Investing in startups is a unique way to diversify your portfolio; however, doing so can be extremely risky.
Pros of investing in startups:
- A successful startup can triple your investment in a short time.
- Early investors are often given an equity stake in the company. Thus, as the company’s value increases, so does the value of your shares.
- The networking opportunity when working with startups is tremendous and can set one up for a future career path.
Cons of getting involved in startups:
- These early-stage businesses are still getting off the ground and establishing their brand.
- Many may not have a steady sales cycle set.
- Market trends out of your control can affect company growth and success.
- Often, large amounts of capital are required to grow or pivot.
You Have To Know What You’re Getting Into
Given the high risk associated with investing in startups, it’s essential to be as knowledgeable about the investment as possible before handing over your money. Startup founders are very talented at selling their ideas. It’s imperative to identify red flags or points of concern so that you can ask the right questions and address issues before potentially investing.
Before we get started, here are some other ways you can get involved with startup investing.
How To Get Involved With Investing In Startups
There are a few avenues you can use to get started:
- Join an angel investing group. Angel investors get involved in the super early stages of a company, receive equity stake, and face little competition from the venture capitalists who tend to come in later.
- Consider startup investing platforms you can join, such as SeedInvest, WeFunder, StartEngine, and Republic. Through these, you can access companies that have already been vetted. It’s an excellent avenue to look into the industry and see what’s available.
- You can also join venture capital funds. These funds pool money from different investors until they hit a minimum. Then, their fund manager looks for the best startups for investing in. This avenue will likely require more capital.
6 Things To Know Before Investing in Startups
The wealthy all have one thing in common – they do not part with their money easily. As an investor, you should have the same hesitation. Take your time to do the appropriate due diligence to ensure your investment is fruitful.
When you hear an investment pitch, keep an eye out for these things:
- The Team
- Financial Standing
- How They Will Execute Their Plan
- Have They Shown Proof of concept
- How They Will Use The Investment
- What Is Their Exit Strategy
1 – The Team
If you’ve seen an episode of Shark Tank, then you know that the Sharks will fork over an investment based on the entrepreneur, their work ethic, and/or the team they have assembled.
So, look for the team. Is there one? Who is involved, and what is their background or expertise? What does each of them bring to the table? What is their specific contribution to the company? Is nepotism involved?
Even if you’re unsure about the company, a solid team that works well together and has a clear vision will likely lead the company to success. Your investment, then, is in the team and its capabilities.
2 – Financial Standing
You don’t need to be an expert on financial statements. Still, there should be a basic understanding of business finances to guide your questions.
For instance, how much money have the founders put into the company? Are there outside investments or investors? If so, how much equity was given up in return? How was the investment spent? What was the return on that spending? Does the company have any debt? Do they have sales?
Jorey Bernstein from Bernstein Investment Consultants, states:
“When reviewing the financials of a startup to determine whether it’s a good investment, consider the following: Revenue growth, look for consistent and accelerating growth over time, as it signals strong demand for the product or service; Gross Margin, divide gross profit by revenue. A high gross margin indicates that the company can generate significant profits from its core business. Ideally, look for a gross margin of 50% or higher, depending on the industry; Operating Expenses, like sales, marketing, research & development, & administrative expenses. A startup with low operating expenses and high revenue growth is more likely to achieve profitability.”
A company’s finances are an objective measure of what’s going on in a startup. They can give you a clear picture of their decision-making, which then dictates the path going forward. Anything that seems off from a financial standpoint should be viewed as a huge red flag.
3 – How Will They Execute Their Plan
Ask many questions regarding the next steps in the company’s plan. Part of this will be dictated by the investment they receive, but the main thing is to make sure their plan makes sense. Are their next steps fruitful and in line with growing more and expanding?
If you’re unfamiliar with what should happen, ask the team for data. What is driving their decisions? How did they come to the conclusions that they made? Are there market trends that are guiding their next steps? Have they reached out to any advisors or leaders within the industry for advice? Which metrics will they use to determine if their plan is working?
Is there a backup in place so that they can pivot if needed?
4 – Have They Shown Proof of Concept
Does the company have any sales to prove that the market needs what they offer? If so, then what are the sales numbers? How much demand are they experiencing? If there are no sales yet, what research did they do to gauge interest? Did they test the market?
A startup may have an excellent product and idea for execution, but that doesn’t mean the product will sell. A good entrepreneur is fully aware of this and does their best to put in the research, make changes, or pivot if necessary.
5 – How Will They Use Your Investment
Understand how the team will apply your investment to the business model. Thoughtful planning and spending in the right places can make a huge difference in how successful a startup can be. As an investor, you should have a complete understanding of the plan.
In addition to monetary investment, as an early investor, you may be asked to invest your time and give advice when needed. Ascertain what your responsibilities will be. Will you be a part of the board of directors? What kind of input will they ask of you? What is the level of time commitment that will be required from you?
Understand what your investment will mean by asking these questions!
6 – What Is Their Exit Strategy
Every company should have an idea of where they want to end up. Many have the goal of being bought out by another. Some wish to build their own and expand until they can go public or make an initial public offering (IPO). Yet others may have a vision for merging with one another and forming a symbiotic relationship.
Depending on the product and the company, the exit strategy can change. As an investor, your ideas of what should happen may differ from the founders. It’s essential to be aligned because the exit strategy can alter the steps leading up to it. The entire execution plan can change.
So, ask about the exit, why they think it’s best, and how they plan to get there.
Bringing It All Together
Investing in startups is exciting but also risky. Know which questions to ask to make the most informed decision possible and manage your expectations.
Spend time with the startup and its founders, and do your due diligence on the industry involved. The more informed you are, the better you’ll be able to negotiate and understand the process.
Diversifying your portfolio by investing in startups can expose you to high growth potential. However, understand that many startups fail, only a few succeed, and even fewer do so quickly. It’s important to remember that investing in startups is a long game that can be very fruitful or not at all. Regardless, by getting involved early, you are taking a chance on the future and people and learning something new and unique every day. That is worth the investment.