Investing in startups is a uniquely high-risk, high-return challenge, but investors can boost their chances by following a few simple guidelines.
Nothing gives you perspective on investing in startups like running one, and vice versa.
Since founding Clever Real Estate in 2017, I've had many "through the looking glass" moments where I found myself considering internal company decisions through the lens of an outside investor. ("If I was thinking about investing money in Clever, would this move inspire confidence or caution?") As one part of a decision-making rubric, it can make you see things from a more objective perspective, separate from your own rationalizations and blind spots.
On the other hand, although my company's still in its early stages, I've already learned so much about what makes a startup successful and what can sink its prospects. With those insights guiding where I put my money, I feel much more confident in my startup investments. Will every one hit? Of course not. But I like my chances.
Pros of investing in startups
Here are six reasons to consider investing in startups.
1. You may be able to exchange your time or skills for shares
Often, established companies offer shares to investors in exchange for money. Startups may instead count any time and expertise you offer as the currency needed to obtain these shares.
2. You can minimize your risk
Sometimes, you can sign an investment contract through which your investment is withheld until the startup reaches a preset goal. If the company fails to reach this goal, you don’t have to actually give it your money, so your investment risk is low.
3. You can diversify your investment
Startups exist in virtually every industry. That’s why, if you plan to make several investments and want to minimize the risk involved with putting your eggs in one basket, investing in startups might be a smart financial move.
4. Your investment could grow rapidly
It’s one thing to buy stock in a long-dominant company that goes public. It’s another to invest early in a startup that later grows substantially. If that’s the case, your initial investment will grow in size tremendously.
5. Lower investment threshold
Many startups have low initial operating costs, so your investment costs will be lower than for many other types of investment opportunities. And with this type of investment, there's a possibility that it may earn you a seat at the table in the company’s boardroom.
6. You can earn big in a buyout
Larger companies often buy startups. This transaction often happens once the startup has proven itself valuable. As such, the amount for which the company is purchased may be much larger than its value when you invested. Your investment will have grown proportionally, meaning you’ll earn far more money from a buyout than the amount you first invested.
Cons of investing in startups
While startups are a potential source of strong financial growth, they carry two investment risks worth mentioning:
1. Startup failure
You’ve likely heard the statistic before: 90% of startups fail. While you can earn large sums on startup investments, the risk of losing all the money you invested is high.
2. Rare short-term gains
If you’re investing in a public company, you can buy and sell shares whenever you please. When you invest in a startup, you commit your money to that company for the long term, meaning that sometimes, you won’t be able to access it for years. You likely will need the startup to be bought or go public before accessing your money again.
If you do want to invest in a startup, here are a few guidelines I've put together, based on my time inside and outside the startup investment world.
Choosing the right company
1. Meet the founders.
There's a lot of truth in the cliche about how you should invest in people, not companies. Starting a business is brutally difficult, and obstacles and problems pop up almost daily. Without a passionate founder who's 100% committed to their vision, the odds of success sink to near zero. Meet them, talk to them, and find out what they're all about.
Another necessity is genuine expertise. We all know there's a superficial level of expertise that can get you through a cocktail party conversation or even a business meeting, but to really make it in your field, you need a deeper level. Deep, genuine expertise is a product of obsession. I would never invest in a company if the founder wasn't truly obsessed with their vision.
One more note on founders: Candor is vital. Everyone's a salesman when they're fundraising, myself included, but there needs to be a certain level of real openness along with that. If I invest in a company, I want to know that I'll be getting real updates, good or bad.
2. Look for customer adoption.
This one is obvious but often overlooked. A great pitch that paints a breathtaking future can dazzle you, but we all know there are no guarantees and that predicting the market is like predicting the waters – we're all just guessing, basically. You may have an amazing vision, but if I'm putting in money now, tell me about how the product is doing now. If the company has gained traction already and customers are using the product, that's huge.
3. Make sure the chemistry is there.
Another cliche with a lot of truth in it is that you should invest in companies that make products you love, with values you share. To that end, I try to really live with a company's product before I invest my money in it. You can often learn more about a company's prospects from its product than from a stack of financial analyses.
There's also a peripheral benefit of investing in companies whose values you share. If you invest in 10 startups, you'll be doing well if one or two of them make it. If you're always going to be losing more bets than you win, your ride will be a whole lot smoother if you can look at your losses with a clear conscience, knowing you made that investment with full, uncompromised judgment. There's no worse feeling than looking at a failed investment and knowing that you cynically went against your gut and your heart. I should exhibit the same integrity that I expect from the companies I invest in.
