What to Know About Investing in Startups
If you are interested in startup investing, there are a few things you should know before we dive into how to invest in startups. From what is a startup to the pros and cons of investing in startups, we have you covered.
What Is a Startup?
A startup is a new or early-stage business that attempts to solve problems through innovative means. They are scalable and created with rapid growth in mind.
Startups are known to be innovative and disruptive. Whether it's technological innovation, business model innovation, operating model innovation, or organizational structure innovation, innovation tends to be at the core of the idea of a startup. Sometimes, startups disrupt entire industries because they are so innovative.
Moreover, startups are scalable. They are able to develop and grow quickly. Startups often focus on finding a repeatable and scalable business model that will allow them to grow at a rapid rate and become profitable. The goal is to find a business model with huge market potential that grows quickly.
Can the Average Person Invest in Startups?
Yes. The average person can invest in startups. And, it is a lot easier today than it was just a few years ago. Prior to the 2016 Jumpstart Our Business Startups (JOBS) Act, there were limited options for the average person to invest in startups. In order to invest in startups prior to 2016, you had to be an accredited investor or invest through a publicly traded fund.
However, the JOBS Act provided the opportunity for the average investor to invest in startups through equity-based crowdfunding, opening an entirely new door for startups to raise capital as well as a new vehicle through which investors can invest in startups.
Why Invest in Startups?
There are a number of reasons that investors choose to invest in startups. Despite considerable risks (that we will talk about next), startups offer tremendous return potentials, an opportunity to invest in ideas and people you believe in, the ability to make an impact, and a great avenue to diversify your investments.
- Potential Returns: Startups provide investors the opportunity to attain exponential returns. While most investments and assets like stocks are limited in their ability to create exponential returns, early investors in successful startups may see rampant returns.
- Belief in an Idea: Some investors invest in startups because they believe in the product or service that the startup is creating. Many people invest in things they want to see in the world, and when they see an idea they think is cool or find something valuable, they will invest in it.
- Belief in a Founder or Team: Many investors invest in startups because of the experience and accomplishments of or a personal connection to a founder or founding team. The majority of early investors in startups are among founders, co-founders, friends, family, and colleagues. These investments aren’t always tied as closely to the strength of the startup's idea but rather to the belief that the startup team will be able to succeed.
- Make an Impact: Other investors invest because they want to make an impact. For this group of investors, making an impact makes them feel good. Maybe they believe in a startup’s mission or vision or its impact on the community, society, or the environment.
- Diversify Your Investments: Investing in startups is also a great way to diversify your investments. As a divestment strategy, you should spread your investment across several startups, or even invest in a startup investment fund.
Risks of Investing in Startups
Investing in startups comes with a long line of risks including investment risks, security risks, and business risks. These risks take many forms: Returns risks, liquidity risks, dilution risks, valuation risks, revenue risks, funding risks, demand risks, growth risks, competition risks, etc. But the biggest risk is the risk of failure.
The reality is that the vast majority of startups fail. When compared to an investment in an established company, where there is a history of revenue and income, the success of a startup frequently depends on whether the startup can find a product-market fit in a large enough market. This is in contrast to an investment in an established company, where there is a track record of revenue and income.
When investing in startups, there is a possibility of losing your entire investment. Approximately 90% of startups fail, so you need to be prepared to lose anything you can invest. If you cannot afford to lose it, you should find a safer alternative for your investment.
Importantly, startup investments are illiquid. In most cases, it takes three to seven years until investors see a return even on investments in successful startups.
Pros and Cons of Investing in Startups
Now that we’ve talked about the risks and rewards of investing in startups, let’s break down the advantages and disadvantages of startup investing:
- Growth Potential — Startup investing provides the opportunity for exponential returns for both founders and early investors. In some cases, investors' returns on early-stage startup investments can be astronomical.
- Diversified Investments — Another advantage of investing in startups is that it allows you to diversify your investments. As a divestment strategy, you should spread your investment across several startups, or even invest in a startup investment fund.
- Tax Benefits — There are also a number of tax benefits available to many startup investors. Under IRC Code Section 1202, Section 1045, and Section 1244 investors may be able to exclude gains on Qualified Small Business Stock (QSBS) (Section 1202), rollover gains on QSBS investments (Section 1045), or write off qualified losses (Section 1244).
