January 22, 2020

The Complete Guide To Investing In Startups

Introduction to Investing in Startups

Investing in startups was once an option reserved for high net worth individuals and institutions.  But, thanks to the Jumpstart Our Business Startups (JOBS) Act of 2012, investing in startups  is now available to all Americans. Passed with bipartisan support and signed into law by then-President Barack Obama, the JOBS Act has helped encourage small business funding in the US by easing many of the regulations that were previously set in place.

Title III of this legislation, also known as the CROWDFUND Act, has opened crowdfunding as a way for companies to issue securities, something which wasn’t possible before. In any case, individual investors are no longer exclusively part of the super-rich in society. Anyone with the necessary know-how can throw their hat into the ring and see exciting results. 

Investing in startups found past successes in companies such as Paypal, Microsoft, Apple, or Google. If you would have invested $10,000 before their Initial Public Offering (IPO), an investor would have walked away with millions. In a span of ten years, between 2002 and 2012, Apple’s stock value saw a booming rise of nothing less than 4,581.7%.

Silicon Valley is the epicenter of entrepreneurship and home to over 13.5% of all global startup deals. The United States, as a whole, has over 30 million small businesses. Every month, over 543,000 new businesses are started, generating 65% of all net new jobs since 1995. The bottom line: investment opportunities exist in overabundance with new business ideas generated on a daily basis. 

Startups of today build tomorrow’s future. Now, thanks to the Jobs Act, anyone can invest in them. This complete guide to investing in startups will tell you everything you need to know about investment opportunities in a startup ecosystem. 

What Is a Startup?

While there is no one definition that best describes what a startup is, Co-Founder of Warby Parker, Neil Blumenthal, defines a startup as “a company working to solve a problem where the solution is not obvious and success is not guaranteed.” Startups are organizations, typically with less than two years of operation, that look to produce a novel product or solution for a growing market need. 

That said, realize that their success is not always guaranteed. In fact, 90% will ultimately fail. There can be hundreds of reasons why most startups don’t make it past their third year. The most common of these include a lack of market need for their product, lack of cash, the wrong team, being outcompeted, or disharmony between the teams and investors. 

Whatever the case for their failure and the risks involved, the potential rewards can be enormous. As a non-accredited investor, you can get in at the ground floor with companies you believe in and help them achieve their potential. You will also be able to see a significant ROI in doing so. 

What Do Successful Startups Look Like?

There is no one-size-fits-all template that defines a successful startup. Nevertheless, there are several telltale signs that are great indicators of early-stage companies with potential. These include some of the following:

A Great Product in a Growing Market

According to Tim Guleri, a venture capitalist, serial entrepreneur, and managing director of VC firm Sierra Ventures in Silicon Valley, the first strong sign of a potentially successful startup is that it has a product in high-demand on the market. In fact, a whopping 42% of startups fail because of a lack of market need for their product. Every entrepreneur that looks to raise capital should make sure that their solution will be in high demand. 

Aside from the product having to be a perfect fit, the market, itself, should also be growing. Though not necessarily a deal-breaker, a growing market is still a strong indication that the startup has room to expand over the long-term. According to the 2018 Global Startup Ecosystem Report, agriculture and blockchain technology are growing quickly. But the tech startup sector, particularly with artificial intelligence, is seeing huge growth potential.

A Committed and Versatile Team

Mr.Guleri also notes that startups that are able to succeed are also those that have a mission and are driven by the right amount of passion to see things through to the end. For this to happen, launching a business needs to be done with a strong commitment toward the creation of long-term value. If the initial goal is to be eventually sold off, very few startups stand a chance to succeed. “This is the exact same reason,” Guleri says, “that it’s not always the best product that succeeds, but the one that has the most committed team behind it.”

Versatility is, yet, another quality that these teams need to possess. By versatility, we are not referring to just their skill sets but also their ability to adjust to different situations. They should be able to adapt to different compensation plans, adopt a new social media marketing strategy, rebrand their business, or even change products. It’s also important that they are capable of quickly recovering from setbacks and know how to fail fast. On a somewhat similar note, co-founded startups also tend to have a higher success rate than single founder ones. 

Fast Growth

Rapid growth is what markets need and what investors look for in a startup. Single-digit growth rates are never a good sign after many months of operating in the market. If a company isn’t able to grow after a certain amount of time, that growth will never happen. While growth can accelerate in a snowball effect fashion, companies that aren’t growing are actually shrinking. 

