It all starts with the idea of finding cutting edge-solutions to everyday problems. That´s where the world of startups takes over. Startups offer high profits for Investors, which also provides high risk in return. Sequoia Capital’s 50 times return from their investment in Whatsapp (acquired by Facebook) should be Investors excited to find the so-called “Unicorn.”But not all ideas evolve far enough to succeed; some ultimately fail.
However, it should remind you that this investment is a highly risky business, and you have to collect enough information on how to invest in a startup of your choice. You should consider how the capital will be used and what effort will be put in, so the odds will increase that the startup will grow and become successful. To reach your goal of getting a return on your investment which may grow to a 5x return or even a 50x return of your start money.
Investors, also known as “angel,” consider helping a startup in the first stages with funding. The number of angel investors has increased in the age of a knowledge-based economy. Nowadays, they invest in thousand of startups with billions of dollars of their money. The information online and the rise of new platforms give individuals access to this investment opportunity.
Before starting, always think about the important risk factor, that you must be willing to lose some to win in the long term. In this guide, you can find various investment strategies to help you manage and judge the risk behind startup investing.
What is a Startup?
If you search for a Definition of a Startup, you can find a lot of different answers. Here I try to give the easiest to understand the definition. A Startup describes a recently founded Company that is in the first stage of its operations. It’s a temporary Organisation and has the mission to find a repeatable and scalable business model, according to startup guru Steve Blank.
Essential is to build and develop a foundation of 6 cornerstones that are vision, team, product, market, business, and culture. The quality of the foundation determines if the startup fails or grows into a successful business. The idea is to manifest themselves differently depending on individuals and the relevant industry. Therefore startup is different in revenue, profit, and employment numbers. Also, time plays a role because it shows more definitive characteristics of startups.
The lifecycle of a startup
The need for a consistent flow of capital determines how long the startup will exist. In a company´s life, there are multiple rounds of investments to grow into a sustainable and profitable business. The first round of investment to help that the idea will be translated into an actual product or solution. Generally, the funding is from the innovator’s own pockets if they´re lucky, with the help of government or institutional funds.
Next is the seed stage which includes investments from family members and friends. Finally, the startup begins to take shape. During this phase, the investors begin to establish a relationship with the founder. They expect and hope that the profit will be substantial, but in reality, the risk is not fairly sizable at this point. These early investors are considered angels. In this category of angel investors, there are also seed venture capital organizations and crowdfunding platforms.
Now the startup enters the so-called Series A investment. In this growing phase, the company begins to deliver some products, and the startup starts to balance the initial entry cost.
This is the point where a startup enters a Series B investment. The venture money, also often referred to as growth capital, dominates this development phase. If the company is, after this period of growth and profit, still successful to this point, the startup eventually reaches maturity. When it goes forward, the amount of generated profit is substantial. It eventually gets bought out by a larger company or floats on a public exchange.
Valuations and Terms
The most important question is: How to find, as an angel investor, this startup with billion-dollar exits?
Investors must not only understand the terms and conditions of their investment but also that the company’s value or worth is based on a multitude of factors. To calculate the investment amounts and to negotiate the terms, valuations must be considered.
Early Stage Valuation
In this early stage, evaluating a startup is quite tricky because there is no financial history and, often, no revenue. This is why many qualitative factors are the way to go in this early stage. Valuation is the financial worth of the company at a given time. The two categories of valuations are the pre-money valuations (value of the company pre-investment) and the post-money valuation (the company’s value after investment). Calculation: Post-money= Pre-money + investment
Pre-money valuation is defined by the lead investor in the investment round. This helps to dictate the percentage of the return that the investor receives for their investment in the company. The factors of the company´s valuations are comparisons of similar companies, the competition in the industry, the management background and experience, and possible future capital needs. The various methods to determine this valuation during the company´s early stages are explained below.
