Investing in Startups 101
The high-speed world of startups, and the risks of investing in them, are well documented, but startup investing can be complicated and there is a lot of information you should know before making your first investment.
This article will try to answer the question “why should you invest in a startup?” by giving you information about the process and what to expect from investing in an early-stage business. If you already know the drill, head on over to StartEngine to see the latest companies raising capital.
Why invest in startups?
Through equity crowdfunding, you can support and invest in startups that you are passionate about. This is different than helping a company raise capital via Kickstarter. You aren’t just buying their product or merch. You are buying a piece of that company. When you invest on StartEngine, you own part of that company, whether it’s one you are a loyal customer of, a local business you want to support, or an idea you believe in.
Investing in startups means that you get to support entrepreneurs and be a part of the entrepreneurial community, which can provide its own level of excitement. You also support the economy and job creation: in fact, startups and small businesses account for 64% of new job creation in the US.
In other words, you are funding the future. And by doing so, you may make money on your investment.
But here’s the bad news: 90% of startups fail. With those odds, you’re more than likely to lose the money you invest in a startup.
However, the 10% of startups that do succeed can provide an outsized return on the initial investment. In fact, when VCs invest, they are looking for only a few “home run” investments to make up for the losses that will compose the majority of their portfolio. Even the pros expect a low batting average when investing in startups.
This is why the concept of diversifying your portfolio is important in the context of startup investing. Statistically, the more startup investments you make, the more likely you are to see better returns through your portfolio. Data collected across 10,000 Angellist portfolios supports this idea. In other words, the old piece of advice “don’t put all your eggs in one basket” holds true when investing in startups.
Who can invest in startups?
Traditionally, startup investing was not available to the general public. Only accredited investors had access to startup investment opportunities. Accredited investors are those who:
- Have made over $200,000 in annual salary for the past two years ($300,000 if combined with a spouse), or
- Have over $1M in net worth, excluding their primary residence
That meant only an estimated 10% of US households had access to these opportunities. Equity crowdfunding changes all of that and levels the playing field. On platforms like StartEngine, anyone over the age of 18 can invest in early-stage companies.
What are you buying?
When you invest in startups, you can invest through different types of securities. Those include:
- Common stock, the simplest form of equity. Common stock, or shares, give you ownership in a company. The more you buy, the greater the percentage of the company you own. If the company grows in value, what you own is worth more, and if it shrinks, what you own is worth less.
- Debt, essentially a loan. You, the investor, purchase promissory notes and become the lender. The company then has to pay back your loan within a predetermined time window with interest.
- Convertible notes, debt that converts into equity. You buy debt from the company and earn interest on that debt until an established maturity date, at which point the debt either converts into equity or is paid back to you in cash.
- SAFEs, a variation of convertible note. SAFEs offer less protection for investors (in fact, we don’t allow them on StartEngine) and include no provisions about cash payout, so you as an investor are dependent upon the SAFE converting into equity, which may or may not occur at some point in the future.
Most of the companies on StartEngine sell a form of equity, so the rest of this article will largely focus on equity investments.
How can a company become successful if they only raise $X?
Startup funding generally works in funding rounds, meaning that a company raises capital several times over the course of their life span. A company just starting out won’t raise $10M because there’s no indication that it would be a good investment. Why would someone invest $10M in something totally unproven?
Instead, that new company may raise a few hundred thousand dollars in order to develop proof-of-concept, make a few initial hires, acquire their first users, or reach any other significant business developments in order to “unlock” the next round of capital.
In essence, with each growth benchmark a company is able to clear, they are able to raise more money to sustain their growth trajectory. In general, each funding round is bigger than the previous round to meet those goals.
When do companies stop raising money? When their revenue reaches a point where the company becomes profitable enough that they no longer need to raise capital to grow at the speed they want to.
What happens to my equity investment if a company raises more money later?
If you invest in an early funding round of a startup and a year or two later that same company is raising more money, what happens to your investment? If things are going well, you will experience what is known as “dilution.” This is a normal process as long as the company is growing.
The shares you own are still yours, but new shares are issued to new buyers in the next funding round. This means that the number of shares you own is now a smaller percentage of the whole, and this is true for everyone who already holds shares, including the company’s founders.
However, this isn’t a problem in itself. If the company is doing well, in the next funding round, the company will have a higher valuation and possibly a different price per share. This means that while you now own a smaller slice of the total pie, the pie is bigger than what it was before, so your shares are worth more than they were previously too. Everybody wins.
If the company isn’t growing though, it leads to what is known as a down round. A down round is when a company raises more capital but at a lower valuation, which can increase the rate of dilution as well as reduce the value of investors’ holdings
How can I make money off a startup investment?
Traditionally, there are two ways investors can “exit” their investment. The first is through a merger/acquisition. If another company acquires the one you invested in, they will often offer a premium to buy your shares and so secure a controlling ownership percentage in the company. Sometimes your shares will be exchanged at dollar value for shares in the acquiring company.
The other traditional form of an exit is if a company does an initial public offering and becomes one of the ~4,000 publicly trading companies in the US. Then an investor can sell their shares on a national exchange.
Those events can take anywhere from 5-10 years to occur. This creates an important difference between startup investing and investing in companies on the public market: the time horizon is different.
When investing in a public company, you can choose to sell that investment at any time. However, startup investments are illiquid, and you may not be able to exit that investment for years.
However, equity crowdfunding can provide an alternative to both of these options: the shares sold through equity crowdfunding are tradable immediately (for Regulation A+) and after one year (for Regulation Crowdfunding) on alternative trading systems (ATS), if the company chooses to quote its shares on an ATS. This theoretically reduces the risk of that investment as well because the longer an investment is locked up, the greater the chance something unpredictable can happen.
Investing in startups is risky, but it is an exciting way to diversify your portfolio and join an entrepreneur’s journey. To discover startup investment opportunities, visit our explore page to see the businesses currently raising capital.
Editor’s note: this article was originally published on March 1, 2019. This article has been updated and expanded to provide more relevant information.