Fast growth means that a startup can avoid many pitfalls, such as being outcompeted, or losing customers, employees, and morale. Slow or no growth, on the other hand, often translates to no cash and no investments. 

A Robust Business Model 

Successful business owners tend to work on their company, not in their company. This means they delegate many of the phone calls, meetings, and emails that may distract from focusing on their organization. Arguably the most important components about a startup are its business model, process, and scalability. 

Entrepreneurs need to thoroughly understand how their business and economic models work and influence the inner workings of their companies. “It’s okay not to have certain ‘cards’ that are not face up, yet,” said Guleri when addressing an early-stage entrepreneur. “This is the reason why you walk up to a firm like ours at Sierra and say ‘Hey Tim, I’m here [at this level], I think I have a pretty strong business model. Here are the six or seven cards that I want to see face-up in the next 18 to 24 months. Will you be my partner?’ I love conversations like that.” 

A robust financial model backs the product offered and keeps everything from falling apart. Guleri also advises entrepreneurs to “be aggressive when it comes to growing your business, but be patient when it comes to looking at the metrics.” 

What Is Startup Investing?

Early-stage investors are those that help startups with raising capital during the development or market research stages. These types of investments divide into three categories:

  • Seed Funding – Seed capital is given to new businesses to get them off the ground, carry out market research, for proof of concept, product design, etc. 
  • Startup Funding – This money will be used for product development and marketing. 
  • Early-growth Funding – These funds are used to establish and boost manufacturing and sales. 

Typically, early-stage investors will provide this funding in exchange for equity or for a sizable return on their initial investment. It’s important to realize that early-stage investing can be quite risky since the startup still doesn’t have a track record of performance. Below are several funding options that are among the most popular. 

Venture Capital

When entrepreneurs look to begin investing in startups, they will need to possess several important qualities and have access to valuable insights, if they hope to ever be successful. It’s also quite certain that they will need to get their hands on some venture capital (VC) funds to make their dream become a reality. Put simply, venture capital funds are a form of financing provided by various investors to a startup that shows signs of long-term growth potential.  

VC funding can come from different sources, such as banks, various types of financial institutions, a venture capital firm, or from individual investors that have an eye for this sort of thing. In some cases, venture capital also comes with technical and managerial expertise, as well as other startup advice and connections provided by the investor.

For emerging companies (ventures), typically with an operating history of less than two years, VC funds are becoming an increasingly popular way of raising money. This is particularly true if they lack access to capital markets, bank loans, debt funding, a government grant, or other forms of traditional business loans. Investing in startups is inherently risky. Nevertheless, venture capitalists receive above-average returns, if their investment pays off.

This, of course, doesn’t mean that venture capital is a “piggy bank” where early-stage business owners come to get their hands on some free cash. To be eligible for VC funding, they need to have a good business model and a track record that shows they can, indeed, be profitable over time. Investors will typically provide financing in exchange for equity and some control over the company. 

Angel Investing

Angel investments can either be done by friends and family, or by high net worth individuals. Such individuals invest money into private companies either to get an ownership stake or some form of convertible debt. Also known as seed investors, business angels, or informal investors, angel investors bridge the financing gap between venture capital funds and smaller sources of financing, such as crowdfunding. 

Usually, VC funding comes from a pooled source of funds, whereas angel investors use their own personal funds. Angel capital invests through an investment fund, a trust, or an LLC. Business angels need to be good at making decisions before they invest. Due diligence is a critical step, since early-stage funding will provide fairly limited information about a startup’s management, financial projections, and business model. 

Crowdfunding

With the passing and implementation of the JOBS Act, crowdfunding has become a popular financing method for many Americans. Since then, this method has evolved into three different types of investing: Donation Crowdfunding, Reward Crowdfunding, and Equity Crowdfunding.

