Startup companies are all the rage, especially with billion dollar acquisitions of mobile apps like Whatsapp and Instagram, and soaring valuations of tech companies after only a few years, like Airbnb and Uber.
Up until the last decade, you could only get a piece of the action if you were a venture capitalist, or had already made a bit of money through entrepreneurship or other means, and decided to become an angel investor. Even then, relationships were the main barrier to entry to investing in the latest and greatest startup companies.
Now, that’s all changing. With the rise of equity crowdfunding platforms (like these) and peer to peer lending platforms (like these), the deal flow for new and interesting startups is being opened up to investors all over the world. The question now is, how do you participate in crowd investing?
Step 1: Do you qualify to invest in startups?
Depending on where you live, you may or may not be able to invest in startup companies online through equity crowdfunding platforms.
Although equity crowdfunding has been enacted in areas like the UK for retail investors, this is not the case at the time of writing in the United States at the federal level, though more and more states have passed intrastate crowdfunding legislation.
At the present time, the main deterrent towards investing in startups online is that you must be an accredited investor (see how here). Therefore, the first step towards investing in startups online is to first determine whether or not it is legal in your particular country for non-accredited retail investors.
Step 2: Which platform is the best fit for you?
Not all platforms are built the same. For example, in our recent interview with the app iNeed, who raised money on both CrowdCube and Seedrs, the UK founder felt that Seedrs had more early stage startups and CrowdCube was a better fit for established companies.
In addition, in our interview with UK-based Syndicate Room, which has helped companies raise nearly £20 million thus far, we learned about the many different types of investment opportunities, including established companies with regular quarterly cashflows and the making of new Hollywood films.
There are a multitude of different platforms out there and it’s best to become acquainted with a few before deciding to spend most of your time looking through the different deals on a particular one, whether that’s Crowdfunder, WeFunder, EquityNet, CircleUp, or another.
Step 3: Analyze the Risks Involved
Investing in startups is a completely different world to playing the stock market and hoping to hit it big. Also, depending on what stage you invest in a company, your strategy will likely differ regarding the terms you seek and the delicate risk/reward balance. Consider some of the points we’ve outlined below.
1. Illiquidity – Seeing as a secondary market has not yet developed for equity crowdfunding, it will be extremely difficult to trade or cash out on any shares that you accumulate, unless the company has a successful exit, which could take the form of an acquisition or an IPO. It might seem like startups these days are having exits every 1-2 years, but realistically, it can take upwards of 5-8 years to build a successful business.
2. Less Active Control – Since you will be investing among a bunch of other crowd investors, you won’t have the same direct line of communication with the founders of the company as you might have if you were the sole angel investor. Unless you own a large majority of the shares and can take on the role of an activist investor, it’s unlikely that your vision for the company will be taken into account as heavily as the founder’s own vision.
3. High Failure Rate – It’s no secret, the majority of new startup companies will fail within the first year of business and an even greater number will fail within the first 5 years of business. Until a founding team discovers “product-market fit” for their company’s main product, there is a large degree of risk that your money will be spent to fuel R&D and, which may or may not be fruitful. Establish businesses naturally will be a safe investment than early-stage startup companies, but the returns will also likely be less.
Step 4: Investing 101: Establish Your Circle of Competence
Staying in your circle of competence, as defined by Warren Buffet, means sticking with investments that use technology, business models, and customer segments that you know intimately and understand. Therefore, you are most likely to be able to correctly predict how the business will look in 5 years.
“We are best at evaluating businesses where we can come to a judgment that they will look a lot like they do now in five years. The businesses will change, but the fundamentals won’t.” (Berkshire Annual Meeting 2006).
Stepping out of your circle of competence turns the investing game into pure speculation. Before investing any of your money in startup companies, I’d recommend first establishing your circle of competence and then proceeding from there.
Early Stage Startups – What To Look For
Early stage startups are extremely counter-intuitive investments, as the way in which a startup looks when it begins can be completely different from how it turns out. Just think, Twitter started as a podcasting business. It’s also extremely easy to under and over-predict a startup’s growth curve.
Therefore, the best data point that seems to correlate with successful early stage seed investments is the biology, psychology, and technical abilities of the founders. This is evidenced by the early stage-investment methodology of accelerators like YCombinator, which stress the founder over the idea. I highly recommend watching the youtube video below featuring Paul Graham. Also, the book The Lean Startup is a good eye opener.
Keep in mind that this advice is geared towards a tech startup company, which is VC-fundable, and not a lifestyle or traditional business, which may emphasize profitability and healthy cashflows over user adoption or daily user engagement. In addition, the advice tends to be geared towards consumer startups over enterprise startups. If you’re looking to learn more about early-stage Saas (software as a service) business models, I highly recommend Hiten’s SaaS Weekly newsletter.
Mid-Stage and Established Startups
Mid-stage startups and established startups are a bit of a different animal when it comes to investing. Although the founding team is still important, the business model, market size, changing customer demographics, and future growth potential should be far more heavily weighed.
At this stage, a discounted cash flow analysis is a must for new investors. Check out this quote from venture capitalist Peter Thiel, who cofounded PayPal.
“In March 2001, PayPal had yet to make a profit but our revenues were growing 100% year‐over‐year. When I projected our future cash flows, I found that 75% of the company’s present value would come from profits generated in 2011 and beyond—hard to believe for a company that had been in business for only 27 months. But even that turned out to be an underestimation. Today, PayPal continues to grow at about 15% annually, and the discount rate is lower than a decade ago. It now appears that most of the company’s value will come from 2020 and beyond.”
I highly recommend his book, Zero to One, which has some great thoughts on the mark of highly successful companies. Aside from the typical metrics like defensibility, good management, and a growing marketplace, he underscores the need for the characteristics of a monopoly. You can the in-depth review of the book here.
What company have you invested in?
I’d love to hear a bit more about your angel investing experience. What companies have you already invested in already or do you wish you invested in? Let me know in a comment down below!
