A Guide to Investing in Startups

Known as one of the lucrative investment opportunities, investing in startups has been experiencing a lot of popularity.

Have you ever thought of investing in early stage startups but found yourself unsure of where to begin?

Many potential investors are faced with questions such as:

• How much should I invest?
• Where can I discover promising startups?
• How do I diversify my investment portfolio?

If you’re among those who lack answers to these questions, you’re not alone.

Many individuals aspire to become business angels and support startups, yet they often feel lost at the starting line.

In this article, I’ll provide some valuable tips to help you kick start your journey.

But before we delve into that, let’s take a moment to explore the history of startup investing and understand the transformation of this field. Just a few years ago, investing in startups was a privilege available for a fortunate few (affluent individuals).

Today, I will be covering all the essential information related to startups as well as the pros and cons.

By the end of this article, you will have clarity on whether or not to invest in startups based on your specific circumstances.

If you want to invest as an expat or high-net-worth individual, you can email me (advice@adamfayed.com) or use these contact options.

What is a Startup?

Startups are relatively enterprises established with the intent of:

• Creating a distinctive product or service.
• Introducing the product/service to the market.
• Making it highly appealing and irreplaceable to customers.

Startups root for innovation, with a mission to address existing shortcomings or establish new categories of goods and services.

In doing so, they challenge conventional industry practices, signaling disruptions across various sectors.

It’s no wonder that many startups are recognized as industry disruptors.

On a broad scale, startups function similarly to traditional companies.

A team of employees collaborates to create a product that will attract customers.

However, what sets startups apart is their approach to achieving this goal of making customers enthusiastic.

Conventional companies often replicate established models and processes.

For example, someone aspiring to open a restaurant may opt to franchise an existing restaurant.

This would essentially mean that the company is adopting a pre-established business framework.

In contrast, startups strive to pioneer entirely new models.

In the food industry, for instance, a startup may offer meal kits, exemplified by companies like Blue Apron or Dinnerly.

These meal kits provide the same outcome as dining at a restaurant—a chef-prepared meal.

Still, they do so with added convenience and customization options that traditional eateries cannot match.

Startups unlock vast scalability, reaching millions of potential customers as opposed to the thousands a single restaurant might serve.

Another critical distinguishing feature of startups is their emphasis on speed and growth.

Startups are committed to swift idea execution, which is often done by employing a practice known as iteration.

This iteration practice involves continuous product enhancement based on user feedback and data analysis.

Typically, a startup commences with a rudimentary product version called a minimal viable product (MVP).

This MVP is rigorously tested and refined until it reaches a state suitable for market introduction.

In addition to refining their products, startups are on a constant quest to expand their customer bases rapidly.

This expansion helps them secure larger market shares, attracting more investments to fuel further product development and audience growth.

All of this rapid innovation and growth typically serves a central objective of going public.

When a company offers shares to the public, it creates an opportunity for early investors to cash in on their stakes, commonly referred to in startup circles as an “exit.”

There were two primary reasons why this form of investment remained exceedingly rare.

Firstly, the associated costs were way too substantial.

Engaging in startup investments incurred expenses that often proved to be huge.

These set of fees included legal fees for contract development.

As a result, it only made financial sense if you were prepared to commit sums exceeding €100,000.

A considerable amount was particularly needed when aiming to build a diversified portfolio comprising 5 to 10 companies.

Consequently, startup investing was primarily within reach of accomplished entrepreneurs or former CEOs and CFOs.

These sets of people usually had amassed substantial wealth throughout their careers.

However, the obstacles didn’t end there. Even with substantial capital, finding promising startups always seemed to be a challenge.

These startup companies weren’t congregated in a single, easily discoverable sector or geography. The absence of a centralized hub made it troublesome for enthusiastic investors to identify worthwhile opportunities.

Naturally, this also made it challenging for many promising startups to secure investment from investors.

In essence, the startup investment landscape faced inefficiencies and limitations in the past.

Nowadays, in the contemporary investment realm, these hurdles have been significantly lowered.

Online investment platforms have emerged, employing standardized contracts and granting quick access to a diverse range of startups.

Thanks to these advancements, startup investing has become accessible to a broader and more diverse range of individuals.