  • Donation Crowdfunding, as its name would suggest, revolves around people (crowds) donating to a company, generally based on altruistic reasons and the donor’s concern for others’ wellbeing.  A startup funded via donation crowdfunding has no duties or responsibilities for its donors. GoFundMe, Fundly, and Crowdfunder are popular crowdfunding platforms for this type of crowdfunding. 
  • Reward Crowdfunding works in a somewhat similar fashion, with the major difference being that investors will receive a reward or discount. Usually, the larger the investment, the higher the value of the reward. Oftentimes, these rewards revolve around pre-sales as a means of proving a concept. Reward-based Crowdfunding platforms include Kickstarter, Indiegogo, and RocketHub. 
  • Equity Crowdfunding, on the other hand, represents a collective effort by individuals to support startups in exchange for some equity. In an equity-based funding model, the company is selling bits of ownership in the form of shares, interest, or membership to all invested crowdfunders. As such, Equity Crowdfunding is a form of investing in venture capital. 

How To Invest in Startups?

Early-stage investing, be it in the form of venture capital, angel investing, or equity crowdfunding is a high-risk, high-return area of investment. The way you go about scouting and investing in startups is an important part of the process. You don’t want to spend years going around the country looking for investment opportunities without actually making an investment. Instead, you would want to optimize your process as much as possible. To do so, you should use the following steps.

Use Equity Crowdfunding Platforms

Some popular equity-based platforms include WeFunder, StartEngine, SeedInvest, EquityNet, Republic, MicroVentures, and Netcapital. All of these platforms will make sure that all startups within their database are compliant with all US Security and Exchange Commission (SEC) regulatory requirements. This means that all startups found on these platforms exist while vetted from a legal perspective. They make a great starting point in your research. 

That said, most platforms will not, however, analyze each company from a strength of investment standpoint. Most platforms do this as a means of providing a level playing field for startups. As such, each individual investor will have to decide on their own which companies are worthy of their investment. This is where due diligence comes into play. 

Due Diligence

To lower your risks and increase your ROI, it’s critical you perform your due diligence before investing in any startup. This implies a bit of digging, especially when important facts remain hidden beneath favorable language. What you need to look out for are the aforementioned telltale signs of successful startups. Here are five basic pieces of criteria to determine the Risk-to-ROI

  • The Market Size and/or Growth – Companies operating in massive sectors like finance or healthcare can still win small shares of the market and turn into billion-dollar organizations. A growing market, on the other hand, indicates the scalability potential of the startup. 
  • The Product/Service Differentiation – It’s important to understand the competition and determine whether the startup’s product will perform. You will need to know why end-users will decide to use this company’s product in favor over another. The smaller the competition and the more innovative the product, the better. Even in a stagnant market, a company can experience fast growth. This is especially true if their product or service addresses a pain point that nobody else’s does. 
  • The Founder’s Experience – Knowing and understanding the founders’ vision, integrity, and industry experience are also key in determining the overall viability of the business. You need to ask yourself if these people have the necessary technical skill, managerial ability, and willingness to succeed. 
  • The Business Model – Similarly, you will need to make sure that the company has a sound monetization strategy and whether its business model can be sustainable, scalable, and profitable. 
  • The Terms of the Offering – Before deciding to invest, you should carefully analyze all the terms and conditions of the deal. These may include things like valuation cap, dilution, pro-rata rights, and more. Also, look at your exit options and compare them to others in the same industry.

How To Earn Money When Investing In Startups?

You’ll have to hold on to an investment somewhere around five or more years, on average. These types of investments aren’t liquid, while their valuations tend to go up with every funding round. There are, however, certain times where you have the opportunity to liquidate your investment. This is usually at a higher valuation than your original input. These events will include the following: 

  • Mergers and Acquisitions – When another company offers to merge with or buy your private company, you will be offered cash in return. 
  • IPOs – On rare occasions, private companies may be able to go public. When this happens, they will offer huge returns to their shareholders. 
  • Funding Rounds – Depending on the terms and conditions, you may also have the possibility to exit your investment whenever the company is involved in another round of investing. 
  • Revenue Sharing and Royalties – Though uncommon, these two options are also possible on occasion. 

If you feel comfortable with the return on investments, you should cash out at these exit events. 

Investing in startups is a great way of helping companies you believe in, while putting your money to work. But again, investing in these early-stage companies is a high-risk, high-reward operation. Luckily, this is where KingsCrowd comes in. We will help you make the most informed decisions and lower your risk. If you want to learn more about startup investing best practices, we urge you to subscribe to KingsCrowd today.


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About: Chris lustrino

A Boston College Eagle for life, on a mission to democratize startup investing for all people at KingsCrowd, with a passion for Fintech, investing, social impact, doing well and doing good, and an avid runner, cyclist and writer.

View Chris lustrino's articles

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