current year

OR

  1. Net worth exceeding $1 million, alone or with a spouse, excluding your primary residence.

These income rules must be met consistently for three years either with a spouse or alone. This means it cannot be met one year with individual income, then the next two years with joint income, unless you got married that year. (3.)

Internet Companies for Investing in Startups for Individuals

Some of the most popular startup investing platforms are listed below.  (I have no affiliation with these companies as of now.)

The fees and rules vary among startup platforms, so do your homework, as always. (But before looking, beware, as I found myself very tempted to invest in a mini golf cart shaped like a surf board at first glance!)

Note that many of the offerings found at the platforms below are only for accredited investors while some are for non accredited investors. The various platforms have different areas of focus and structures, with different minimum investments.

  • WeFunder.com, for example, has a restaurant, brewery and a crop related startup on its home page.
  • StartEngine.com has a vast array of startups on its home page including inventions, vehicles and technology.
  • SeedInvest.com appears to offer startups geared toward science and technology.
  • Indiegogo.com combines startup funding with selling recently launched products.
  • MicroVentures.com offers both early and later stage funding, as well as both debt and equity based funding.
  • Lending Club structures loans to small businesses so investors earn higher than typical interest on their loans.

Note: As of this writing, I have not invested with any of these platforms yet. I have, however, invested in several startup businesses.

Investing in Stocks Vs Startups

Remember that small business startups have a very high failure rate, while, on the other hand, it is extremely rare for a company in the Russell 2000 or S&P 500 stock index to fail.

For this reason, smart investors usually allocate only a very small amount of their investment portfolio to small business startups, and only after they reach a certain level of wealth.

It’s often said that you should only invest money that you can afford to lose into startups.

Remember, too, that you can immediately have access to stock investments if you need money. Granted, most mutual funds take a day to sell, but stocks can be sold instantly.

Startup investing funds can be tied up for years, on the other hand. In other words, publicly traded stocks are highly liquid, while startup investments usually are not highly liquid.

Another major difference between publicly traded stocks and startups is that few startups are profitable at the seed stage. On the other hand, most publicly traded companies are profitable, or at least have been at some stage.

Click Here to Read My Post How to Know If the Stock Market Will Go Up or Down

Why Do Investors Invest in Startups?

If investing in startups is so risky, why do investors put their money here? The lure of high returns is the answer. Research shows that venture capitalists return expectations are around 25-35%, while Angel investors have an expected return of 20 to 25% according to Patriot Software . (4.)

Compare this to the very long term total return of around 10% from passive investing in a stock index like the S&P 500.

While most startups fail, occasionally a startup will deliver returns in the hundreds. Therein lies the reason many more seasoned high net worth investors invest in startups.

What Is the Difference Between a Startup and a Small Business?

Small business is a very broad term. A small business can be a solo entrepreneur making money from running a blog from home, a local business such as a restaurant or service, or a company that has gotten several rounds of funding. Even a company with publicly traded stock can be considered a small company.

Small businesses can be new companies or companies which have been in business for decades.

On the other hand, a startup is usually a newly formed company in need of funds to grow or stay in existence as opposed to an established business.

What Defines a Startup Company?

The term startup is relatively new to the business world. Definitions vary, and even the term startup is somewhat loosely defined. The term startup usually refers to small businesses that plan to get funding and reach a large market.

There are usually only one to three people involved with running startups initially. They often “bootstrap” to get started. Bootstrapping is the term for getting by with little money while working long hours without staff.

Now, however, since crowdfunding has come on the scene startups can get funding without having to bootstrap for long, if at all.

What Is the Difference between Investing in Stocks and Startups?

Startup funding happens very early in the life of a small business at the initial funding. Publicly traded stocks, on the other hand, are offered after a company has gone through several layers of expansion funding and become a big company.

While penny stock investing exists, investing in stocks usually refers to investing in larger, established companies that have gone public. With the rise of passive investing, investing in stocks often these days refers to investing in index funds, usually the S&P 500 index.

While both investing in stocks and startups usually involve buying some level of ownership in the company, the similarities end there for the most part.

How to Invest in Startups

Investors can invest in small businesses at several different levels, depending mostly on the amount they want to invest, and their net worth and or income (nonaccredited or accredited investor). The typical startup funding may happen through several or even all these stages:

  1. Seed capital – Often comes from the owner’s savings, or friends and family
  2. Crowdfunding – Raised from a large market in small amounts
  3. Angel Investing – Raises larger amounts, usually from one investor
  4. Venture Capital – Comes after the initial funding stages
  5. IPO (Initial Public Offering) or purchase by another firm – Some or all the company is publicly owned

Note that nowadays, however, with crowdfunding options available, startups can skip the friends and family funding stage, making it much easier to launch a startup business.

