Thanks to new rules passed in February 2017 by the Securities and Exchange Commission, any person interested in investing in startup businesses can now do so. Previously you had to be an accredited investor and have an annual income of at least $200,000 or a net worth of $1 million.
There are several steps you should take when considering how to invest in a startup.
1. Decide on an industry you want to invest in
If you are new to investing in startup businesses, it is best to start with industries you are familiar with. The ideal industries are ones you have worked in or have a strong knowledge of. The more you know about the company’s market, the easier it will be to decide whether the company and its ideas will be a good investment for you.
If you want to invest in a company that is not in your industry of expertise, you should discuss that company with at least five people who are in that industry. Get feedback from people who have experience in that field and hear what they have to say about the business.
2. Figure out your risk tolerance
It could be years before you see any return on your investment in a startup company. You could completely lose all of the money you invest.
You need to decide how risky you are willing to be and what amount of money you are prepared to invest in a single company. Never invest more than you are willing to lose.
If you are not willing to risk a lot or this is your first time making an investment in a private company, you may want to consider a debt investment instead. This means that you are giving them a loan and instead of waiting for a payoff, you will receive your money back with interest attached. This can be very attractive to a startup company because getting a loan from a bank is nearly impossible unless a company can show three years of financials.
3. Decide how active you plan to be
Some investors simply want to provide their capital and let the company continue in the way that they see fit. Other investors not only want to invest capital but want to have an active role in the management of the company. Think about how much time you have to devote to this and discuss with any companies that you are considering investing with what they would like from you.
4. Find a network of people
Get in touch with lawyers, accountants, consultants, and other investors who have experience working with or investing in early stage companies. These people are very likely to be able to connect you with companies that are looking for investors.
5. Decide on your investing entity
Think about and discuss with your lawyer and accountant, the best legal entity to use to make your investment. You should consider your tax structure and any existing investments you have. You can invest in a startup as an individual, through a family trust, an Individual Retirement Account (IRA), an LLC, or as an LLP.
6. Do your due diligence
Find out as much about the company as you possibly can. Look into the market they’re in, look at their competition, and speak to the people who work there to get an overall picture of what they think the future of their business looks like. You should know as much about this company as its owners before you commit to handing your money over.
There are several factors that you should look at when doing your due diligence:
- Their products
- The management team and their backgrounds and experience levels
- The company’s differentiation from its competitors
- The company’s business model
- Their distribution channels
- Their current customers
- Market size and dynamics
- How competitive the market is
- Their historical financial performance if they’ve already begun operations
- Their financial projections for the future
- Any legal issues they may currently have
- Know whether the company is Tier 1 or Tier 2
7. Invest in companies you believe in
Invest in companies that you would happily endorse whether you had a monetary stake in them or not. Look for companies that excite you, that stand out from the others.
8. Do the legal paperwork
There is probably going to be legal paperwork that needs to be completed when you invest with a company. You may need to fill out an investor questionnaire and a verification of your identity before you can invest in a private company. Be sure to bring these to a lawyer who has experience dealing with investment agreements similar to yours.
9. Sign documents
When you invest in a private company you usually have to sign an investment agreement that explains all the terms and conditions of the investment. Be sure to read through this carefully and make sure that everything you wanted out of the agreement is clearly outlined.
These documents should also be brought to an experienced investment attorney to be reviewed. If there are any other special requests you have for this agreement, they should either be added to the investment agreement or a secondary contract should be drawn up by your lawyer for both parties to sign.
10. Release the funds
Sometimes the investment agreement and other legal documents do not become legally binding until certain conditions are met. This can be anything from a certain date passing to an amount of money being raised by the company.
If this is the case, be sure to keep the investment funds in a third-party escrow account until all of the conditions are met and the contract is legally binding. At that point, you can release the funds to the company.
11. Diversify
One of the most important steps to investing, whether in startups or otherwise, is to diversify your investments. Investing in startup companies is a big risk and you want to make sure you spread that risk across different companies and industries.
Begin investing slowly, especially if you are investing large amounts of capital. Follow the same steps with each business before investing. The more time you spend researching and the more people you network with, the easier it will become to build a portfolio of investments.
12. Be careful investing with friends
Investing with friends can seem like a good idea, but it is often the worst idea. You need to be able to ask the hard questions and speak up when something isn’t going right. It’s very difficult to do that when the management team are close friends.
Make a startup investment
There are a few ways to go about making a startup investment.
- Invest in pre-vetted startups: These are companies that have already had the due diligence done by attorneys and have been found to be solid investments. You can usually find these on angel investor websites. There is sometimes a fee involved in joining these websites, but the companies listed for investment have been thoroughly questioned, saving you the job of doing it.
- Take a portfolio approach: Invest a smaller amount in several different companies at once. Instead of putting all of your money into one company, you can diversify the same investment by channeling it through a few smaller investment and spreading your risk.
- Reserve some of your capital: Another way to lower your risk is by making an initial investment that is smaller than the total amount you are willing to invest and investing it during a second or third round. Once the company shows that it is growing and that your investment is being used wisely, you can assess whether you want to invest additional capital.
- Invest where you can add value: Invest in companies where your expertise is needed and where you feel that you can make a difference.
It’s important to understand that with these new laws and regulations opening up investing to any person who wants to invest, the competition for investing in good companies is stiff. With all types of crowdfunding-style sites popping up across the internet, it is becoming much more common for companies to take small investments from a large number of people rather than very large investments from a select few.
This method allows companies to keep a lot of their management power while still raising a lot of money. These crowdsourcing websites also allow a company to grow their brand and reputation faster than was ever possible before.
Only once you have done your research into the different companies and industries where your investment is needed will you be able to totally know what type of startup investment you want to make.