Venture Capital Method of Valuation
The Venture Capital Method is the first and most popular method used by investors. It relies on many quantitative factors generated by exceptions.
(Expected exit value ÷ expected return) – amount invested = pre-money valuation
This method will generally produce higher valuations because it is based on future projections.
Berkus Method
The Berkus Method is a hybrid approach of qualitative and quantitive criteria with five qualitative characteristics:
1. Sound Idea (Product Risk)
2. Prototype (Technical Risk)
3. Quality Management Team (Execution Risk)
4. Strategic Relationships (Competitive Risk)
5. Sales (Production Risk)
The monetary value of each is between $0 to $500,000. To get the valuation of the company, the assigned values are summed together.
Scorecard Valuations Method
Similar to the Berkus is the Scorecard Method with a more complex hybrid approach. The first step starts by noting the valuations of other pre-revenue companies in similar sectors and industries. Where the valuations are averaged.
Next, a venture score is assigned to pre-established qualitative factors like the Berkus method. A company that proves average in certain areas when compared to similar companies receives a score of 100%. More impressive
companies get larger scores.
Every area gets a percentage weight, for example, (1. Sound Idea 15%, 2. Prototype 10% …), which will be multiplied by the percentage of the comparison.
Weight % x Comparison % = Factor
The sum of the factors is multiplied by the average valuations of the other pre-revenue companies in the first step.
Late Stage Valuation
Valuating a company later in the company´s lifecycle is easier. The company now has a record of its past financial performance and more accurate future projections. Investors can analyze this history and the company´s revenue to generate more quantitatively based valuations.
To evaluate this late stage, companies search for “discounted cash flow (DCF)” in their preferred search engine. It is critical to understand a company´s valuation before investing. Knowing the various factors in calculating a valuation can lead to better, more responsible investment decisions.
Deal Terms
After a proper startup valuation, deal terms must be negotiated and agreed upon in term sheet documents. The terms give the valuation of the startup and the amount of investment for the startup by platform or individual as well as co-investors. The form of investment is noted and recorded in the deal terms. The protective right and preferences are enumerated and reserved.
Best Startup Investment Strategies
There exist various strategies and approaches for investing in startups to minimize some of the risks and maximize the potential returns. Angel Investment is a risky but rewarding nature.
Industry Choice
An investor should actively choose the investment, the startup, its target market, and its industry. Also, the surrounding market condition at a certain time is a factor to look out for. Some industries are just better than others. Another factor is determining investments in a given industry based on the investor’s experience. Therefore if an investor is a doctor, then he may have certain insights about the medical world, which proves valuable when investing. Expertise can increase returns over the long term.
Diversification
Always diversify your investment in any asset class. It is unwise to bet on just one or two startup companies. The odds are higher that the startup returns less than the initial investment amount. To get better chances at finding a billion-dollar winner, invest in more competitors. The winners can more than compensate for the losers.
You should also maintain a portfolio of startups in various industries with various business strategies. Aswell diversify based on company age in participating in some early-stage, mid-stage, and late-stage investments. Around 10-20 companies are good for building a robust, diverse portfolio.
Due Diligence
Due Diligence means investigating a person or company before signing a contract. Spending time investigating helps to influence investment outcomes positively.
Post-Investment Involvement
After an investment, there are additional contributions an investor should make to increase the likelihood of a high return. These form of participation includes mentoring, financial monitoring of the startup, and establishing a business relationship on behalf of your investment. This the reason why many investors attempt to secure a board seat; it allows the investor to maintain a degree of post-investment involvement.
An Investor should incorporate a hybrid of these different investment strategies to increase the odds of getting a higher return out of the investment. The general rule for investors is to diversify, draw on previous experiences, and do the legwork before and after investing to ensure that a project reaches its full potential.