- Risk — There is considerable risk in investing in startups, and the earlier you invest, the riskier it is. The fact is that most startups fail. Even startups that reach the scale-up stage fail at staggering rates where 75% of venture-backed businesses never provide a return for investors and 30%-40% of investors lose everything.
- Liquidity — Startup investments also lack liquidity for your investment. It is often difficult (if not impossible) to sell your equity in a startup until the startup reaches an exit event.
- Research and Information Gathering — It can also be difficult to research and gather information to carry out due diligence on startup companies. Compared to publicly traded companies for which there is readily available information, it can take considerable time and effort to research startups where little information is available.
Stages of Startup Investments
Investing can be broken down across several stages of startup funding. These stages are the pre-seed stage, the seed stage, and then on to Series A, B, C, and beyond. The stage a startup is currently in relates to how to invest in startups. While early-stage companies can be invested in as angel investors or through crowdfunding, later funding rounds are often raised from venture capital and private equity companies, and it can be difficult for non-accredited investors to invest in these stages of startup investment.
The “Pre-Seed Stage” refers to the earliest days of a startup before any major funding is raised. At this stage, startups are usually still working on their idea and just beginning to develop their product(s) and/or service(s). The majority of pre-seed funding raised by startups is raised from startup founders' families and friends. However, more and more startup incubators, accelerators, angel investors, and venture capitalists have become increasingly willing to invest in pre-seed ventures hoping to strike gold by investing early.
The “Seed Stage” refers to the stage when startups begin to acquire their first significant investments. Most early-stage capital comes from outside sources, such as family and friends, business loans, angel investors, startup incubators and accelerators, or crowdfunding platforms like SeedInvest, StartEngine, and Wefunder. There are several avenues for the average investor to invest in seed-stage companies including angel investing and crowdfunding.
Following the seed stage, the next stage of funding is known as Series A funding. For investors, "Series A" represents the type of stock they can purchase. Series A funding rounds are primarily funded by angel investors and angel groups, private equity, and venture capital. While only accredited investors and extremely high net-worth individuals can typically directly invest in startups Series A funding rounds, there are several publicly traded startup investment funds that non-accredited investors can invest through.
Series B and Beyond
To keep developing their product or service, bolstering their team, and fueling growth, startups that have already received Series A funding may have to return to fundraising. Series B funding and beyond is typically funded by private equity and venture capital, therefore, like Series A funding, non-accredited investors would typically need to invest in these startups through publicly traded startup investment funds.
Recommended: For more on the stages of a startup, read our article on Stages of Startup Funding.
Ways to Invest in a Startup
There are several ways in which you can invest in a startup, depending on the stage of startup that you want to invest in. Angel investing, crowdfunding, and venture capital all provide opportunities to invest in seed and early-stage companies for both accredited and non-accredited investors.
Investing in Startups as an Angel Investor
One way to invest in startups is as an angel investor. Angel investors are often informal investors, and many of a company’s first angel investors come from the owner’s friends, family, and people that they know.
If you are looking to become an angel investor, look to your own network, or consider beginning to network in your local startup community. Most angel investors source their deals through their own networks.
There are also several online platforms such as AngelList and FundersClub where startups can solicit funds and angel investors can source deals with investments of as little as $1,000. However, most angel investments require that you be an accredited investor.
Investing in Startups through Crowdfunding
The most popular way for the average investor to invest in startups is through crowdfunding. Equity crowdfunding provides investors the opportunity to research and invest in a curated selection of startups and early-stage businesses.
Both accredited investors and nonaccredited investors can participate in equity-based crowdfunding. It is important to note, though, that nonaccredited investors are limited in the amounts that they can invest in startup ventures within a 12-month period.
Many equity-based crowdfunding sites have emerged for investors to explore startups in which to invest. Some of the most popular equity-based crowdfunding sites include SeedInvest, StartEngine, Wefunder, Republic, and MicroVentures.
