What do you need to know for startup investing?

Who doesn’t dream of investing a few thousand dollars in a startup company that goes on to become the next Facebook, Apple, or Microsoft? Of course, there is no harm in dreaming of making a fortune, but the reality is that some 90% of startups fail within their first five years of existence.

Where to invest

For those willing to take the risk though, there is undoubtedly money to be made by investing in such companies, sometimes a huge amount. The secret is identifying which enterprises to choose and being prepared to wait for a number of years; the average is between five and seven, before seeing any return.

Unlike stocks and bonds, where investors choose businesses they believe will grow and become more profitable, startups are all about individuals. The investment is made in entrepreneurs who have ideas that require cash to turn them into innovative products or services, which, with luck, will fill a hole in the market that no one else has spotted. With this in mind, it makes sense to invest in an individual who is known and can be trusted. This is particularly true if the entrepreneur is at a point where he or she only has an idea, known as first tier level. In most cases, cash raised is generally described as being derived from friends, family and fools (FFF).

Another key difference between investing in stocks, bonds and commodities is that startup companies are often looking for investors who are able to contribute time and expertise to assist in their development and growth. It is therefore advisable for would-be investors to only concentrate on businesses operating in sectors in which they have a degree of knowledge and experience.

How to invest

At the present time, anyone intending to purchase startup equity has to be registered as an ‘accredited’ investor with the US Securities and Exchange Commission (SEC). Registering involves the individual signing of a form confirming that he or she has a net worth, excluding their primary home, of $1 million, has received an income of a minimum of $200,000 in each of the past two years or has received a household income of over $300,000 over the same period.

The government is currently in the process of finalizing and introducing a new set of regulations intended to relax existing requirements relating to the level of earnings required to be recognized as an accredited investor. It is also now possible to become a member of an online syndicate, with an investment of as little as $1,000, and entrepreneurs are able to advertise for potential investors on the Web and even via tweets.

As with stocks and shares, it is sensible to build up a portfolio of startups and to restrict initial investment to between 5% and 10% of the total funds available. If everything goes according to plan, returns of five to ten times the amount invested can be expected in around five years. However, it is also possible that a total loss might be sustained.

Newcomer advice

As an alternative to investing as an individual, it is also possible to become a second tier investor by joining an angel investing group. There are several benefits to this option, especially for newcomers. Angel groups are made up of investors who are likely to be highly experienced, who know how to go about vetting entrepreneurs, and who often allow members to spread their money across multiple startups.

The majority of angel investors restrict themselves to dealing with startups that are geographically local to them. This is because they usually demand a seat on the board where their money is being spent, to keep an eye on how the company is progressing and to ensure they are able to take a hands-on role.

Another option that has only recently become available to non-accredited investors is crowdfunding, an online system that enables individuals to invest as little as $20. Two of the most popular sites are Indiegogo and Kickstarter.

It is essential that newcomers to investing in startups remember that it can be a minimum of three years, often longer, before they can reasonably expect any return and that they cannot simply sell their stock. The only way cash can be released is by way of an IPO (Initial Public Offering) or M&A (merger or acquisition).

Newcomers to startup investing are strongly urged to seek professional advice before risking any of their hard-earned savings. As with any form of investment opportunity, it is always best to start small, risking only the maximum amount of money that can be lost without causing financial hardship. They should also only invest in business sectors that are familiar to them; ideally areas they have worked in for a number of years.