Business

How to invest in a Startup? [Guide]

How to invest in a startup?

It all starts with an idea to find cutting edge-solutions to everyday problems. That´s where the world of startups takes over.  Startups offer high profit for Investors, which also provides high risk in return. Sequoia Capital’s 50 times return from their investment in Whatsapp (acquired by Facebook) should Investors excite 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 of your investment which may grow to a 5x return or even a 50x return of your start money.

Investors, also known as “angel,” consider to help a startup in the first stages with funding. The number of angel investors has increased in the age of 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 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 the vision, team, product, market, business, and culture. The quality of the foundation determines if the startup fails or growths 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 along if they´re lucky with the help of government or institutional funds.

Next is the seed stage it includes investments from family members and friends. Finally, the startup begins to take shape. During this phase, the investors begin to establish a relationship between 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 as 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 eventual reaches maturity.  When it goes forward, and the amount of generated profit is substantial. It eventually gets bought out by a larger company or float 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 an conditions of their investment but also that the companies 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 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 companies pre-investment) and the post-money valuation (the companies 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 need. 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 with the percentage of the comparison.

Weight % x Comparison % = Factor

The sum of the factors multiplied by the average valuations of the other pre-revenue companies in the first step.

Late Stage Valuation

Valuating a company later in a 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 your 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. Form of investment is noted and recorded in the deal terms. The protective right and preferences are enumerated and reserved.

Best 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 to determine investments in a given industry, based on the experience of the investor. 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 some late-stage investments. Around 10-20 companies is a good spot for building a truly robust, diverse portfolio.

Due Diligence

Due Diligence means to investigate a person or company before signing a contract. Spending time with 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 high return. These form of participation includes mentoring, financial monitoring the startup and to establish 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 to get 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 his or her 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 of 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 is private equity displays with 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 the financial performance. When this method works right, it can save poorly-performing companies from bankruptcy and turn them into profitable enterprises. The 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 which 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 buying 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 like 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.”

The 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 public 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 lesser than in the hands of fewer, larger investors.

Several leading equity crowdfunding platforms focus on different markets and sectors. The global leading 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 from 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, gain share in the market, and receive significant revenue, other, larger companies look in a startup´s success and want a part of it.

An M&A transaction is a way to gets 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 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 a liquidation event. 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 sell their shares when an IPO has happened because it would cause a liquidity crunch. Investors are required to wait before they start selling their share 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 a 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 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 return on their investment.

Dividends

A company has shareholders who set payments called dividends. There is 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 growth of the company.

Liquidation Preference

Liquidation Preference is the process where investors see a return of 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 determine the money that an investor receives during this event.

More complex is 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 Prefered A Shares. These 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 it 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 energizing, but when done right, rewarding. So hopefully, with this newly received information, you can make your own success story by investing in Startups.

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.

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