What to avoid
1. Overhyped and overpromising companies
Again, we all know there's salesmanship involved in being an entrepreneur, especially when you're raising funds. But there has to be a solid business core underneath the hype. If a company seems to be all hype, that's as red of a flag as there is.
I'm wary of companies that make outlandish claims and promises. We're all trying to be the next billion-dollar startup, but we all know there's a reason those companies are called unicorns – they're incredibly rare. If you're trying to feed me billion-dollar guarantees, I'm going to question your sense of reality. There's a fine line between confidence and delusion.
2. Risky industries
In 2019, a lot of investors are making money in what I call commodified vice. This includes industries like marijuana and cryptocurrency. A lot of investors are making money in these fields, but in a high-risk world, startups in these industries are the highest risk of all.
I personally steer clear of this type of investment. If the existence of your business rests on the ongoing avoidance of the law, I don't know how you can build long-term stability. We've seen that in the difficulties a lot of legal marijuana businesses have had with simple banking, since federal law still prohibits marijuana, and in ongoing government attempts to regulate and control cryptocurrencies. That's part of the reason my startup deals with real estate – there's no industry more fundamentally stable.
3. Getting bogged down in numbers
We all love a good data set, but don't get tunnel vision when you look at a startup's data. If it's still in the early stages, you won't find many solid conclusions there, much less any certainty.
If you're thinking of investing in a young company, look at the big picture and the people involved first, and the spreadsheets second. Many times, the financials they provide investors are more useful in telling you how they view themselves than anything else.
Steps to invest in a startup
1. Do your due diligence.
Let's start with the fundamentals. Before you put your money up, go in with a totally open mind and start your research from square one.
I'm not talking about sitdowns with the founder; I'm talking about their paperwork, making sure they've dotted all their i's and crossed all their t's. Look at their corporate records and make sure everything is in order – incorporation, their leases and contracts, how their shares are issued, and everything in between.
2. Run the numbers.
A startup's valuation is someone's best guess at how much the company is worth – but make no mistake, it is a guess. Why take someone else's word for it? Always run the numbers yourself to see what your investment might be worth. You might be surprised (in a good way or a bad way).
While you do this, ask the founders how much money they've already raised. If they're asking you to be the first one in the pool, you should know that going in. On the other hand, if they've already raised a lot of money from their customers, that should ease some of your anxiety.
3. Take a hard look in the mirror.
Once you've scrutinized the companies you're thinking of investing in, do the same to yourself. These are risky, long-term investments. You won't be able to cash out for years, maybe a decade, and unless you hit the luckiest streak in investor history, you're going to lose some money. Do you have the patience for that? Do you have the stomach? Most importantly, do you have the liquid capital?
For the small and moderate investor, crowdfunding is the best way to get in on a rising company. The following platforms, which offer opportunities to invest as little as $100 in vetted startups, are some of my personal favorites.
This crowdfunder accepts less than 1% of the companies that apply to seek funding, so you know you're seeing the best of the best on the platform. SeedInvest claims it has nearly 260,000 users and has fully funded more than 220 companies.
Each company on SeedInvest has a different minimum investment and a deadline to raise its funds. One innovative SeedInvest feature is the auto-invest option: If you invest at least $200, it will build you a diversified portfolio.
Through MicroVentures, you can invest in startups for just $100 (or more, if you’re feeling lucky). You can choose from among dozens of startups such as data storage programs, beauty subscription plans and rideshare platforms. As of late 2020, MicroVentures’ hundreds of thousands of users can choose to invest in more than 400 startups. Previously, MicroVentures allowed users to invest in now-huge companies such as Slack and Airbnb, and the platform’s all-time investments total $220 million.
For as little as $100, WeFunder users can invest in companies making everything from vegan beauty supplies to CBD products. Investors can purchase stock, convertible notes or debt, and if the company doesn't hit its funding target, investors get their money back. WeFunder has enabled $83.5 million in investments since 2013, so you know it's solid.
This platform is the everyman's version of AngelList, the leading investment platform for accredited startup investors. In fact, AngelList played a pivotal role in passing the JOBS Act, which made crowdfunding viable, and Republic was founded by AngelList alumni. Republic users can invest as little as $10, and all companies are intensively screened.
In addition to offering investments, the Republic platform hosts six different investment groups, allowing for discussion, ideas and advice. Group members are also encouraged to invest together.
Additional reporting by Max Freedman.