Understand the risks involved and the process to become a startup investor for your chance into this new type of investment
We’ve talked a lot about becoming a startup investor lately, taking advantage of the new opportunity in equity crowdfunding to invest in early-stage companies. We’ve covered returns, risks and a complete how-to in analyzing startup investments.
I’ve summarized and linked all the prior articles below. Knowing the process as well as the potential for double-digit portfolio returns…is startup investing for you?
It is a lot of work, analyzing the best deals and avoiding the flops, but the return trade-off is higher than you’ll find in any other asset class. It’s how the 1% has been able to keep getting richer while the rest of us struggle in the stock market.
Before you make the decision, let’s recap what it means to be a startup investor and how to get started.
Should you be a Startup Investor?
A lot of advisors will tell you startup investing isn’t worth the risk or that it’s not for regular investors.
There is risk that any one startup investment will fail. In fact, up to about half of the investments most angel investors make fail to return even the original investment. That’s just how small business works and how startup investing works.
Just like you don’t judge the risk in your stock portfolio by just one company, you can’t judge startup investing by one deal. You spread your risk out over a portfolio of 20 investments or more and returns start to average out and overall risk comes down significantly.
Besides the reality of investment risk, there are two more problems with the advice you’ll get from mainstream advisors. First, it’s just the old way of thinking that kept regular investors out of startup investing for decades. Government regulators have kept investors like you and me out of early-stage investments since the 1930s, under the guise of our own ‘protection’.
The big money players were just fine with keeping the rest of the investing community out of the opportunity to protect their own returns.
The second problem with the advice is that it’s made simply because many advisors don’t understand how to invest in early-stage companies themselves. They’ve built their business on selling investors into commission-based funds and are afraid that the revolution in startup investing may take that away.
I won’t tell you that everyone should invest in startups or that it is definitely right for you. That’s for you to decide.
What I will tell you is that startup investing can be an opportunity to reduce the risk around a stock portfolio and boost returns to meet your investing goals. Billionaires like Peter Thiel and Marc Andreessen didn’t get that way by investing in stocks and bonds, they made it on investing in companies like Facebook before anyone else.
While startup investing has been around as long as there has been business, equity crowdfunding is still evolving as an opportunity. Take your time and learn how to become a successful investor and get ready for great returns.
How to Become a Successful Startup Investor
We started our series out with the question, should you invest in equity crowdfunding or stocks? Of course, the answer ends up being both. While stocks will probably remain the largest portion of your net wealth, unless you’re getting close to retirement, there are definitely some advantages to startup investing.
Stocks are more liquid, meaning you can buy or sell them more quickly, and the value of shares do not usually change as much as startup companies. That kind of safety is important in a portfolio but may not help you meet your investing goals. The stock market has returned just under 8% annually over the last several decades and many advisors like Jack Bogle and Bill Gross are predicting returns of 6% for a decade or more going forward.
Even if half of your startup investments fail to return any money, the winners carry the potential to average out for a portfolio return well above any other asset class. Average returns on angel investor portfolios are around 26% annually, more than three-times the return on stocks.
In fact, the return on a $10,000 investment in stocks or bonds is just a blip compared to the potential in startup investing after 20 years. Using historical annual returns over the decade to 2013 (4.6% for bonds, 7.6% for stocks and 26% for startup investing), that $10,000 could become over one million by the end of two decades.
The first step in becoming an investor is to understand the way investments are made and the bigger picture, something we talked about in this post on types of equity crowdfunding deals. The alphabet of regulations and rules can be intimidating at first but the basics are all you really need to invest.
- Investors with less than $1 million in net worth are restricted to investing in Regulation CF (crowdfunding) offers. Investors are also limited to the amount they can invest each year, up to $2,000 or 5% of their income.
- It is important to understand exactly what you are getting for your investment; common stock, preferred stock, debt that converts to stock, or just the right to invest in stock in the future.
- The process for signing up to a crowdfunding website, linking financial accounts and ultimately investing in a company is fairly easy but always do your research on each startup before investing.
A lot of work goes into researching and analyzing startup companies. I typically spend 30+ hours researching the market, looking over financial projections and talking with management.
Nobody could do this with every potential startup investment so I suggested some warning signs in startup investing to weed out the worst deals without wasting your time. Check for these warning signs first before you spend time digging deeper into the deal to save time and money.
Once you’ve got a few deals that look like they might make for good (great?) investments, it’s time to get started analyzing the crowdfunding investment and the company’s potential. This starts with researching the market in which the company will compete.