Now, let us have a comprehensive look at some of the steps related to startup investments.

How Startups Raise Capital

In general, there are three prominent methods by which startups opt to raise their capital.

Let us have a look at each of those methods briefly.

Equity Financing

Equity financing refers to the process of investors purchasing shares or other ownership stakes in a startup.

Investors who opt for equity become shareholders and partake in the company’s profits and losses.

Their primary goal is often capital appreciation, and if the startup succeeds, investors will realize substantial returns when the company goes public or is sold.

Common examples of investors in this category include angel investors, venture capitalists (VCs), and occasionally friends and family.

Equity financing is well-suited for businesses with significant growth potential but limited initial revenue.

It relieves owners from the burden of repaying debt, enabling them to expand their operations and collaborate with experienced partners.

However, it often involves relinquishing some degree of ownership and control.

Related content: Private Equity and Venture Capital Financing

Debt Financing

Debt financing is when a company secures funds from investors or institutions with the agreement that it must be repaid with interest.

Debt investors receive a fixed income stream but typically do not share in the company’s equity growth.

Sources of debt financing include traditional banks, online lenders, financial institutions, and occasionally, investors.

Debt financing is most appropriate for startups that have a clear path to profitability and the capacity to make timely repayments.

While it allows business owners to retain full ownership, it comes with the risk of debt obligations.

Such debt obligations can be challenging for businesses with unpredictable cash flows.

Grants

Grants are non-repayable financial contributions provided by governments, foundations, or other organizations.

This is often done by administrative authorities or other entities to support specific initiatives or projects.

Eligibility for grants revolves around economic sectors, charitable endeavors, or research and development (R&D) activities.

Startups must meet the grant’s specific requirements to be considered.

Grants are beneficial for startups engaged in research, innovation, or other activities aligned with the grant’s objectives.

They are an attractive option for eligible entrepreneurs as they provide financial assistance without surrendering ownership or incurring debt.

Now, let us have a look at some of the common methods for investing in startups.

How to Invest in Startups

The investment stages of startup companies are based on factors like risk-reward ratios, stage of business, exit plans, etc.

In most cases, the individuals interested in startup investing are required to have a net worth of at least $1 million (in cash and financial assets) or an income of $200,000.

This level of income or net worth lets an individual fall under the category of “Accredited Investor”.

You can even get access to investment opportunities in startups through an investment provider (like me).

Methods of Investing in Startups

Retail investors have the opportunity to engage in a variety of investment options throughout a startup’s development stages.

These investment opportunities fall into two main categories:

• Direct Investment:

In this scenario, the investor directly injects capital into a specific startup without the intermediation of entities like venture capitalists, debt financiers, or private equity firms.

Angel investing is typically a direct approach to investment.

• Indirect Investment:

In this situation, the investor invests in a venture capitalist, debt financing, or private equity firm.

Subsequently, these intermediary firms allocate the invested capital to various startups, leveraging the funds obtained from individual investors, such as yourself.

— Angel Investing

Angel investors, typically high-net-worth individuals, invest capital into businesses in exchange for an equity stake in the company.

Angel investors often engage with businesses at the seed stage, with their investments spanning approximately 4-5 years.

Investing in startups at this early stage carries inherent risks.

However, if the startup prospers and experiences substantial growth, there is potential for substantial rewards.

Angel investors can exit their investments through various means, such as:

• Selling their shares to larger investors
• The company going public (initial public offering)
• The company being acquired by a larger entity

To be recognized as an individual angel investor, one must possess net tangible assets of at least (approximately $250,000).

This is typically the case in most countries.

Additionally, they must self-declare their intent to invest in a startup as per regulatory authority requirements in their country.

For corporate entities, a net worth exceeding $1 million is the requirement to be deemed eligible for angel investing.

— Venture Capital (VC)

Venture capitalists are professional investors who manage funds that invest in startups in exchange for equity shares.

VCs make larger capital investments compared to angel investors and often focus on later-stage startups.

Such startups usually come with established traction or success.

Venture capitalists participate in various startup stages, from seed to growth.

The investment horizon varies but typically extends over 8 to 10 years with the expectation of a profitable exit.

