Thanks in part to the Securities and Exchange Commission’s 2016 crowdfunding regulation, investing in startups and local businesses isn’t just limited to accredited investors — anyone can do it, in a variety of ways.
Investors can buy into a privately managed startup or venture capital fund that invests in pre-IPO opportunities, purchase company shares online through crowdfunding platforms, or work directly with a local company to buy a percentage of equity.
[See: 16 Things Investors Should Know About Crowdfunding.]
Whether it’s a mom-and-pop or a tech business, the legal and financial due diligence required of investors, as well as the level of risk, is the same.
“They’re either home runs or they’re strikeouts,” says Gregory Sichenzia, a founding partner of New York-based securities law firm Sichenzia, Ross, Ference Kesner.
Investments can be made in companies at different stages of establishment too. For example, a company may be soliciting its first round of investment to get started (seed stage), or may have established revenue but needs investors to grow (late stage).
You should also have a genuine interest in the companies you choose, says David Shanahan, an entrepreneur and COO of Web startup AltaClaro and founder of the business consultancy Civili Consulting.
If the chance of hitting it big with a fledgling company intrigues you, do it carefully with the following tips in mind.
Examine the legal documents. Startups may be so intent on the big ideas for their business that they don’t always have their corporate records in order, Sichenzia says.
You’ll want to look into whether the company is legally incorporated, that the shares are properly issued, and that the leases and contracts the company claims to have are ratified, preferably with an experienced securities attorney, Sichenzia says.
“Enter these investments with the mindset of a student,” Shanahan says. “Ask questions, be open, and learn as much as you can about the idea, the company, the people and the startup culture in general.”
Crunch the numbers yourself. A startup’s valuation is anybody’s guess. Valuations for startups are arbitrary because they may lack established revenue, Sichenzia says. Even the management team may be using a hypothetical valuation.
You’ll want to do your own analysis of what your share is worth. “Your $1,000 or $100,000 may buy a different percentage,” Sichenzia says.
Also, ask the company how much it has already raised, says Mike Norman, cofounder of WeFunder.com, a crowdfunding platform for startups that has facilitated $20 million in investments for startups.
“If the company has been able to raise a lot from the majority of its customers, it’s a great indicator of how well-run the business is,” he says.
[See: 7 Things Fund Managers Ask Company Managers.]
Know the risks. Startups require bold, patient investors. Always remember these investments are high risk, Norman says, and you should not expect to see a return on your money for up to 10 years.
In fact, your investment may not pay off at all, and Shanahan says investors should be prepared to lose some money.
Instead of sinking all your funds into one startup, spread the risk around by helping to seed several businesses.
“If you invest in one startup, the odds are pretty good that you will lose all your money. If you invest in 10, you might find one that pays for the rest of them,” says northern California business and tax law attorney Roger Royse.
Your other investments should be liquid enough that “you are not relying on this particular investment for a short-term return,” Shanahan says, and you also won’t be able to cash out at any given time.
Lend rather than invest. If waiting a long time for an investment return (or possibly never seeing one at all) frightens you, make a business loan to a promising startup instead. This could take the form of a revenue share agreement, in which you are repaid from a portion of the business’ revenue annually, Norman says.
“The potential for reward is lower but so is the risk,” he says. Plus, you won’t wait long for a return. You can expect to make about 8 percent interest on your money immediately.
“Debt is a much more straightforward way of getting your money back,” Norman says.
Meet the top brass. A company’s management is one of the biggest components or predictors of its success. “Get to know the founding team on a personal level,” Shanahan says. You should like them as people, he adds.
Sichenzia suggests reviewing management’s past and present qualifications carefully, and don’t take anyone at their word. Even if a company’s owners are friends of friends, always verify what they tell you.
[See: 10 Skills the Best Investors Have.]
Their passion should also be contagious.
“After all, a startup is simply a group of people with an idea — usually a crazy one — and passion is the fuel that drives the vessel that ultimately becomes success,” Shanahan says.
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How to Invest in a Startup originally appeared on usnews.com