Investing in Startups Through Venture Capital
Another way to invest in startups is through venture capital. Although most venture capital firms only raise capital from high net worth individuals, endowments, foundations, pension funds, and trusts capable and willing to make significantly large investments, there are opportunities for both accredited and non-accredited investors to invest venture capital in startups.
Some alternatives for the average investor to invest in startups are publicly traded funds such as Small Business Investment Companies (SBIC), Business Development Companies (BDC), and Private Equity (PE) firms. Some of the biggest publicly traded firms in these spaces include:
- Hercules Capital (HTGC)
- Horizon Technology Finance (HRZN)
- Apollo Global Management (APO)
- The Blackstone Group (BX)
- The Carlyle Group (CG)
- KKR & Co. (KKR)
How Much Can You Invest in a Startup?
There are limits to how much the average person can invest in startups. The question really comes down to whether you qualify as an accredited investor or not. Accredited investors are individuals and businesses that are permitted to invest in and trade securities that are not yet registered with the SEC or other financial authorities.
The SEC does not set limits for accredited investors to invest in non-registered securities, such as equity in a startup; however, there are limits on how much a non-accredited investor can invest.
According to the SEC, to qualify as an accredited investor you must have:
- Net worth over $1 million, excluding primary residence (individually or with spouse or partner), and
- Income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years and reasonably expect the same for the current year.
Both accredited and non-accredited investors may be able to start investing in startups with as little as a $10 investment through regulation crowdfunding. Non-accredited investors can also invest in startups by purchasing equity in publicly traded SBIC, BDC, and PE firms.
However, non-accredited investors do face limits on the maximum amount they can invest in securities that are not yet registered with the SEC, such as crowdfunding investments.
According to the SEC:
“If either your annual income or your net worth is less than $107,000, then during any 12-month period, you can invest up to the greater of either $2,200 or 5% of the lesser of your annual income or net worth.
If both your annual income and your net worth are equal to or more than $107,000, then during any 12-month period, you can invest up to 10% of annual income or net worth, whichever is lesser but not to exceed $107,000.”
Keep in mind that how much you can invest and how much you can afford to or should invest in a startup are entirely different questions. It is a good idea to never invest more than you can afford to lose, as, no matter how appealing, startups are risky investments.
How to Choose Startups to Invest In
Choosing startups to invest in should depend on your specific situation, risk preferences, and approach. Experienced startup investors each have their own criteria for choosing startups; however, their most important criteria are the product or service, startup team, market potential, and valuation.
Like any other investment, you should do your own due diligence before making any significant investments in a startup. Consider what you know about the industry or sector that you are considering investing in. Most experts recommend only investing in what you understand.
What do you know about the team? Are the founders and startup team experts in their domain? Do they have previous experience in the industry or sector? Have they founded a previous company, or do they have experience working in other startups?
What is the market potential? Just because a startup is developing an innovative product or service does not mean that a large enough market exists to scale and grow a startup. It is essential for the market potential to be large enough to allow the startup to grow and reach its aspirations.
What is the startup’s valuation? Startup valuation can fluctuate wildly. While established companies are valued highly based on their performance, startup companies do not have a track record by which to value them and often rely on multiples and projections based on early counts or estimates of customers or users. As an investor, you need to pay attention to how attainable you believe the startup’s projections are and compare this to the value and equity you will receive for your investment.
Best Startup Investment Sites
Since the inception of The JOBS Act in 2016, a number of platforms have grown to facilitate equity-based crowdfunding, allowing the average investor to invest in individual startups.
When it comes to investing in startups, several startup investment platforms offer investors the opportunity to research and invest in a curated selection of startups and early-stage businesses.
Here are some of the top equity-based crowdfunding platforms supporting startup investment:
SeedInvest is one of the most popular equity-based crowdfunding sites that allows just about anyone to invest in startups and early-stage companies through Regulation A and Regulation CF crowdfunding offerings.
Startups that make it to the SeedInvest platform are highly scrutinized for potential and viability. According to SeedInvest, fewer than 1% of the startups and early-stage businesses that submit requests to solicit funding on SeedInvest are ultimately approved.
SeedInvest boasts 620,000+ investors in the more than 250 companies that they have successfully helped raise $410 million in capital. SeedInvest does allow companies to set their own minimum investment requirements, which means some larger raises are only open to accredited investors.