- How fast are sales growing for companies already in the market?
- How many companies are selling to the market and is there control by one or a few?
- Is the market local or do companies sell on a global scale?
- What is competition like in the market? Are companies competing on price or quality?
Researching the market is going to be a big step in the process of finding great investments but it’s also a lot of work. It’s why most investors will tell you, start with only investing in industries you know. Having a professional background in an industry means you’ll already have an idea of competition and what it takes to be successful.
You might not find a lot of investments within your specific industry but it’s better to make fewer investments based on stronger certainty than throw darts at a bunch and hope some hit the mark.
A lot of startup investors won’t even bother with financial statements. I’ll admit that nearly all early-stage companies have horrendous finances with little or no revenue and huge losses. That doesn’t mean you should just avoid putting together an estimate of the sales and profits on potential investments.
You don’t necessarily have to write out a full income statement or the other financial statements, but you should at least look at management’s projections for sales. Compare management’s expectations with what you know from your market research. Is it even possible they’ll be close? What kind of growth do they need to reach that level of sales and how much money might they need in funding to pay for expenses? Check out this post on analyzing equity crowdfunding proforma estimates.
A lot of startup companies will say you can’t put a value on the company. They’ll say sales and expenses are so uncertain that it’s impossible to measure the company’s worth and that an investment should be made just on the potential for a future return.
Don’t believe them for a second.
I’ve walked out of deals before when management tried to pull this crap. I don’t invest my money on hope or potential, I invest in companies that will be worth more in the future than their value today. If I can’t estimate what the company is worth now or calculate a future value, I’m out the door.
There are three methods I use to value startup investing deals. Whenever possible, I try to use all three methods to find an average value as well as get different perspectives on the return potential. Two of the methods, public comparables and acquisitions, can almost always be done while the discounted cash flow is less useful.
- Discounted cash flow valuation takes your estimates for future earnings and discounts them to a present value. There are a ton of assumptions here and most of the value is from your estimate of cash flows well into the future. Still, it is another check you can use to weed out the ‘Hell NO’ deals for better portfolio success.
- The public comparables valuation compares potential sales of the company against prices for companies with publicly-traded stocks. What are investors willing to pay in the stock market for a company in this industry?
- The M&A (merger & acquisitions) valuation looks at what other companies are paying for startups in the industry. Since acquisitions are by far the most common investor payoff in startups, this is usually the most relevant valuation method.
Startup investing isn’t like the long-term, buy-and-hold approach with stocks. After you have invested in a company, you’ll need to keep an eye on any filings and other investment news. This will help you protect your crowdfunding investment and make the decision easier when the company comes back to investors for more money…because they almost always do.
It will take at least three to five years for any of your startup investments to start paying off. Investing in very early-stage companies could mean you’ll be waiting for up to ten years for your investment to be returned. During this time, weaker companies will be failing and almost all will ask for more money.
Nobody said investing in startups would be easy.
Follow a rational investing strategy, staggering your total investment over several funding rounds and waiting patiently for the exits, and you WILL realize portfolio returns of twenty- and thirty-percent.
- Accept that there are going to be some failures. Invest in five or six deals a year and maintain a portfolio of around 20 companies.
- Invest no more than 50% of your total planned investment in the first round of funding for a company, especially if it is an early-stage startup. Save some money back for later rounds to protect your ownership share or to invest in winners that still need more money.
- Consider joining a group of investors that can pool their insight into different industries or combine their knowledge in a specific sector.
Finally, learn where to find the best crowdfunding investing resources to make your research and analysis easier. Your first few deals will be pretty daunting but don’t be discouraged. After investing in a few companies, you’ll start to get a feel for looking over campaigns and financials. All your prior market research will become a library of insight you can use for each new deal and you’ll be able to make the investment decision much faster.
Becoming a startup investor is easy, becoming a successful startup investor is quite a bit more difficult but well worth it. There are few asset classes that offer the potential to create generational wealth and family legacies.
Don’t let the work involved in startup investing keep you from taking advantage of the opportunity. While many investors put as much as 20% of their wealth in startups, there’s nothing wrong with taking it easy and devoting a smaller amount. Besides the monetary benefit of investing in startups, you are also helping to drive the economy and making it possible for an entrepreneur to achieve their dream.
Use this blog as a resource for understanding and investing in startup companies. Read through the blog posts on equity crowdfunding investing and seek out some of the resources I’ve highlighted. If you’re investing within your industry, you’ve already got a head start on the research and are well on your way to higher returns. Until next time, successful crowdfunding!