Investing in startups is not for the faint of heart. These businesses are just beginning to develop, and their expenses typically exceed their revenue. In fact, most of them will fail.
But you could find yourself sitting on a goldmine. Case in point: Andy Bechtolsheim, co-founder of Sun Microsystems. He invested about $100,000 in Google just months after founders Larry Page and Sergey Brin created the tech giant in their garage.
Bechtolsheim is now worth about $3 billion. That could be you.
Digital innovation has opened countless doors to startup investment opportunities across the nation and in the local community. But it’s all about pursuing the right idea. And an individual needs to understand the basics of a startup to do that.
At its earliest stage, a startup is a business that is only an idea. It has no market-ready product, customer base or revenue stream, and it is usually funded by its founders or their friends and family. That idea is then researched and developed and tested, ideally with paying customers.
Startups can then pitch their business to angel investors after becoming operational and establishing a revenue stream. These investors provide capital to startups in exchange for equity in the business. Angel funding typically ranges from $100,000 to $1,000,000.
Startups can attract more funding from a venture capital firm if they can demonstrate rapid traction and revenue growth. These firms usually invest several million dollars for a substantial (but minority) equity stake.
Angel investors typically exit their investments when the company is sold to a strategic buyer (a larger company in the industry), or in increasingly rare occasions, through an initial public offering.
So you want to invest in a startup?
Rolling the dice means you’re going to be contributing to job creation and capital formation. And you could get high returns. But there are some things to consider.
The first consideration is wealth. Individuals were once required to have an annual income of at least $200,000 or a minimum net worth of $1 million before investing in a startup. The Securities Exchange Commission established that accreditation rule in 1982.
However, the commission modified that rule in May (based on the 2012 JOBS Act). Now, non-accredited individuals can invest in startups through online crowd-funding sites such as FlashFunders, NextSeed and SeedInvest. However, there are strict limitations.
Before injecting money into a startup, there are some front-end objectives every first-time investor needs to handle. First, you’ll need to consider whether or not you’re seeking a return based on investment or involvement.
After that, you should consider how much money you’re willing to invest over a period of time, because you’ll need to diversify across several startups due to the high failure rates.
Finally, you need to think about your relationship to the company and how you want to be involved. That determines how informed you are.
Know the risks — and rewards
Once you’ve set your objectives, you need to get educated. Part of that education is learning the risks associated with startup investments.
Approximately 500,000 small businesses are started across the nation every year. About half of them fail in the first five years, according to the Small Business Administration.
So the odds of receiving a return are equivalent to flipping a coin. That fact probably leaves you thinking, “Why should I invest in a startup?”
“If you’re disciplined, diversified and patient, angel studies show you can expect to generate a 20-plus percent rate of return on your money, which is roughly double historical returns in the public markets,” said Matt Dunbar, managing director of the Upstate Carolina Angel Network.
Find your investment opportunity
Once educated, you’ll need to find startups to invest in. Online portals not only offer non-accredited investors educational resources but also help them identify eligible startups for investment. Accredited investors can consult an angel network — a professionally managed group of angel investors that sources and structures startup investments and provides educational resources to new investors.
The South Carolina Angel Network operates several groups across the state, including the Upstate Carolina Angel Network in Greenville, the Electric City Angels in Anderson and the Spartanburg Angels in Spartanburg.
“Angel groups allow you to find investment opportunities in or near your local market while giving you a chance to get to know the companies and entrepreneurs much more intimately than a public market investment,” said Dunbar. “Investing in local startups helps attract entrepreneurs who create new jobs and wealth, ultimately improving the quality of life and economic vitality in the community.”
Before investing, you need to evaluate several aspects of the startup: the team, market, technology and business model. These are critical to success.
After you’ve invested in a startup, start looking for another one. Diversifying your portfolio is essential for making money in startups, because so many fail.
“You have to swing at enough good pitches to hit home runs that make up for the strikeouts,” Dunbar said.
Angel investors can add significant value to the startup after investing by using their experience, expertise and connections to help the company succeed. That guidance combined with the entrepreneur’s skill and dedication can attract a buyer.
Once the company exits, the entrepreneurs and investors are then well positioned to create and invest in more startups, building momentum in a virtuous cycle that can have a long-term impact in the community.
4 tips on choosing a startup
Here are some quick tips for startup investing. These tips are general overviews of the vetting process. Ultimately, you should focus on the resourcefulness of the entrepreneurs and look for evidence that the market will buy what the company is selling.
But most importantly, do not invest money you can’t afford to lose.
1. Evaluate the product being offered.
The startup’s product should have some defensible competitive advantage, and its market should be large and growing. Most importantly, you should talk to customers and determine if and why the market will adopt the startup’s product. You should also examine the competition and the startup’s other competitive advantages.
2. Consider the stage of the business and its finances.
You want to choose startups that are ready to enter the market, and you should investigate how it plans to spend your money. And while you can’t rely on five-year projections, you can ensure the startup has a scalable model with attractive unit economics. Also, you need to review the amount being raised and how fast it’s being spent, because the No. 1 job of the startup is not to run out of cash.
3. Pay more attention to the jockey, not the horse.
The startup has to be led by a person with the right skills, motivations and aspirations. The founder should be resourceful, trustworthy, determined, creative and persistent. The entrepreneur’s ability to build the right team is also critical.
4. Examine the structure of the deal.
In order to generate returns commensurate with the risk of investing in a startup, you’ll need to make sure you pay the appropriate price. Startup valuations are an art rather than a science, but you want to structure the investment so as to have the possibility of generating a 50 percent rate of return (to make up for the inevitable strikeouts).
Matt Dunbar contributed to this article. He is the co-founder of the South Carolina Angel Network and managing director of the Upstate Carolina Angel Network.