SeedInvest also offers an auto-invest feature that lets you diversify across SeedInvest startups. The auto-invest feature does have a minimum investment requirement of $200 and comes with a 2% processing fee each time you invest.
StartEngine is another widely popular equity-based crowdfunding site, allowing both accredited and unaccredited investors to participate in equity-based crowdfunding through Regulation D, Regulation A+, and Regulation CF crowdfunding offerings.
StartEngine requires campaigns to establish a minimum and maximum amount they want to raise. As long as the startup you invest in raises more than the minimum funding goal, it’s able to keep what it raises even if it does not meet its maximum funding goal.
StartEngine has facilitated 760,000+ investors to invest over $500 million in more than 500 companies with investments beginning at as little as $100.
Wefunder is one more popular equity-based crowdfunding site. Wefunder allows both accredited and unaccredited investors to participate in equity-based crowdfunding through Regulation D, Regulation A+, and Regulation CF crowdfunding offerings.
Wefunder is an all-or-nothing platform, meaning that your investment is placed in an escrow account and if the startup you are investing in does not reach its goal, your investments will be returned to you.
With a minimum investment size of $100, the average investor can begin investing in the startup or startups they believe in. To date, 1.5 million+ investors have invested over $501 million in more than 1,900 companies through Wefunder.
Republic offers another option for investing in startups and early-stage companies. Similar to many of the sites mentioned above, Republic allows both accredited and unaccredited investors to participate in equity-based crowdfunding through Regulation D, Regulation A+, and Regulation CF crowdfunding offerings.
Republic also screens companies that it allows to raise capital on the platform. It says that it selects the companies that get approved for the platform based on a four-step screening process and performs due diligence on each company.
Republic has helped facilitate more than $700M in new capital from over 1.5M investors in 600+ deals. Republic also allows companies to set their own minimum funding requirements, with requirements starting as little as $10 (although the typically minimum funding requirement is $50).
Another popular equity-based crowdfunding platform is MicroVentures, allowing accredited and non-accredited investors to invest in startups and early-stage companies for as little as $100. MicroVentures offers opportunities to invest for both accredited and non-accredited investors through primary and secondary investments (for accredited investors) and equity-based Regulation CF and Regulation A crowdfunding.
Similar to other equity-based crowdfunding platforms, MicroVentures also has a highly competitive screening and due diligence process for the startups approved to raise capital on their platform.
MicroVentures has facilitated more than 200,000 investors to invest upwards of $450 million in funding in 900+ deals for startups and early-stage ventures. Republic also allows companies to set their own minimum funding requirements, with requirements starting as little as $10 (although the typically minimum funding requirement is $50).
What is a startup company?
When we hear the word startups, we often think of new companies, but not all new businesses are startups, per se. In the startup community, startups typically refer to new- and early-stage businesses attempting to solve problems through innovative means. They are scalable and are created with rapid growth in mind.
Can anyone invest in startups?
Yes. Anyone 18 years old or older can invest in startups in the United States. The 2016 JOBS Act eased restrictions on non-accredited investors invested in unregistered securities and provides the opportunity for the average investor to invest in startups through equity-based crowdfunding, opening an entirely new door for startups to raise capital as well as a new vehicle through which the average investor can invest in startups.
How much does it cost to invest in startups?
The average person can invest in startups for as little as $10 through regulation crowdfunding or by buying stocks in publicly traded SBICs, BDCs, and Private Equity Firms that provide startup investments.
Are startups a good investment?
While startup investments have the potential to provide exponential returns, investing in startups remains exceptionally risky. Some estimates suggest that fewer than 25% of businesses in their early stages ever produce a profit for their investors. The safest strategy for investing in startups is to diversify your investments across multiple startups or a startup fund.
How much money can you make investing in startups?
Startups provide the opportunity to invest in a company early and potentially see exponential growth. However, investing in startups is exceptionally risky. Remember, more than 90% of startups fail, and even among promising scale-ups that make it as far as Series A funding, only 20%-25% have a successful exit while 30%-40% of investors in scale-ups lose their entire investment.