Introduction to Investing In Startups
Many of us have heard incredible stories of startup founders who rode the wave of their company’s success to impressive financial returns. And perhaps you have wondered, “If only I had been able to co-invest with Steve Jobs in the early days of Apple, or with Jeff Bezos when he started Amazon, how different would my life be right now?”
Well, while you may have missed the boat in the past, there is still hope. Platforms such as Propel(x) offer accredited investors the opportunity to invest in high-quality science and technology startups, so that you do not miss the next opportunity.
That is not to say that every tech startup is a success because it is not. For every success story, there are multiple failures, so it is critical to set yourself up for potential success when deciding to invest in startups.
This blog post aims to educate accredited investors about the why, what, who and how of investing in startups.
Why invest in startups?
As an investor, it is essential to understand your specific goals and risk appetite before making an investment decision. It is the same when it comes to investing in startups. So, why should you invest in startups?
Key considerations include:
- Diversifying your portfolio – the old saying of “Don’t put all your eggs in one basket” is very appropriate here. It is essential to spread your investment funds across different asset classes, and preferably those that are uncorrelated with the public market. Investing in startups and venture capital offers that opportunity to investors. The potential for higher financial returns with startups is genuine (but on the flip side, so is the potential for losses). A promising startup operating in a potentially lucrative sector with a talented management team and backed by a brilliant and unique idea, product, intellectual property, and potential exit strategy can return profits to investors at significant multiples of the original investment.
- Startup performance does not necessarily correlate with the financial returns of the broader markets, so having startups in your investment portfolio means you have some diversification and protection built into your investment portfolio. For example, if a startup has a competitive edge in its field and executes well on the go-to-market and customer acquisition strategy, the startup may outperform the market thus potentially returning a significant alpha to its early-stage investors.
- These days, the term ‘impact investing’ is becoming very popular. Impact investing is where investors can direct their funds to startups operating in meaningful areas such as quantum computing, healthcare, transportation, and sustainability. The investment goal in this case serves a dual purpose – to deliver potential financial returns to investors and create the potential for real social and environmental benefits at the same time. Investors can make a choice based on their personal alignment with a startup’s cultural values and mission of the company.
How to decide where to invest? – Choose an industry sector
Startups operate in a wide range of industry sectors. Choosing a sector with the appropriate balance between risk and reward is an important consideration that goes beyond the scope of this simple guide but is a vital part of your due diligence. Startups leveraging advances in science and technology across sectors present an opportunity for investors because of the potential for growth, the inherent value of their typically significant intellectual property and their potential to have an impact beyond just monetary returns.
Is startup investing right for you? – Know your investment risk profile
Investing in startups is not for the faint-hearted or the impatient. Startup investing is highly volatile, and financial returns can take many years and you can lose your entire investment. It is essential to understand your personal risk profile and resilience before deciding to invest in startups.
Startup investing is also usually highly illiquid, even less liquid than real estate, and you are putting your hard-earned money into a very early and unproven venture. When it comes to science and technology startups, the timelines are long, and financial returns, if any, can come a long way down the line. If any of these things keep you up at night, angel investing may not be the right investment option for you.
Will I get fixed returns on my investment? – Illiquidity
Shares in a company listed on a stock market, such as the New York Stock Exchange, can be publicly traded without limitation on the investor’s financial position. This is because the company has registered and fulfilled its obligations with the financial regulator in that country, such as the Securities and Exchange Commission (SEC) in the United States.
Startups are different – they are typically privately held and not listed on any exchange. Therefore, once you make the investment, you are stuck with it till there is a ‘liquidity event’ i.e., the startup is bought by a larger company or, if the startup goes public. Of course, there is a possibility that neither may happen, and the startup may simply shut down without ever returning any money to investors.
Who can invest in startups? – Accredited Investors
Because startups carry many risks, so for the most part, only accredited investors with sufficient knowledge, experience, and financial resources have the ability to invest in them directly. An accredited investor must meet minimum income and net worth requirements as described by the SEC.
With the adoption of the JOBS Act in 2012, unaccredited investors gained greater access to private investment opportunities via crowdfunding platforms.
How to invest in startups
There are four critical components of investing in startups, as outlined below:
1. Sourcing Deals
Knowing where to find high-quality, curated deals is the first piece of the puzzle. If you are new to angel investing, finding promising investment opportunities can be a significant obstacle. Accessing “quality deal flow” is a vital first step to establish yourself as an angel investor.
‘Deal ﬂow’ refers to the rate at which angel investors receive business proposals. The first level goal is to develop quality deal ﬂow because this represents inbound proposals from startups that can generate potentially above-average returns for their investors.
