Is Investing in Startups A Good Idea?

While highly risky, investing in startups can help you rake in big bucks.

In the last couple of decades, fueled by technological advancements, startups have made our lives easier. Today, a click of the button is all we need to hail a cab or buy essentials. Successful startups have raked in millions through their products and services, and so have their investors.

The global startup economy is valued at around US$3 trillion and saw around $300 billion in venture capital investments globally in 2019. Startup investing has never been hotter or come with more potential for profit, but it also comes with big risks. Amateur investors need to learn all they can about the process and the startup before making the leap.

What is startup investing?

A startup is essentially a newly established private company, around 5-10 years old, and is designed to scale very quickly. When you invest in a startup, you are buying equity, or a part of ownership in the company, and rights to its future profits. If the company succeeds, you will make returns proportionate to what you invested in. On the other hand, if it fails, you will lose all your initial investment.

The initial investments in a startup usually comes from the founders themselves, and their friends and family, in what is usually known in fundraising as the ‘friends and family round. At a very early stage, a startup may also raise a small amount of what’s known as seed capital, usually from investing funds dedicated to seed funding.

As an investor, the chances of you making the highest returns with minimum investment is when the company is just starting out. If you wait till a startup goes public, you could miss out on 95% of the gains.

In subsequent stages of funding, venture capital firms, angel investors, and high-net-worth individuals may offer financial backing to get the company through its difficult initial stages. When the company starts to grow, it can approach previous investors or new, more deep-pocketed investment firms for larger rounds of funding.

An investor makes money when they sell all or part of their stake in the company during a liquidity event such as an IPO (Initial Public Offering) or an acquisition, or when the company pays dividends.

The pros of startup investing

Highly profitable

Investing in startups can be extremely rewarding and can have a high rate of return, especially if the startup has a sound business idea and strategy. For instance, Andreessen Horowitz, who had invested US$250,000 in Instagram, saw a return of over 300X (or $78 million) when Facebook bought the company for $1 billion two years later.

This is also a great example of how you can earn high returns if the startup gets bought by large corporations for a lucrative sum.

Gain market recognition

If the startup you have invested in succeeds and gains recognition, it will in turn build your reputation as a savvy investor. This in turn could open up opportunities to invest in more innovative companies.

Be part of positive change

By investing in startups, you are becoming part of a positive change and helping bring new innovations to life.

“People often invest in what they want to see in the world, whether it’s more sustainability or a really cool sneaker company,” Elias Stahl, founder of environmentally friendly shoe company HILOS, told Forbes. “There’s no better opportunity to see something that you want in the world and to support that.”

The cons of startup investing

Here’s the bad news: 90% startups fail, and according to 2019 data from the U.S. Bureau of Labour, 2 out of 10 startups go out of business within the first year of operations. Last year, 7 of the most heavily funded startups in the U.S. and Asia-Pacific shuttered operations.

Hence, while highly rewarding, investing in startups can also be quite risky. It is important to know the risks before you decide to invest in a startup.

Losing your investment

If the startup fails before you’re able to get any money from it, you will lose your initial investment.

Illiquid investment

Unlike publicly traded stocks, startup investments are illiquid. This means that they cannot be traded and you may not be able to sell your stake until the company goes public or gets acquired.

The results take time

Even if a startup succeeds, it may take many years for you to see substantial returns on your investment. Typically, it takes 7-10 years for a major liquidity event, such as an IPO, to occur for startups. For instance, ride-hailing company Uber, which was founded in 2008, went public in 2019 with a valuation of $82 billion.

How to invest in a startup

You can be an angel investor if you have a high net worth and wishes to invest in early-stage startups. Angel investing is often the primary source of funding outside of friends and family for startups. While risky, it helps foster innovation.

If you are a wealthy investor, you can also become part of a venture capital firm. Venture capital investing (usually done through a pooled investment fund) is mostly sought by startups that are past the seed and angel stages and are believed to show long-term growth potential.

If you do not have a high net worth like an angel investor, you can invest in startups through startup investing platforms or crowdfunding sites. These platforms will provide a range of companies and you can invest very low amounts.

Some of the common crowdfunding sites include Wefunder, SeedInvest, StartEngine, MicroVentures, and Republic. While SeedInvest requires you to invest at least US$500, the rest require as low a minimum investment as $100.

Additionally, if you’re an accredited investor (an individual that satisfies at least one requirement regarding net worth, income, asset size, governance status, or professional experience) you can invest through AngelList. A leading startup investing platform, the site requires investors to have at least $200,000 ($300,000 if married) in income, or a net worth of at least $1 million.

Ultimately, whether you should invest in a startup depends on your financial situation and your circumstances. However, before you invest, it is advised to do plenty of research about the startups you want to invest in, seek advice from your financial advisor, evaluate the risks and be prepared–in the worst case–to lose everything you invested.

Header image by Akil Mazumder from Pexels

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