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How to Invest in Startups and Does it Make Sense?

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how to invest in startups

Investing in innovative companies can be tough to do through the stock market. By the time a company has an initial public offering (IPO), the company has already gone through a huge growth spurt. Even well-known household names such as Peloton (PTON) and Airbnb (ABNB) have struggled to increase in value since going public.

To capture financial upside from innovators like these, investors needed to invest much earlier than an IPO. They need to invest when these companies are startups. 

Startup investing certainly offers financial upside, but it comes with unique risks and low liquidity that make it largely unsuitable for most investors. If you’re curious about what it takes to invest in a startup, here’s what you need to know.

Table of Contents
Startups As An Asset Class
How to Invest in Startups
Startup Investing Pros and Cons
When to Avoid Startup Investing
Final Thoughts

Startups As An Asset Class

Startup investing could mean anything from giving your kid $20 to start a lemonade stand to investing millions of dollars in a company that’s seeking late stage funding. Typically, hedge funds and private equity firms that do a lot of startup investing call it venture capital investing.

Thanks to new online platforms, venture capital investing has opened up to regular investors in the past ten years. However, hedge funds and venture capital firms still do the lion’s share of venture capital investing in the United States.

For these institutional investors, venture capital investments has been one of the top performing asset classes year in and year out. Its performance has nearly matched the S&P 500 which experienced one of the longest bull markets ever, until recently. Much of the return in these asset classes comes from the top-performing companies that achieve returns of 5X, 10X, and even higher. 

But startup investing isn’t all rainbows and unicorns. Unicorn is actually a term used to describe a startup that becomes worth more than $1 billion. Startup investing involves the risk of loss, incredibly long holding periods, and no way to cash out early. Because the investments are so risky, many venture capital websites only allow accredited investors to invest. 

If you’re interested in startup investing, it's important to carefully weigh how startups could fit into your overall investment portfolio. They are certainly not the right vehicle to hold money that needs quick access.

How to Invest in Startups

If you have a direct connection to a startup company, you may be able to invest using your personal connections. These connections typically get you into investments earlier, with less capital and less costs (since you're typically direct), and have the most upside potential. But they are also the riskiest - the earlier you invest in a company, the more likely the company is to fail.

Otherwise, you're likely limited to investing via online platforms. Serious venture capital investors should consider using multiple online platforms for their investments. Or, should probably work with a venture capital fund.

If you want to be a part of existing deals, new platforms are making it easier. Of the companies listed below, AngelList is the largest and the friendliest to diversifying startup investments. However, future unicorns or companies that reach a $1 billion valuation, may seek funding on any of these sites. Keep in mind there are other sites as well. You can read our reviews of these sites.

  • AngelList
  • SeedInvest
  • Propel(X)
  • Equitybee

Startup Investing Pros and Cons

The Pros

Opportunity for outsized returns. Few investments offer as much upside potential as startup investing. An index fund investment that returns 10% per year will double in a little over seven years. During that seven years a unicorn investment may be 5X to 10X in value. Some even produce larger returns.

Contribute to a more innovative economy. Startup companies are often some of the most innovative companies on the planet and aim to solve some of life’s thorniest problems. As a venture capital investor, you can invest directly in companies that are creating tech that will become ubiquitous in under a decade, solving supply chain issues, reducing fossil fuel dependencies, or developing life-saving technologies. 

Invest in people you believe in. Some angel investors focus less on a startup’s aspirations and more on the people who lead the startup. As an angel investor, you can invest directly in the people that you think are most likely to make positive changes and produce economic returns. This can be a particularly compelling reason to invest if you have a personal connection to a startup founder.

The Cons

Startups are risky. Investing in startups is a risky business. Plenty of startups fail to launch. They run out of money before they manage to find a market for their product or service. Others create an amazing product, but larger competitors manage to squeeze them out of the market. Venture capital investors have to be okay with seeing deals go to zero. 

Illiquid investments. According to AngelList, most startups have a seven- to 10-year holding period before they have an exit event. The money you invest in startups could be locked up for a decade or more. Typically investors have no way to access their invested funds, even if they need the money.

You may lack the skills needed to invest in the startup space. When it comes to investing, it's often better to be lucky than good. That being said, startup investing involves taking calculated risks on companies that may not have a clear path to profitability. 

Figuring out how to evaluate these companies involves both luck and skill. You might be overly bullish on certain types of companies, only to find out a decade later that they were all duds. Investors who don’t have experience in the venture capital world may find that they don’t have a knack for identifying profitable companies.

When to Avoid Startup Investing

You need the money soon. Startups typically take seven to ten years to see a return. But some take more time, and some never produce a return at all. It’s best to think of venture capital investments as completely locked up. You won’t be able to get your money back if you have regrets.

You’re not prepared to lose it all. Venture Capital Investing has a huge range of possible outcomes. This visualization from AngelList shows just how diverse outcomes can be. Over time, some investors see triple digit returns year after year, while others may lose money. Even using a startup investment fund is no guarantee that you’ll see positive returns. If you’re not prepared to lose all your money, you’re not prepared to invest in startups.

You’re not taking care of retirement investments. As an investor, you might have a huge appetite for risk, and a willingness to lose all your money. But startup investing isn’t a replacement for prudent financial management. 

Final Thoughts

You should still be intentional about saving for an emergency fund, paying off high interest debt, and investing in stocks and bonds for retirement. With a strong financial foundation in place, you’ll be in a much better place to be able to take risks.

The post How To Invest In Startups (And Does It Make Sense) appeared first on The College Investor.

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By: Hannah Rounds
Title: How To Invest In Startups (And Does It Make Sense)
Sourced From: thecollegeinvestor.com/40096/invest-in-startups/
Published Date: Mon, 20 Jun 2022 07:15:00 +0000

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