In the past, quality deals were hard to find if you were not connected to the key players in the network or based out of a location such as Silicon Valley or New York. However, in recent times, finding quality deal ﬂow has become much easier through early stage access provided by online investing platforms such as Propel(x).
2. Evaluating deals
Once a potential deal has been sourced, it is critical to identify the risks and evaluate the potential opportunities so that an informed decision can be made on the industry sector as well as the company. This process is called “due diligence.” Strategies and techniques for due diligence will vary between investors, and it is crucial to find an approach that works for you because all of us have different investing goals and risk appetite.
There are various resources available online to do due diligence on startups. Propel(x) does due diligence for its listed startups by evaluating the following areas:
- Market Risk: To evaluate the market size and potential for growth, identify the number of people or companies that would be willing to pay for the startup’s technology or product.
- Competitive Risk: It is essential to understand the startup’s competitive landscape and the barriers to entry.
- Technology Risk: There have been famous cases such as Theranos (which turned into a $700m horror show) where initial claims were made that were later proven false. Technology risks are often higher in science and technology startups than in other sectors, making it all the more important to verify the technology developed by a startup.
- Regulatory Risk: Evaluating whether the technology is in a highly regulated area such as pharmaceuticals or financial services is an important consideration. There may be many regulatory and compliance hurdles that could be barriers to market entry and could add significant time before the start up has a product that it can bring to market.
- Intellectual Property (IP) Risk: Understanding the startup’s intellectual property (IP) and the intellectual property’s specific ownership is critical. For example, the IP may rest with the inventor, or a patent may be named an associated entity that is not owned or controlled by the startup. There could be a complex IP licensing arrangement that affects the controlling interest. There is no guarantee that the company will be able to secure patents for its products or technology.
- Execution and Exit Potential: The saying “bet on the jockey, not the horse” refers to a heavy focus on the management team and leadership rather than the business idea or technology because a high-quality management team is often the most critical investment criterion. Further, a realistic, well-planned, and strategic exit plan is a must in order for investors to see a potential financial return.
Disclaimer: These are a few of the key risk areas that Propel(x) looks at. This list is not exhaustive and does not include all of the risks associated with startups. It is very important that you conduct your independent due diligence on every opportunity, to make sure that you understand all of the risks of the specific investment, before making an investment decision.
Here are a few more blog posts on due diligence which you may find helpful before making your first investment.
- The Importance of Due Diligence when Investing in Startups
- Conducting Diligence on Deep Technology Startups
3. Making the investment
Once you have made a decision, the next step is to decide how much you can afford to invest and then structure the investment. The main options are outlined below:
- Direct Personal Investment: This is a high-value investment with direct engagement and involvement with the company and a minimum investment typically around $25,000; or
- Syndicates: Syndicates make angel investing accessible for more people by lowering the minimum investment, where people join forces and pool their money to invest with others. Propel(x) syndicate minimums are $5,000 per investment
You can fund your investment through various sources:
- Joint Investment Account: This is where you invest with a co-signer;
- Trust: Trusts are often used for investments because they allow for generational wealth, where the trust, not an individual, makes and holds the investment;
- Individual Retirement Account (IRA): It can be complex but possible to structure a startup investment using an IRA, which can have significant tax benefits.
4. Monitoring the investment deal until exit
Startup investments are not “set-and-forget”. Investing your funds in a startup means taking responsibility, following the company for updates and keeping track of what they are doing with your money.
Knowing the company’s potential exit strategy and the opportunity for a potential liquidity event allows you to be ready for action when the time comes. For example, attending shareholder meetings is an opportunity to gain direct access to the key players in the company.
When investing via platforms such as Propel(x), monitoring a deal until exit, if any, is taken care of because you will receive continuous updates from the startup founders directly.
Research, research, research.
The first step for investing in startups is doing your due diligence as a whole and then on specific startups to ensure your money is invested wisely. Utilizing an alternative investment platform which offers a high-quality, curated deal flow of vetted investment opportunities significantly cuts down your research time. Propel(x) offers free resources such as Angel Resources and our blog. If you are curious to see which startups are currently looking for investments, you can create a free account on Propel(x) and kickstart your investment journey with us!
Private Placements are a high-risk investment, and an investor could experience an entire loss of principal. Private investments are highly illiquid and risky and are not suitable for all investors. Investments in early-stage private companies should only be part of your overall investment portfolio.
Past performance is not a guarantee of future performance. There is no guarantee that any exit strategy will come to pass and there is no guarantee that an investment will be profitable.
This blog post was originally published on July 9, 2021 and was updated on April 7, 2022.