How Does Crowdfunding Work for Investors?

Crowdfunding is when a lot of people invest small amounts of money into a startup or small business at an early stage. The total amount of capital raised varies, but companies can only raise $1.07 million from equity crowdfunding each year due to regulation as of this writing.

Since crowdfunding is done from a large number of investors, online startup companies have been created that accept entrepreneurs to be featured on their website and offer services that allow investors to invest in them.

In other words, these companies connect the entrepreneurs with the investors. Many of these companies also vet the entrepreneurs carefully before allowing them in their portfolio.

Crowdfunding Vs Angel Investing

Before online equity crowdfunding was born, entrepreneurs had to self fund or raise money from friends and family, and then, seek angel investors if they wanted more funding. Angel investing still exists, but equity crowdfunding has given investors and entrepreneurs a new avenue.

Equity crowdfunding raises funds from a large group of individuals while angel investing raises capital from individual investors.

Angel investing often involves some mentor-ship. It’s very unlikely that a crowdfund investor would be a mentor or assist the entrepreneur as an angel investor might.

Also, crowdfunding typically takes many small investments, while angel investing has traditionally been done by a fewer number of investors but with larger investments. As startup investing grows, however, the old model in early stage investing is changing.

Now, angel investing (larger investments) can also be done through some of these internet portals that match investors with entrepreneurs. Gone are the days when you must have a local angel investing group in your home town to be an angel investor. This is yet another exciting evolution taking place due to the internet.

How Does Angel Investing Work?

Angel investors are individual investors, but they sometimes invest as a group.

There are angel investor groups in various cities that meet to allow startups to pitch, evaluate startups opportunities, and support startups on their entrepreneurial journey.

To get a better understanding of angel investor groups, you can check out the Central Texas Angel Network, one of the country’s most active, here.

Fortunately, this angel investing group is in Austin, so I attended some of their meetings as a participant in an Entrepreneurship Launch university program in recent years. This program gave me a broader understanding of both how small business funding works and was also helpful in running our own mini online businesses.

At angel investing organization meetings, much like on Shark Tank, small business owners pitch their companies with the intention to get funding from angel investors. The angel investor group then discusses the pros and cons of the investment, and angel investors can choose to invest or not.

“Family offices” are often represented at angel investor meetings.

A few years back, I had the opportunity to practice pitching my business, and even got a publishing joint venture offer as a result. Pitching your business is not for the faint of heart, and I respect any entrepreneur who has the courage to pitch in front of a group of seemingly smart investors judging you!

Angel Investor Vs Venture Capitalist

The next layer of funding (and investing) often comes from venture capital.

Both angel investing and venture capital have been around for decades, long before the internet startup companies that match investors to small business owners following the JOBS act.

How does angel investing, and venture capital differ?

For starters, angel investing typically occurs before venture capital.

Angel investors are usually accredited investors who provide funding for entrepreneurs, while venture capitalists are usually firms.

Angels make investment decisions based on the founders, the overall business model or idea, and the likelihood of success. Angel investing is sometimes done locally.

Venture capitalists, while focused on the founders also, are also able to scrutinize the financials and metrics since the business has usually existed longer than a business seeking angel funding.

Funding Size for Angel Investors Vs Venture Capital

The average angel investment in mid-2016 was only $33,000, while the average for venture capital deals was almost $12 million as of mid-2016.

According to Business.com, angels invest between $25,000 and $100,000, while venture capitalists invest $7 million in a company on average. (4.) (5.)

As you can see, in general, venture capital deals are much larger than angel investing deals. This is because angel investors fund companies earlier in the development phase than venture capitalists.

Larger companies naturally need more funds to have an impact on their growth. Venture capital deals are still high risk. The companies at this stage may not be profitable but they have revenue. (6.) https://corporatefinanceinstitute.com/resources/careers/jobs/private-equity-vs-venture-capital-vs-angel-seed/

Support from Angel Investors Vs Venture Capitalists

Venture capitalists tend to be more involved in the companies they fund. For example, they help the companies they invest in with strategic planning and recruiting management to help implement that plan.

Angel investors sometimes aid small businesses in which they have invested in more of a mentorship capacity. Unfortunately, this assistance is often done out of necessity rather than desire, however, so that the investors can recoup their investment since many entrepreneurs need help.

