How to invest in a Startup
It was 2013 when I received my first Stock Options from a Startup, which then allowed me to become Shareholder of the same, and which today have a valuation of 80MLN $ USD. This may not be the case for you if you have not been part of the initial team of a startup that later went through different rounds of fundraising (seed, Series A, etc … more on that in a future post), however, you can invest in a startup too. Here we will see how.
The effective internal rate of return for a successful portfolio for angel investors is approximately 22%. However, this comes with a greater level of risk, as less than 10% of companies that raise a seed round are successful in then raising a Series A investment.
To compensate for this higher level of risk, the legislator provides that only an “accredited investor” can invest in a startup. The Securities and Exchange Commission (SEC) defines an “accredited investor” as one with a net worth of $ 1M in assets or more (excluding personal residences), or have earned $ 200k in income for the previous two years, or having a combined income of $ 300k for married couples. If you qualify as an “accredited investor” or already are, I recommend the AngelList platform.
In the other cases, startup investing became easier in 2012 with the passage of the Jumpstart Our Business Startups Act (JOBS), which relaxed some federal securities regulations and made it easier for businesses to seek investments through crowdfunding. The Securities Exchange Commission also voted in 2016 to adopt rules that made crowdfunding more possible.
In this case, here is a list of platforms that may be right for you:
There are various reasons for recommending these platforms, but I want to focus here on an often underestimated element, the selection of startups. As stated above, this is an extremely risky business (less than 2% of all startups gain traction and scale). Professional investors like venture capital, use machine learning models, and still get it wrong. At the very least, when stock-picking of listed companies, they have met the requirements imposed by the Exchanges and the Securities and Exchange Commission (SEC), moreover, all information is made public. So how can we expect an average investor to be able to correctly choose which startup to invest in? Here is when the concept of selecting startups is important.
Republic.co, for example, claim that has a less than 5% acceptance rate. For the selection, they use what they call the FPTM model is used: Founders — Product — Traction — Mission. Furthermore, during the Due diligence, the following elements are considered: Business model, Social impact, Market, Technology, Team, Fact-checking, Terms, Runway, Eligibility.
If that’s not enough, here is a quick guide on the differences between Public Companies and Startups, and how to conduct a due diligence youself.
For public companies:
- Larga cap companies are less volatile
- Trends in revenue, operating expenses, profit margins, and ROE over several quarters or years and compare to the industry
- Is the company a leader in its industry or its specific target markets? And, is that industry growing?
- See if it is undervalued (P/E, PEGs and P/S)
- Find out if the founders and executives hold a high proportion of shares and whether they have been selling shares recently
- debt-to-equity ratio to see if It’s able to meet its debts and still grow.
- short-term and long-term price movement. Stocks that are continuously volatile tend to have short-term shareholders
- Is the company planning on issuing more shares? If so, the stock price might take a hit.
- analysts rating
- Long and Short-term Risks
For startups:
- Include an exit strategy. More than 50% of startups fail within the first two years. Plan a strategy to recover your money should the business fail.
- Consider entering into a partnership: Partners split the capital and risk, so they lose less if the business fails.
- Figure out the harvest strategy for your investment. Promising businesses may fail due to a change in technology, government policy, or market conditions. Be on the lookout for new trends, technologies, and brands, and get ready to harvest when you find that the business may not thrive with the changes.
- Choose a startup with promising products. Since most investments are harvested after five years, it is advisable to invest in products that have an increased return on investment (ROI) for that period.
- Instead of hard numbers on past performance, look at the growth plan of the business and evaluate whether it appears to be realistic.
I hope this article was helpful to you. If you are thinking of investing in a startup to diversify, or you are already doing so, you may have found interesting insights here. If you would like to share them, I would be grateful for your feedback. Thanks for reading this far.
