How to Invest in Startups

Investors are no longer limited to public equities.

The U.S. Securities and Exchange Commission’s 2016 crowdfunding regulation gave the green light for everyday investors to invest in early stage startup ventures. Investors may now access more options in the private market and pre-initial-public-offering opportunities.

As fewer companies are going public and more companies are staying private for longer, you may be interested in expanding your investment opportunities into startups that are growing quickly.

Now that everyday investors have access to opportunities in the private market, it’s important to consider whether alternative investments like startups have a place in your investment portfolio. Here’s what you need to know about investing in startup companies:

— What is a startup, and why should you invest in one?

— How to choose a crowdfunding platform.

— How to evaluate startups to invest in.

— The risks of investing in startups.

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What Is a Startup, and Why Should You Invest in One?

A startup is a company that creates a product or service from the ground up. There are different development stages of a startup, as the company gradually grows and finds where it fits in the marketplace. Startups tend to be disruptive and innovative; they try to find solutions to an existing problem.

Because of these characteristics, startups can be a strategic way to diversify your investments.

One of the reasons to consider investing in startups is simply because they’re now available to ordinary investors.

Private markets are much larger than public markets, and while they’re riskier, it makes sense for retail investors to explore these opportunities now that there is access, says Swati Chaturvedi, co-founder and CEO of investment platform Propel(x).

If you’re interested in investing in startups you believe in, it’s best to get in at the early stage — or what’s called the seed funding stage, where money is used to get the company off the ground. You can also get into a startup during later rounds of funding, but this could present a higher barrier of entry since by this stage a company is more developed.

Another reason to invest in startups is that they have a possibility of generating higher-than-average returns. The flip side of being a higher-risk investment is that there can be a lot more room for growth in startups compared to publicly traded companies.

“Usually, public companies, especially nowadays, are at least in the single-digit billions in terms of valuation and can only go up so much, whereas, for early-stage startups, they’re in the single-digit or double-digit millions in terms of valuation, and there’s obviously a lot more room for upside,” says Adam Moelis, co-founder and CEO of Yotta, a personal saving platform.

Startups as an alternative investment also offer investors another way to think about your portfolio allocation strategy.

“Instead of saying 70% stocks and 30% bonds, I’m going to transition to 60% stocks, 30% bonds and 10% in alternatives,” Chaturvedi says.

There are several categories within alternative investments, startups being among them, and you should hold a portion of your alternative asset allocation, she says.

How to Choose a Crowdfunding Platform

Investing in startups has been simplified with crowdfunding platforms allowing investors to access startup investment opportunities.

Take a look at how a prospective crowdfunding platform is structured. There are many businesses that are looking for funding. That said, look for the percentage of companies that are ultimately selected to be on the platform. Does the platform itself take a stake in the startups? That’s an important question to ask, as well as how the crowdfunding platform screens the companies it brings to investors.

“Look for platforms which offer you the opportunity to connect with the founder,” Chaturvedi says. This way, you can ask them questions and learn about the company directly from the source.

Depending on the crowdfunding platform, there can be different entry points. You can find a platform that allows you to invest as little as $10 or as much as $5,000 or more. Even those platforms that have seemingly higher entry points, Chaturvedi says, are still lower than in the larger private market.

[Read: Q&A: Why to Focus on Factor-Based Investing]

How to Evaluate Startups to Invest In

Public companies are required to report their financials on a quarterly and annual basis. These reports allow investors to learn more about a company’s growth prospects and financial position.

But startup companies are not required to provide financial reports to the public. This can make it challenging for investors to do proper due diligence. That said, there are ways to work around this challenge.

One way to find out more about a company, Moelis says, is to evaluate other investors in the company and to check whether the company has a well-established team.

Vet the founder and the team’s background and industry expertise, and see if they have created other businesses or products in their niche. If the company has a good team, Moelis says, it can adapt to the market if changes arise.

It can also be helpful for investors to have experience in the industry in which the startup operates. That way you can make careful estimates on the viability of a startup in the future.

Chaturvedi says there are two questions investors should ask themselves when researching a startup: What is the startup’s market potential, and is there competition?

Being aware of industry trends and understanding how a startup fits in that space allows you to make better informed and potentially more lucrative investment decisions.

Moelis also recommends going into an investment with your risk-return profile in mind. Many startups struggle in the beginning stages and often fail in the first years of development. So, as he says, understanding the statistics of this alternative asset class will put investors in the right mindset to set expectations.

[Read: How to Build an Investment Portfolio.]

Risks of Investing in Startups

Given that startups are a high-risk investment, Chaturvedi suggests that investors “only invest money you are willing to lose.”

Experts say diversification among startups is a good way to mitigate risk in this alternative asset class, rather than being concentrated in just one or even a few startups. By investing in many startups, you have a better chance of finding a company that will succeed.

Chaturvedi recommends investing across 15 to 20 startups, since a majority of startups end up failing.

“If you invest $100k in 10 companies, $10k each, you will find the first thing that you’ll do is lose $50k of your money, and that will happen within a year or two years. So your portfolio could be underwater for some time because the best companies are building and don’t see an exit for a long time,” she says.

If the market for a startup ends up falling through, your investment can end up dropping to zero. “A lot of these startups don’t have a track record, so you’re betting on a vision,” Moelis says.

Startups also have liquidity risk. Your cash could be tied up for seven to 10 years. The money you invest is not accessible to you for a long time, and there is a possibility of not seeing that money again.

Since there’s a high probability of losing money, “make sure it’s a small percentage of (your) entire investable assets,” Chaturvedi says.

Takeaway

While startups can be a high-risk investment, investors can reap big rewards if a company finds success down the line. One of the biggest considerations you need to make is how startup investments fit into your risk tolerance and overall investment strategy.

To position yourself profitability, do your due diligence in this alternative asset class and understand all possible outcomes — both positive and negative. Even if you do your best research, you should know there is still no guarantee that a startup will be successful.

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How to Invest in Startups originally appeared on usnews.com

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