♦ Wealth Building Tip – Do thorough research and remember that the rule of thumb for angel investing is to diversify among ten different companies to increase the probabilities of having at least one that is very successful.

Venture Capital Vs Equity Crowdfunding

According to Corporate Finance Institute, seed investments can deliver returns of up to 100x or more of the initial investment when they succeed. Remember, seed investing is the first stage of funding. (6.)

This insane return is offset by the fact that they have a very high failure rate. What an investor must factor in is the rule of thumb that out of ten startup investments, the investment in several will be lost completely for half of them. The goal is to find a few needles in the haystacks, knowing that most seed investments will be lost since most startups fail.

Investing in Individual Startups Via Venture Capital Funds

Rather than investing individually in a group of startups, there are funds that focus on venture capital investments, giving individual investors this option. Some of these venture capital funds are available to non accredited investors, depending on the structure of the fund.

There are two main ways to invest in venture capital funding. The options depend on whether you are an accredited investor or a non accredited investor.

Venture Capital Funds for Accredited Investors

There are venture capital funds that invest directly in the startups, generally structured as LPs (Limited Partnerships). Such funds are for accredited investors only.

According to a post on business.com by expert VC investor Will Jiang, venture capital funds have a fiduciary responsibility to their limited partners, a big advantage. (7.)

Wealth Building Tip – Seek investment opportunities that have a fiduciary responsibility to their clients or investors.

Venture Capital Funds for Non Accredited Investors

There are companies that offer funds that invest in companies which provide venture capital. Such companies don’t invest in startups themselves. Some of these companies are publicly traded.

Since these are public companies, you don’t have to be an accredited investor (or even qualify under the crowdfunding regulations) to invest in these funds. KKR, Blackstone Group and Carlyle Group, for example, are known for offering such funds to individual investors. (8.)

Pros of Venture Capital Funds

Granted, venture capital funding will occur much later than initial startup seed funding, but venture capital funds could align with the goals of some investors wanting to get started easily in startup investing. Also, there can be advantages to early stage investing through a venture capital fund vs individual startups for several reasons.

First, since risk is high investing in startups, a firm can bring a whole team of expert individuals to find and invest in the best small businesses, thereby lowering the risk significantly. Some of the startup companies available online, however, vet the companies in their offerings beforehand, but I assume not to the extent that would take place in a fund.

In a fund, you’ll end up with tiny investments in many different companies. The upside is that this will give you diversification.

The risk of investing with a venture capital fund is also lower simple because the investing is done at a later stage than investing startup seed capital. Once a company gets to the stage of venture capital funding, it has become more established as a business.

Not only this, but with each round of funding, an entrepreneur must prove herself all over again to have a chance of getting investors. This requires continually improving the business throughout all the funding stages.

Investing in Venture Capital Fund Cons

Since venture capital funds invest in many different companies, the upside potential gets watered down when you do get a real winner. It’s a trade off between higher potential gain and lower risk.

Also, the fees can be quite high for venture capital funds.

There could be exit fees if you want to sell your shares in a venture capital fund.

Many venture capital funds are available only to accredited investors so not everyone can invest in them.

Successful funds become huge as soon as the word gets out. It’s hard for funds to find enough companies to invest in. This is true for all funds investing in both small company stocks and startups, but even more so with startups. Just think about a fund trying to invest 500 million or a billion dollars into a large, diversified group of tiny startups. It’s hard to find, evaluate and monitor that many great early stage companies.

Due diligence aside, a savvy individual investor, on the other hand, can easily make investments into startups in the $1,000 to $250,000 range (or more). It takes some work, but this strategy suits some investors, especially those with small business or financial expertise, who enjoy being involved with startups.

Wealth Building Tip – Single investors are nimble, and this is a huge advantage that very few funds can claim.

Also, like most stock related investments, the performance of these funds will be heavily tied to the overall stock market and the economy. This can be an advantage to investors who stay attuned to economic cycles and buy when equity assets are priced cheaply as a whole. This can be a disadvantage to those who make investment decisions without considering the overall market and economic cycles.

While a bad economy hurts almost all companies, a few carefully chosen startups could have an advantage in that it may not be correlated to the overall stock market. This is particularly true with companies with a business model that thrives during bear markets and economic downturns.

A large company example of this is utility companies. As my dad used to say, the last thing to go out are the lights. The revenue for utility companies keep coming in even during bad times.

On the other hand, since equity funds as a whole tend to move with the broad markets as a whole, early stage investing through a venture capital fund could be a disadvantage during economic downturns.  On the other hand, owning a small basket of startups that are non-correlated with the economy could be a real advantage over fund investing during such times.