VC investments carry a high-risk, high-reward profile.

VCs typically seek rapidly growing businesses with the potential to become industry leaders.

Venture capitalists aim for profitable exits through initial public offerings (IPOs), acquisitions, or secondary sales of their startup shares.

— Venture Debt

Venture debt involves providing loan capital to firms from professional lenders.

Venture capital elements may be incorporated into the structure, such as warrants or options resembling equity.

This arrangement allows lenders to earn more if the startup succeeds and gains value.

Venture debt often features shorter investment periods, typically spanning 12 to 36 months.

Venture debt is perceived as having lower risk because it involves lending rather than stock ownership, resulting in potentially fewer rewards.

Venture debt is repaid with interest.

The exit strategies involve repayment from the startup’s cash flow or refinancing through other debt instruments.

— Private Equity (PE)

Private equity (PE) firms invest in private companies, including startups, intending to achieve long-term profitability.

PE firms focus on established startups and may use various investment forms, including equity, debt, or a combination.

Private equity investments can vary, typically ranging from 5 to 8 years, depending on the strategy of the PE fund.

Private equity investments usually comprise companies with established cash flows, offering relatively lower risk compared to early-stage investments.

However, the potential returns can be substantial, particularly in buyout scenarios.

— Crowdfunding

Nowadays, several crowdfunding sites even offer access to small-scale investors.

In general, crowdfunding involves the pooling of money from several investors with smaller investment minimums.

The minimum investment amount can be as low as $500, which can be easily accessed by everyday investors.

Some of the online platforms that allow individuals to partake in startup crowdfunding are as follows:

• StartEngine
• Indiegogo
• Kickstarter
• Fundable
• CircleUp
• Patreon
• Wefunder
• IFundWomen
• GoFundMe
• Crowdcube
• MicroVentures
• Seedrs
• Mightycause

A Step-By-Step Guide to Invest in Startups

Here’s a step-by-step guide to help you make better decisions and gain more profits when investing in a startup.

1. Familiarize Yourself

Before you start investing in startups, it’s essential to gain a solid understanding of the startup ecosystem.

Familiarize yourself with the following aspects of startup investing.

• How does startup funding operate?
• Identify your areas of interest.
• Recognize industry trends

This knowledge will guide your decisions regarding which industries and growth stages you want to invest in.

What to look for in a startup

To determine if a company is worth investing in, consider the following factors:

• A compelling vision that sets the startup apart.
• A strong and capable founding team.
• A significant target market with growth potential.
• A well-defined and scalable business model.
• Evidence of progress, such as customer acquisition and partnerships.
• A competitive advantage in the market.
• A clear growth strategy.

Investment terms should also be favorable and transparent.

How much to invest in a startup

The amount you invest can vary widely, but typically, angel investments range from $10,000 to $1 million or more.

The choice of investment amount is entirely up to you and the specific investment opportunity.

2. Have a Clear Strategy

Determine your investment motivation, such as financial return or a desire to support specific causes.

Define your:

• Investment goals
• Risk tolerance
• Investment horizon
• Portfolio allocation
• Industry preferences
• Geographic preferences
• Level of involvement
• Value you can contribute

3. Search for Startups and Founders

Connect with founders through your network of angel investors and entrepreneurs you already know.

Attend startup events, engage on LinkedIn, reach out via email, or explore angel syndicates and investment platforms.

4. Assess the Startup

When you’ve found a promising startup, evaluate the following key aspects:

• Credentials of the Founding Team
• Innovation and market potential of the idea
• Intellectual property protection
• A comprehensive and realistic business plan

5. Talk to the Founders

If possible, getting to know the startup founders is essential while making a direct investment.

Try to assess their:

• Capability to execute their vision
• Mindset and dedication
• Compatibility with your goals

Always try to invest in people you believe in and ideas you want to support.

6. Estimate the Company Valuation

Understanding the company’s value is crucial for determining your share price.

Valuation can be done through methods such as comparable analysis, Discounted Cash Flow (DCF) analysis, etc.

7. Execute Due Diligence

Conduct thorough due diligence, verifying information, checking financials, and seeking expert opinions.

This sort of due diligence will allow you to ensure there are no hidden issues.

