How Can Average People Invest in Startup Companies?
A startup is a company that is still in the beginning stages of development.
While the “beginning stages” of a company can be defined in very broad and loose terms, a defining feature of any startup is that it has not yet gone public.
In many cases, a startup may still be in the idea stage and the founders are looking for ways to get their idea going.
It is possible to invest in these startups, but it’s considerably different from investing in stocks issued by publicly traded companies. It can be very rewarding, but it is also quite risky.
Here’s what you need to know about investing in startups as an average investor.
Who Can Invest in Startups?
Despite what you might think, startup investments are accessible to everyone. But that wasn’t always the case. Recent regulatory developments have dramatically eased the limitations on a startup’s ability to raise capital. These regulations reduce the barriers placed on both the startups themselves as well as the individuals who may invest in them.
JOBS Act
The first step was the passage of the Jumpstart Our Business Startups Act (JOBS) of 2012. The key provision of this act that relates to startup investing is Title III, otherwise known as Regulation Crowdfunding or the Crowdfund Act.
The Crowdfund Act
When companies need to raise outside capital, the traditional methods are borrowing or issuing equity securities (stocks). Companies that wish to offer their securities to the general public must register them with the SEC and follow strict guidelines. Otherwise, they are limited to offering those securities to accredited investors.
The Crowdfund Act offers an exemption to the lengthy and expensive public offering process. It permits companies to raise a maximum of $5 million dollars through crowdfunding within a 12-month period.
Accredited investors are not restricted as to how much they can invest. However, there are limits on the amount any non-accredited investor can give to a startup. Those limits depend on your net worth and earned income.
If either your net worth or earned income is less than $107,000 then you are limited to investing the greater of:
- $2,200
OR
- 5% of your annual income or net worth (whichever is greater)
However, if your net worth and annual income are both larger than $107,000 then you can invest 10% of your income or net worth. The total amount you can invest in startups in any 12-month period is up to a maximum of $107,000.
Find investment brokers to help you build your portfolio.
Should You Invest in Startups?
The best place for you to invest your money and the decision to invest in startup companies depends on your financial goals, situation, and personal preference. In order to decide, there are some things you need to be aware of. It’s helpful to understand some of the main pros and cons of investing in startups.
Pros of Startup Investing
There are some positive aspects of startups that you may prefer over publicly traded companies.
Return on investment
Compared to the return on traditional investments like stocks and bonds, startup returns can be very attractive — averaging over 20% per year.
Access to management
Because startups are by definition not publicly traded and the investor pool is smaller, you may have access to the leadership of the company and may be able to influence its direction. Investors in public companies have voting rights, but there are many other investors too and your votes may not carry much weight.
Cons of Startup Investing
There are also significant downsides to investing in startups that you need to consider.
Failure rate
While the average return on investment for startups is much higher than the average return on stocks, those results are very skewed by the large gains made by the most successful companies. According to a report by Startup Genome, roughly 90% of startups fail, 10% within their first year. That means you could easily lose the entire amount of your investment. To properly diversify, you need to invest in a portfolio of different startups.
Diversification
It may be harder to diversify your startup portfolio due to the minimum investment requirements that some companies impose on investors.
Liquidity
If you invest in a startup, you will usually not be able to cash out at any time. You may have to wait for a liquidity event, such as an initial public offering if it goes public or during a buyout if the company is acquired. Unlike a publicly traded stock, investments in private companies can’t be traded at will on an exchange. That is a key difference between startups and other types of investments.
How to Invest in Startups
Any investments made due to the rules of Regulation Crowdfunding are required to be completed through an appropriately registered intermediary. This can be a trusted broker-dealer or an online funding portal specifically established for that purpose.
Crowdfunding platforms are required to follow certain rules and protocols in offering the service, and companies that use them to source investors must use only one platform at a time.
Some of the options include the sites listed below, but there are many others as well.
Linqto
Linqto is an investing platform that facilitates investment in private companies. You must be an accredited investor to use Linqto, but you might be surprised at the threshold required to do so. Even if you’re new to investing, if you meet the qualifications to become an accredited investor, it can be a good way to get your foot in the door with companies before they go public.
Wefunder
Wefunder allows you to invest as little as $100 into startups of your choice. When you invest through Wefunder they hold your money in an escrow account until the funding is completed and released to the company. If the fundraising fails, then your money is returned to you.
Seedinvest
Seedinvest allows you to browse the list of companies that are currently seeking funding through their platform along with some information about them.
Seedinvest critically examines the companies on their platform and only a small number are approved. Although you should still perform your own due diligence, this screen can help you sort out your options.
Republic
Similar to SeedInvest, Republic performs its own screening process before it allows companies to raise capital via their platform.
The platform is free for investors to use, and companies only pay if they are successful in raising their desired funds.
Fundable
Fundable was created by startup founders and is similar to Seedinvest and Republic, although the founder perspective is evident on their website. They have published a comprehensive set of guides to help explain the crowdfunding process and what to look for.
What Types of Investments Are Available?
The type of investment available depends on the type of funding that the company desires. There are four basic types of crowdfunding investments. A company seeking capital through crowdfunding may offer one or more of the following:
Startup Investing Frequently Asked Questions
What is a liquidation event?
A liquidation event is an opportunity for you to cash out your investment. Common examples include when a company is successful in going public, getting acquired, or merging with another company through a buyout. Often, it takes years for a liquidity event to occur.
How do I research potential startup investments?
Companies that seek crowdfunding are required to provide certain information about their product, service, and business model that is made available on the funding platform they choose. You can access one of these portals (such as the ones listed above) to see the information.
Is investing in startups risky?
Investing in startups can be very risky. The vast majority of startups fail. Only 40% ever become profitable. Even startups founded by owners who have been successful in the past only have a 30% chance of success.
How do I know if I am an accredited or non-accredited investor?
Accredited investor status is defined by the SEC. If your net worth is over $1 million or your income is $200,000 ($300,000 as a couple) in each of the prior two years with a reasonable expectation of that in the current year, then you can apply to become an accredited investor.
How do I make money from my investment?
You make money when you sell your ownership interest through a liquidity event.
How long will I have to wait before I can cash in?
You should expect to hold your investment for five or more years before a significant liquidity event occurs.