Different Types of Investing in Startup INVESTMENT VEHICLES
There are many different private asset classes for investing in private startup companies. Various platforms operate through different methods and frameworks and also on different time frames. Some are fund-based, and others allow investors to build to or their portfolio through company investments. Venture capital and private equity are common fund-based venues for investing in private companies. Angel Investing and crowdfunding are fund-based investment vehicles for building portfolios.
Venture capital
Venture capital is one of the oldest and best-known methods for investing in early-stage companies. This technique involves significant risks but also may offer above-average returns on investment.
Venture capital firms (VCs) invest in later-stage growth companies, often starting in B round, beginning when companies bring revenue but not necessarily on a consistent basis. VCs build a portfolio from different ventures or startups to raise funds from large institutions. They also invest in very young companies and then use a “build-up” investment strategy. As Mark Kachurs, former CEO of Cuno, says: “In venture capital, you start with people, and then you try to figure out what numbers you can make.
Private Equity
Similar to venture capital, private equity displays distinct characteristics in mindset and investment approach. Private equity firms seek to build from the “top-down,” restructuring what a company already has. VCs start with enthusiastic investors, while private equity firms often begin with under-optimized companies.
It is taking an existing company with products and existing cash flow, then restructuring that company to optimize its financial performance. When this method works right, it can save poorly-performing companies from bankruptcy and turn them into profitable enterprises. Investment in later-stage companies may require a higher entrance fee, but the risk at this stage is lesser. A famous and one of the largest examples would be AngelList, with big startup databases and syndicate networks.
Angel Investing Networks
Angel investing Networks serve to connect investors with startups that have characteristics of social media. Most likely, they may not serve as financial intermediaries between investors and startups. These Networks allow potential investors to browse long lists and profiles of startup companies rather than buying preorganized funds. The startups are generally very early stage or even around the seed stage. Similar to social media, these platforms allow investors to build networks with other investors to join the funding of startup ventures together. There are different types of angel investing networks.
Incubators act as angel investment networks, and they offer workspace and materials in exchange for a share of the company. They act as a forum to connect startups with angels and funding.
Crowdfunding
Crowdfunding is a format for startup investment allowing investors to build their startup portfolios rather than buy into funds. It is a collective investing process that allows many individuals to invest smaller amounts, forming a so-called “crowd.” Crowdfunding platforms differ from angel investor networks; they organize and assemble the crowd instead of individual angel investors. Crowdfunding is open for more people because the buy-ins are not so huge as for VCs and private equity. The two main forms of crowdfunding are reward-based and equity-based.
Reward-Based Crowdfunding
This reward-based crowdfunding form is a cheap way for companies to test and build around their products. To avoid equity and control of a company, entrepreneurs often pre-sell their product or offer rewards to get people to fund their companies and product development. It takes the form of reward-based crowdfunding when this exchange of rewards and funding generates a funding “crowd.”
A popular example is Kickstarter, where companies run these all-or-nothing funding campaigns with a target amount and final deadline. A tiny amount of generally 1$ minimum can individuals contribute to a campaign. But this is not for an investor who wants to archive investment returns and make real money.
Equity-Based Crowdfunding
Equity-based crowdfunding is for an investor who wants to make real money with generally higher (but still lower than VCs) investments. The investor funds startups and projects in return for equity. These individual investors pledge various amounts of money to collectively reach the goal for the company funding in return for equity. That may be converted into publicly traded stocks. Crowdfunding is generally earlier than Vc Funding in company life. Because the investment collected from a large crowd of investors diffuses the risk across many, which is lesser than in the hands of fewer, larger investors.
Several leading equity crowdfunding platforms focus on different markets and sectors. The leading global equity crowdfunding platform by dollar invested is OurCowd.
Accreditation
The offering of private, unregistered shares has significant regulations. Investment providers like VCs, private equity firms, or equity-based crowdfunding platforms have an existing legal framework of investor protection. For investors who want to purchase unregistered shares is the accredited investor exemption.