8. Negotiate the Deal

Create a term sheet and negotiate key deal terms with the startup founders.

The term sheet should cover aspects like valuation, pre-emption rights, and investor consent.

9. Get Tax Relief

Take advantage of tax relief schemes, which offer significant tax breaks for investing in early-stage, high-risk companies.

10. Manage Your Investment

Once your investment is in place, manage it according to the terms agreed with the founders.

This may involve attending board meetings, providing strategic guidance, and mentoring founders.

11. Make a Return on Your Investment

Your return on investment will come when your equity grows in value.

This can occur through selling shares back to the founders, mergers or acquisitions, or an initial public offering (IPO).

Keep in mind that angel investors typically hold their shares for at least five years for a potential profit.

However, investing in startups carries inherent risks, with up to 60% of startups failing in their early years.

Invest wisely and be prepared for potential rewards and risks associated with startup investments.

Related content: Should I Sell My Company Stocks?

Pros and Cons of Investing in Startups

Advantages of Investing in Startups

• High Reward Potential:

Startup investments are typically made in early-stage companies with substantial growth potential.

If you identify a promising startup, your investment can experience exponential growth within a short span.

These startups may not have a proven track record, but if they succeed, the rewards can be significant.

• Portfolio Diversification:

Mitigating risk is possible through diversifying your investment portfolio across different startups at various stages of development.

• Change-maker:

Startup investing offers the opportunity to contribute to positive change by supporting innovative ideas and companies that can make a difference in the world.

• Side Hustle:

Pro: Many individuals view angel investments in startups as a side hustle that can generate additional income.

The dynamic nature of the startup ecosystem provides a platform to analyze and invest in innovative ventures.

• Involvement in Innovation:

Investors have the opportunity to participate in the development of innovative products or services, contributing to advancements and breakthroughs.

• Collaboration with Ambitious Teams:

Investing in startups enables individuals to work alongside talented and driven teams of entrepreneurs, providing a learning experience and the chance to be part of exciting ventures.

• Equity Stake in High-growth Companies:

Investors have the potential to acquire equity stakes in high-growth companies, which can become valuable assets over time.

Disadvantages of Investing in Startups

• High Risk Investment:

Startup investments are inherently risky due to their early-stage nature.

Business models and teams may lack stability, increasing the risk of losing your investment if the startup fails.

• High Volatility:

Startups often experience significant volatility during their initial years, affecting not only their finances but also their founders, teams, market conditions, and competitors.

This leads to a high level of uncertainty and emotional risk in your investment.

• Long-holding Periods:

Startup investments typically involve a lengthy holding period of 7-8 years on average.

This illiquidity can be disadvantageous if you require quick access to funds for emergencies.

• Limited Liquidity:

Investments in startups can be illiquid, tying up your capital for an extended period, making it unsuitable for investors needing quick access to their funds.

Note: It’s crucial to remember that not all startup investments will succeed, and there is a risk of not achieving the desired return.

However, the potential rewards of investing in startups can be highly attractive for those willing to embrace some risk.

Bottom Line

If you are unsure of where to invest, while having access on a global scale, it is wise to go ahead with European countries like:

• Sweden
• Finland
• Denmark
• Norway
• Switzerland

On the other hand, some other countries deemed best for startup investments include:

• Australia
• UK
• Singapore
• New Zealand
• Germany
• China
• Russia
• Brazil
• India

Note that startup investments do carry a higher level of risk, and therefore, it is wise to make sure they are suitable for you.

Evaluating whether an investment is worthy or not depends on individual circumstances.

Therefore, it is wise to consult an investment expert before tending to proceed with such endeavors.

However, I have provided some useful information that can help in evaluating whether or not you can profit from startups.

If you don’t have the necessary time or expertise to tend to your investment portfolio, then I can be of assistance.

I have helped numerous expats and high-net-worth individuals achieve financial freedom through my top-notch financial solutions.

Feel free to contact me to find out whether you can be my potential client and profit from my best-in-class investment services.

Pained by financial indecision? Want to invest with Adam?

Adam is an internationally recognised author on financial matters with over 830million answer views on Quora, a widely sold book on Amazon, and a contributor on Forbes.