How to Invest in Start-Ups

How to Put a Small Investment to Work with an Entrepreneur

How to Invest in Start-Ups
October 6, 2014

Perhaps you are intrigued by the thrill of investing in a start-up company and watching it grow into a thriving enterprise. Or, maybe you think start-ups represent interesting high-risk, high-return opportunities. How do you go about investing in them?

First, you need to meet a set of wealth criteria to become registered as an accredited investor with the SEC – for now.

The 2011 Dodd-Frank legislation adjusted the accredited investor criteria to a minimum of $200,000 in income in the last two years ($300,000 for couples) and expectation for that to continue in the current year, or a net worth of over $1 million excluding the value of a primary residence. This is designed to ensure that investors dealing in startups and other unregulated investments are capable of handling potential losses.

What about crowdfunding sites like Kickstarter and Indiegogo where you can contribute as much or as little as you want? Sorry – as of this writing, equity crowdfunding is not allowed at these sites. Although the 2012 JOBS act approves this activity, the SEC must write the rules for this new form of equity funding. They have released proposed rules, but they are still dragging their feet on finalized rules. For now, you will need to go the accredited investor route.

However, there are plenty of websites that allow you to do the same sort of crowdfunding as an accredited investor. Sites such as AngelList, Funders Club, Wefunder, and Rock the Post allow you to browse potential investments online, research them, invest in them, and acquire regular feedback on performance.

The sites vary in fees, format, and the degree of assistance they provide. Some are clearly targeting the smaller investor in anticipation of the JOBS act final rules; others focus more on the accredited investor. It is also possible to learn about specific startups through friends, associates, and by performing investment research in the traditional and online financial press.

Regardless of your preferred mode of finding candidate companies, it is vital to dig deeply into each prospective start-up before investing. Here are some guidelines for that process:

  • Do your Research – A startup needs more than just an excellent idea. Many great ideas are impractical or uneconomical to produce and difficult to monetize.

    Get the details on any startup in which you plan to invest. Understand the structure, and stick with LLCs to avoid personal liability concerns. Review the business, financial, and marketing plans, as well as their market analysis. How do they plan to break into the market, or are they pitching disruptive technology?

  • Look at the people behind the company. Do they have sufficient experience and skills along with a record of success? Are they diverse or all concentrated in one field (i.e. all technical and little financial expertise)? Have they anticipated and addressed challenges in their plans or is it all pie-in-the-sky optimism?
  • Invest in What You Know – Stick with fields that you know and understand so you can cut through irrational optimism and ask tough questions.

    You may want to check out any local startup incubators through universities of business consortia that may provide better insight into good investments. Investing in a successful local startup is a delightful bonus.

  • Remember the Risk – The vast majority of start-ups fail, so treat this money as a high-risk component of your portfolio, perhaps just above lottery tickets. If you cannot afford to lose it or may need short or intermediate-term access to it, don’t invest it. Diversify your startup investment holding to the extent you can and maintain the above criteria. Spread the risk around.

  • Set an Exit Strategy – As the old joke goes, if you don’t know where you are going, how do you know when you’re there? Think ahead to your eventual exit strategy.

  • Unless the company goes public with an IPO or is acquired, your exit options are limited. Set a reasonable time horizon for this investment, and perhaps a return level at which point you want to begin looking for buyers.

Even if you do not qualify as an accredited investor now, you may want to look over the crowdfunding sites. If the SEC follows through, you may be able to be an angel investor with as little as 100 to 1,000 dollars – and perhaps you can help fund the next Google or Facebook.

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