The Criteria vary by country, but the general idea is the same around the globe: Accredited investors are wealthier and more experienced about capital markets. They understand the risks of their investment through higher qualifications better and can take a hit if the investment collapses. Investors are often required to be accredited to participate in startup investing.
Returns
It all depends on the company´s performance and its potential exit to get various types of returns from a startup investment. Business exits have many ways, some positive and success-driven, others negative and failure-driven. Such exits are M&As, IPOs, soft landings, and dissolutions. Dividends paid by companies are also a form of return on investments.
M&A
Mergers and acquisitions, or M&As, are an exit strategy, particularly among Israeli startups. An example is a purchase where Facebook bought messaging platform Whatsapp for 19 billion dollars in 2014. Sequoia Capital is the lone venture capital investor with over $60 million over three investment rounds. The Facebook acquisition was a humble $3.5 billion, which is a near 50X return from Sequoia Capitals’ investment.
When a startup picks up momentum, gains a share in the market, and receives significant revenue, other, larger companies look at a startup´s success and want a part of it.
An M&A transaction is a way to get this portion of a startup´s success, its product, and market traction. The bigger Company buys the startup. The purchasing money is then divided between everyone who owns a part of the acquired company or its shareholders. The acquired company receives some money directly in cash and sometimes indirectly from stocks of the buying company. But this cash is not generally transferred at once or immediately; there is an agreed timeframe for payments in multiple installations.
IPO
Fairly common is that companies go public or undergo an IPO, an initial public offering. If a startup grows large enough and has significant revenue, it may seek an IPO. The shares on the public market must be registered by the company so that the equity can be traded publicly. Public trading then frees up investors to sell their earlier bought stocks, ideally for much more money than the purchase price.
The proper timing of an IPO is essential because there must be a public demand for that specific company´s equity. When the stock is on the public market, it should be consistent with the company´s final valuation. IPOs are simply liquidation events. In the earlier stages of a company´s lifecycle, an angel can´t really get cashback on his original investment. After an IPO, he may eventually can; most companies have a lockup provision. This should prevent investors from immediately selling their shares when an IPO has happened because it would cause a liquidity crunch. Investors are required to wait before they start selling their shares post-IPO.
Soft Landings
Soft Landings help companies to avoid falling out of the market. These exit doesn´t bring large returns for investors. However, they allow investors to get a portion of their money back, also allow team members to remain employed, and save founders from bad press.
Acqui-hiring is a type of soft landing when a larger, more successful company acquires a smaller company, not for its product or idea but for its skilled employees. So only the most skilled employees will be adopted before the startup may fail. The soft landing may save startups from much worse and dramatic fates, but investor generally receives only a small fraction of the return on their investment.
Dividends
A company has shareholders who set payments called dividends. There are several reasons for a company to use dividends. When investors want to make money on the stock market, they often buy dividend-bearing stock to get near-immediate income. If a company is performing extremely well and reeling in large profits, it may redistribute those profits to investors in the form of dividends rather than investing in further company growth.
Liquidation Preference
Liquidation Preference is the process where investors see a return on their initial investment. There are two major factors during this liquidity event: The first factor is the proportional returns to an investment, which means the number of shares one owns from a company determines the money an investor receives.
More complex are the liquidation preferences. They establish a certain hierarchy. There are different types of investment, as well as different types of shares. Between ordinary, preferred, and different classes, shares exist a distinction.
An investor who purchases shares in the A round owns Preferred A Shares. This preferred shareholder A receive their percentage of dividends before a shareholder from a lower class like C, for example. It also exists distinctions between shareholders and other forms of investors like debt holders. So, Liquidation Preferences are the order in which investors get their capital returned.
Conclusion
Nowadays, even individual investors have access to top startup investment opportunities. There is also a lot of information from different platforms to strategies and forms of returns, which investors should research to better understand the terrain before making an Investment. While rewards can be huge, always keep the high risk behind them in mind. Never invest money which you can´t afford to lose! You should also be willing to diversify your portfolio, hedge your bets, and also do market research, and investigate the people and the company behind a startup.
