How to Invest in Startups: Best Practices

TheStreet

Ford (F - Get Report) , Walmart (WMT - Get Report) , Southwest Airlines (LUV - Get Report) , Microsoft (MSFT - Get Report) , Facebook (FB - Get Report) , Uber (UBER) -- they all have at least one thing in common. They began as startups, the buzzword that's been sweeping the nation for the last decade and emptying the pockets of investors with an eye on the next big thing.

What exactly a startup is can be a surprisingly difficult question, one whose answer has changed over time. While the parameters of a startup's age, revenue and scale have fluctuated with the culture, a general consensus holds, that it must be a relatively new company (less than 10 years old), offer a service that seeks to innovate on a market problem rather than imitate prior solutions, and most importantly, hold significant potential for growth. The last of these factors has done the most to capture the minds and money of investors. The stocks of companies like Facebook (FB - Get Report) , Netflix (NFLX - Get Report) and Amazon (AMZN - Get Report) , whose values have multiplied many times over since their IPOs, currently stand as gold mines for those who got on board early. They are also a stinging rebuke for those who passed on the opportunity.

For a while, SEC regulations restricted investment opportunities in these fledgeling companies to a select circle of owners, relatives and venture capitalists. But in 2012, as startup frenzy found its foothold in America, the Obama administration passed the Jumpstart Our Business Startups (JOBS) act, opening the prospect of investing in startups for average Americans through crowdfunding.

This term, crowdfunding, also has multiple uses, but pertaining to the JOBS act, this meant that startups could sell a small number of securities to a large number of investors via a broker-dealer or SEC-and-FINRA-registered funding portal. 

How to Invest in a Startup: Best Practices

The most important rule for investing in startups is don't get lost in the hype. While some startups have been a source of tremendous returns for those who got in on the ground floor, the vast majority either never take off or suffer a long, lingering death before fading into obscurity. You have to know what separates these, and while you can never be totally sure, you can at least know a few traits that startup successes have in common.

A Well-Researched Market

It may seem obvious, but knowing the demand for a product plays a key role -- one that's often hazardously ignored -- in a startup's success. This means extensive research of the target market base until an accurate picture of demand forms. It also means understanding what income-bracket you appeal to, what revenue-model is appropriate for your service to that audience, and how to price competitively within the market you're entering or perhaps, disrupting.

Disruptive Presence

A major indicator of a successful startup is its disruptive potential. Services like AirBnb, Netflix (NFLX - Get Report) , and Uber all created new markets that either disrupted or outright abolished the markets that existed prior to it.

For a company to do this, it'll have to be willing to take some risks, to offer something that breaks off from what's worked in the past and establish the new normal. This comes with the risk of aggravating competitors in existing market, but competitors will always become aggressive if a real threat to the existing market is out there, and any real threat holds good chances at becoming a real success.

Defined Company Culture 

If you want to see a company scale, you better hope it's got its act together before it all goes out under a microscope. This extends from minutiae like benefits, promotions, sick leave, and vacation policy to the broad strokes of company culture. Expanding is tiring work, and if you want motivated workers and an attractive message for consumers, you'll need a clear notion of what your business does, what beliefs and values inform its operations, and how its workers can live those out in their day-to-day work.

Twitter (TWTR - Get Report) is an example of a company culture success. It had a strict idea of creating a platform for short, shareable status-updates and ruthlessly improved on that simple goal while refusing to be distracted by the other possibilities that came with massive growth. By clearly defining what it's company was about it became the undisputed leader in the micro-blogging service it offers.

Highly Engaged

One last key component all successful startups share is there capacity to engage with and learn from people at all levels of their business. This means responding to data from test-markets early on (see Facebook's launch in Harvard), this means taking the advice from investors, advisors, mentors, and customers seriously, this means transparency and accountability for what's going on within the company as it grows.

No company can go its entire lifespan without making any mistakes. Communicating what's happening and listening to the feedback that comes with this offers the most reliable method for a startup to deal with or bypass its growing pains.

Now that you know a few traits to look for, here are some practices to remember when investing.

Make Sure You (and others) Understand the Company

If you're going to invest in a startup, it's best to go for one that's been pre-vetted. Thankfully, most of the services that allow regular people to get in on startup investing (some of which are listed below) do that vetting for you. The scrutiny changes with each platform so make sure you look into the nature of that process and find something you feel comfortable with.

That doesn't take you off the hook though. Just because a startup is vetted doesn't mean you should throw money at it. While a company consists of myriad factors for the savvy investor to inspect, a good base would be the four factors listed above. Start out by examining the company on those merits and seeing whether you still feel confident about its potential for growth.

Diversify (Carefully)

Diversification is always a good way to mitigate risk, but in a sector as volatile as startups, a blind "spray-and-pray" method probably won't serve you well. Finding that billion-dollar unicorn out of the startup bunch will easily offset any losses you take, but only if you invest in it deeply enough. Rather than spreading yourself to thin, try diversifying within a carefully curated group that spans multiple industries. That way you'll be able to both provide serious capital for these companies and dodge the worst effects of any sector-specific volatile.

Invest What You Can Afford

Again, it can't be emphasized enough that investing in startups is a risky game. As a rule of thumb, you should only invest what you can afford to lose. A good way of figuring out this number is looking between 1% to 5% of your net worth and determining what you could lose within this range given your current financial status.

Now here are some places you can invest with.

CircleUp

Companies on CircleUp tend to have at least $1 million in revenue already secured and exist in the technology, fitness, or food and beverage markets. The platform's machine learning engine evaluates millions of companies to determine the most promising of the bunch.

Once you've registered with the platform, you can invest in its startups either through direct company investment, in which you buy up shares through the site, or circles, index-funds typically made up of shares from dozens of companies chosen by a qualified CircleUp member.

SeedInvest

SeedInvest bills itself as a highly-selective equity crowdfunding platform, claiming to accept only 1% of all companies that apply for listing. The site provides a streamlined approach to crowdfunding, allowing users to invest directly in the companies listed. It formerly only allowed accredited investors to use its services, but now (with the exception of offerings listed as Reg D), non-accredited users can now invest in startups with minimums as low as $500.

Wefunder

Wefunder played an instrumental role in the creation of the JOBS act in 2013, opening the way for the equity crowdfunding that the previously listed platforms and many others facilitate. The site stands out for its exceptionally low minimum investment thresholds, sometimes going all the way down to $100. The site provides a fairly comprehensive summary of the companies they've included in their listings and include a large segment of companies in the biotech, green energy, insurance, logistics, retail, and packaged food sectors.

Can Anyone Invest in a Startup?

Yes! A major provisions of the 2013 JOBS act was that anyone, not just accredited investors, could take part in funding a company during its early stages. However, due to the risk involved, the SEC has regulations in place limiting the amount that any individual from the general public can invest in a company over a 12-month period. This investment limit varies with income and net-worth, ranging anywhere between $2,200 to $107,000.

Pros of Investing in a Startup

  • The chance to make massive returns if/when the company scales up
  • Supporting something with the capacity to create serious change in markets and the way people live
  • Building a reputation as an investor with a sense for what will be trending in the future

Cons of Investing in a Startup

  • High chances of failure (only one in a hundred startups that receive venture capital funding grow to become billion-dollar companies)
  • Potential for the company to have unexpected, negative impacts
  • Investments aren't tradable like stocks, usually must be held onto till company goes public or gets acquired