When you invest money in a startup, you essentially get equity in exchange of capital. The equity you hold comes in the form of partial ownership of the company. If and when the company makes a profit, its investors get returns that are proportionate to their investments. If the startup fails, its investors lose their money. While there is no foolproof way of making money by investing in startups, knowing how the process works as well as identifying the pros and cons is bound to hold you in good stead.
Passing of the Jumpstart Our Business Startups (JOBS) Act in 2012 simplified how average individuals could invest in startups. The process became simpler still after 2016, when the Securities Exchange Commission (SEC) voted in favor of adopting rules to make crowdfunding more possible. Now, just about anyone can think about investing in a startup.
What you need to understand at the onset is that startup investing is typically a high-reward high-risk exercise. In addition, the SEC has set limits that surround how much you might invest during any 12-month period. Depending on how much money you earn and your total net worth, this amount varies from $2,200 to $107,000.
The Equity You Hold
The equity you get to hold in a startup is typically illiquid – meaning it is not easy to sell. As a startup investor, you stand to make profits when you sell a part or all of your equity during a liquidity event. This may happen through an acquisition or an initial public offering (IPO).
Pros and Cons of Investing in Startups
Following a strategic approach is vital if you hope to make the most of your startup investments. While there are possible pitfalls, the main reason startups keep attracting investors is the possibility of generating significant profits.
- A planned approach brings with it potential for high profits – either through buyouts or IPOs
- You may get a startup’s shares by offering your skills or time
- You may diversify your investments across industries and geographies
- You would be responsible for creating jobs if the startup succeeds
- You may begin by investing relatively small sums
- A large investment may earn you a seat on a company’s board of directors
- Investing in startups is viewed as high-risk – given the significant number the ventures that fail
- You might not be able sell your equity until the company goes public or is purchased by a bigger business
- Incorrect valuations on the higher side may serve as a barrier when investing in startups of your choice
The Way Forward
If you plan to start investing in startups on your own, carrying out due diligence is crucial. This includes going through any given company’s records and ensuring that the numbers it presents are in order. You also need to account for the fact that you might not be able to cash out for a few years, and that you might end up losing your money.
An easy way to invest in startups is to get a professional to do the groundwork for you. A good investment consultant with expertise in startups can help you narrow down on the right types of alternatives through effective deal scouting based on factors such as industries, revenue, demographics, geographies, as well as your tolerance to risk.
If you’d invested in Google, Apple, Dell, or Amazon before they went public, your money would have multiplied many times over since. While the potential of big returns by investing in startups continues to draw an increasing number of investors, following a planned approach is crucial for success. Consider steering clear of high-risk industries and startups that seem overhyped, and make sure you create a diversified portfolio.