Startup investing is inspiring and energizing, but when done right, rewarding. So hopefully, with this newly received information, you can make your own success story by investing in Startups.
Frequently Asked Questions on How to Invest in a Startup
What is a startup?
A startup is a new and emerging company that is still in the early stages of its development.
Why should I invest in startups?
Investing in startups can provide high returns on investment, as well as the opportunity to be a part of the growth of a new and innovative company.
How can I invest in startups?
There are several ways to invest in startups, including through crowdfunding platforms such as SeedInvest, Wefunder, and others, becoming an angel investor, or working with a financial advisor to find startup investment opportunities.
What is an angel investor?
An angel investor is an individual who invests their own money into early-stage companies in exchange for equity in the company.
Can I invest in startups if I’m not an accredited investor?
Yes, there are now several investing platforms that allow non-accredited investors to invest in startup companies.
Are there different ways to invest in startups?
Yes, there are several ways to invest in startups, such as investing in a company directly, investing in startup funds or portfolios, or investing through a crowdfunding platform.
What is the minimum investment required to invest in a startup?
The minimum investment required to invest in a startup can vary depending on the platform or investment opportunity. It can be as low as a few hundred dollars or as high as $1 million.
What are some cons of investing in startups?
Investing in startups can be risky, and there is no guarantee of a return on investment. Additionally, startups can take years to become profitable and may require additional funding.
How do I become an angel investor?
To become an angel investor, you typically need to have a high net worth and meet certain income or asset requirements. You may also need to have experience as a successful entrepreneur or investor.
Can individuals invest in startups via crowdfunding platforms?
Yes, individuals can invest in startups through crowdfunding platforms like SeedInvest and Wefunder, which allow investors to buy shares in a startup.
How can I find startups to invest in?
There are several ways to find startups to invest in, such as attending startup events and networking with entrepreneurs, working with a financial advisor, or researching startup investing platforms and opportunities online.
What is startup investing?
Startup investing is the process of putting your money into a young, growing company in the hopes that it will become successful and multiply your initial investment.
How can I make money investing in startups?
If the startup you invest in becomes successful and grows in value, you can make a profit by selling your shares at a higher price than what you initially paid for them.
Can anyone be a startup investor?
Generally, yes. Anyone who has the financial resources to invest and is willing to take the risk can become a startup investor.
What are the cons of startup investing?
Startup investing can be very risky, as many startups fail. Even if a startup succeeds, it can take years before you see a return on your investment, if at all.
How much money do I need to invest in startups?
There is no set amount, but some investment platforms require a minimum investment of $1,000, while others allow you to invest as little as $10.
What is seedinvest and how does it work?
Seedinvest is an online platform that connects investors with early-stage companies seeking funding. Investors can browse through various startups and invest in the ones they believe have potential.
Is it necessary to have a financial advisor when investing in startups?
No, it is not necessary, but it can be helpful to have a professional guide you through the investment process and provide advice on managing your portfolio.
What is Wefunder, and how does it work?
Wefunder is an online investment platform that allows people to invest in startups. Investors can browse through a variety of startups and put their money into the ones they are interested in.
What is venture capital, and how is it related to startup investing?
Venture capital is a form of private equity funding that is provided to early-stage companies. Venture capitalists invest in startups that they believe have high growth potential and can provide support with business strategy and operations. Venture capital is one way to finance a startup and can be helpful for startups that need significant funding to get off the ground.
How can I get in on the ground floor of a startup?
You can look for startups that are in their earliest stages and reach out to the founders or look for opportunities on investment platforms like Seedinvest or Wefunder.
Source: Ebook The Guide to Successful Startup Investing
The ebook licensed under Creative Commons Attribution 4.0 was shortened, remixed, and rewritten for this article.