Click Here to Read My Article How Will a Stock Market Crash Affect You? 

Should You Invest in Startups?

The answer to this question will be based on your own net worth and wealth plan. As stated in the website of one of the startup companies noted above, only invest what you can afford to lose.

The fact is that investing in single startups has extremely high risks.

But stocks drop, too, and companies go bankrupt. This means investing in stocks has risks, too, right?

When compared to investing in stocks vs startups, we have all seen that a stock market index can drop 50 or 60% during a nasty bear market!

But here is the big difference between investing in startups vs public stocks: Almost all the companies that are in the major stock market indexes regain most, if not all their value over time.

Very few medium to large publicly traded companies go bankrupt. On the other hand, the overwhelming majority of startups fail, period. Investors, then, must realize this when putting a portion of their portfolio into startups if they choose to invest there in the same way that stock market investors must accept the reality of bear markets.

Again, the rule of thumb I was taught for investing in individual startups was to diversify among ten companies if you’re going to invest in startups at all. This means that, like most things worth doing, it will take time and effort to research and follow ten companies.

This reminds us once again that there is always a trade off with investing. Higher returns have higher risk.

Does Startup Investing Make Sense?

Think about being a very early investor with any big successful publicly traded company. This unlikely but possible scenario is what draws investors to startups.

At a minimum, with a well researched and diversified portfolio, a startup investor might succeed in choosing at least one highly successful startup with a small portion of an investor’s portfolio.

This can be all it takes to reach financial independence for individual investors with high risk tolerance and patience. Or perhaps a venture capital fund makes sense as an alternative investment in a diversified portfolio.

Since the initial criteria for any investment I make is whether it can be bought undervalued, startup investing interests me. While it has high risk and requires extra due diligence, startup investing is not insane. In other words, it’s not tulip mania, it’s not over leveraged real estate in 2007, and it’s not tech companies with outrageous PE ratios as they were in 2000.

For the most part, it seems that startup investing funds the projects of hard working, highly innovative and motivated individuals doing what company founders have done throughout time. Now, however, these trailblazers can launch their companies without Wall Street, layers of necessary delays and expensive corporate bureaucracy.

And I sort of like things that force us, as investors, to do our own homework. Besides, it levels the playing field just a tiny bit between us and Wall Street.

And, what individual investor can truly get in early on a sound and promising IPO offering anywhere near the opening price anyway?

And now individuals can invest much, much earlier than the IPO stage with the possibility of astounding returns, or at least returns that beat passive index investing, for a prudent portion of their portfolio.

Yes, it is still the wild west of startup investing, but with some seemingly sensible government regulations in place, and without the complexity, hype and inaccessibility of IPO offerings.

Plus, you can assess a startup yourself by answering practical and simple questions like:

  • Does the model make sense?
  • Is the founder qualified?
  • Is the founder a strong leader?
  • Will the product sell?
  • Where will the product sell?
  • Is the product selling now?
  • How much does the product cost to make and deliver?
  • Is the company making money?
  • How much are the expenses relative to the revenue?

These facts are not hidden behind layers and layers of corporate accounting complexities and reports. Early stage investing comes with a small set of books (likely audited by a CPA), that are likely easy to understand. You can probably even ask a question about where any holes may appear and even get real answers from the actual company owner.

I like the idea of investing in startups as an individual investor. I’ll be writing more about startup investing. Stay tuned. Let me know if this interests you in the Comments section below.

Please remember, I don’t recommend any investment, ever. You are responsible for your investments despite what you may have read elsewhere😊

Prosperity and Peace

Camille

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Investing in Startups for Individuals

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Sources:

  1. https://help.wefunder.com/#/getting-started-for-investors/304616-wait-how-is-this-legal
  2. Wikipedia- https://en.wikipedia.org/wiki/Jumpstart_Our_Business_Startups_Act
  3. CNN Business – https://www.cnn.com/2018/09/30/success/startup-invest/index.html
  4. Data compiled by Patriot Software https://www.patriotsoftware.com/accounting/training/blog/venture-capitalist-vs-angel-investor/
  5. Small Business Finance https://www.sba.gov/sites/default/files/Finance-FAQ-2016_WEB.pdf
  6. Corporate Finance Institute – https://corporatefinanceinstitute.com/resources/careers/jobs/private-equity-vs-venture-capital-vs-angel-seed/
  7. Business.com – https://www.business.com/articles/angel-investors-vs-venture-capitalists/
  8. https://www.fool.com/investing/2017/06/05/how-to-invest-in-venture-capital.aspx

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