An Introductory Guide of how to Invest in Startups
Would-be investors in anything are taking a risk. Those who are looking to invest in startups are taking a bigger one!
However, the potential rewards of investing in an early-stage company can be huge, hence the understood attraction for this type of investment.
To help you understand what is involved in startup investment and give advice on selecting the right types of startups to invest in, this WOWS Global ‘How to invest in Startups’ guide will focus on:
- The pros and cons of investing in startups.
- Explain a tried and trusted 5-point method for selecting the right startups to invest in.
- Provide some best practices to follow when it comes to investing in startups.
Using this knowledge and your instinct will help those looking to invest in startups make a far more informed decision,
First up though is…
What Routes are There Into Startup Investment?
Various high-profile success stories of venture-backed startups that have gone public have certainly piqued the interest of private and individual investors. Gone are the days when it was predominantly angel investors, venture capitalists, and big-money investors who were the only ones to invest in startups.
Investing in startups allows an investor to purchase shares at the early stage of a venture’s growth journey. Better still, these shares are available at an attractive price.
There are now numerous ways for individuals to purchase shares in startups and these include:
- Direct Investment: Purchase of shares directly in the company.
- Online Investment: This is typically through an equity crowdfunding platform or a co-investment platform.
- Indirect Investment: Via a professionally managed fund.
However, before using any route to invest in a startup you need to understand whether this type of investment is for you. To help you do that here are the…
Pros and Cons of Startup Investing
It has been touched on but there have been (and will continue to be!) various high-profile startup success stories. This shows clearly that investing money into a startup is one of the great ways to reap high returns.
Anyone considering investing money in a startup needs to be aware of the potential benefits as well as the possible downsides. To that end, let’s start with the Pros of this type of investment and understand what motivates an investor to put their money into a startup…
The Pros of investing in startups:
- Potential profits: As will be seen later in the piece, with good planning, investing in a startup can be very profitable. It will benefit you to pay particular attention to those startups that provide solutions, ones that bring value and develop new trends that match the constantly evolving knowledge-based economy.
- Diversify your portfolio: By definition, startups are an asset class that allows you to get into a different investment channel. Investments across the board are risky. Through portfolio diversification, you will be minimizing the chances of taking a big hit during any downturn.
- A varied range of options: This relates to diversification but investors will find startups in just about every industry and market sector. Because of this, it allows them to diversify investments across markets as well as cap sizes and to include emerging market investments in their portfolio.
- Buy-out potential: A startup that thrives is often purchased by larger corporations who see them either as a potential competitor or want leverage from the technology the startup has created. Assuming the startup(s) you have invested in sell at a high price the returns on your investment will be very healthy indeed.
- Creating jobs: Investing in a startup is helping the economy to move in a positive direction. Investors' money is used to get a startup on its feet and then allows them to expand. If the startup in question succeeds and grows you will have contributed to the creation of jobs.
Although the growth potential of a startup is limitless they are also considered a high-risk investment. The reason is that only a small percentage succeed. This means that before committing funds to a startup you need to be fully aware of the potential downsides to this type of investment. With this in mind here are…
The cons of investing in startups:
- A significant risk: As lucrative as a startup investment may seem you need to fully accept that this investment could never succeed. Investing in a startup is a very high risk, your ROI (Return On Investment) depends completely on the venture in question growing, prospering, and becoming a success.
- Incorrect valuations: Do bear in mind that the majority of startups are given valuations that are more aligned with Silicon Valley. That can be the case even though the company in question has yet to gain any real traction. This can create a difficult barrier when looking to invest in a startup that you see as being of real value.
- Lack of liquidity: Unlike publicly traded stocks, startup investments cannot be traded. This means you might not be able to sell your stake before the startup is acquired or goes public.
Selecting the Right Startup - A Tried & Trusted 5-Point ‘M’ Method
Increasing your chances of selecting the right startup to invest in is no easy feat. One way to help you focus on which startups to invest in comes with the tried and trusted 5-point ‘M’ method.
Here’s what that involves…
#1 - Management team
It is important to understand how experienced and entrepreneurial the founder(s) and key management team of a startup are. Key questions to ask yourself are whether the management team in question can execute an effective growth strategy and do they have the ability to create shareholder value.
#2 - Model - The Business and the Revenue models
Carefully consider whether or not the startup has an innovative, disruptive business model. With that will come an understanding of how the startup in question is already making money, or how it intends to turn a profit.
#3 - Market
This is a 3-pronged consideration. What is the opportunity? What is the market size? What is the potential for overall market growth?
#4 - Money
How much capital is required by the business and how has the management team outlined the use of these funds to create value for their venture?
#5 - Momentum
Understand what the company has achieved to date. Does the venture have a healthy customer pipeline or early commercial traction?
One factor to bear in mind with the ‘M’ assessment approach. None of the 5 considerations is more important than the others. However, many experienced startup investors feel an accurate assessment of the management team is pivotal to their final decision on whether to invest or not.
Best Practices for Investing in Startups
There is no magic wand when it comes to investing in the right startup but there are best practices!
When considering which type of startups are the right type to invest in there are some best practices to follow. Here are some very important ones:
Industry sector choice
Investors need to carefully choose the industry sector and target market of the startup they are considering putting money into. As with everything in business, certain industries may not be the best to invest in at certain times.
This means investors should carefully consider the prevailing market conditions. By doing so it will identify which industry sectors are hotter than others.
If you have experience in a particular industry then use your knowledge to the full. For example, if you are involved in the travel industry you could well have insight into the trends and what types of applications are needed to improve a traveler’s experience.
That being the case, concentrate on startups that have applications to fill these needs. Investors with insight and expertise in a sector are often connected with higher investment returns.
This is a crucial factor when considering if the startup you are looking to invest in has the right credentials. Take time to investigate the company before agreeing to and signing any investment agreement.
Due diligence includes looking extensively into the founders' background, assessing their financial records, fully understanding the product or services they will offer, and what business or consumer needs they will solve.
When carrying out your due diligence you need answers to the above and other key questions such as:
- How is the startup's capitalization table formalized?
- Are there already lots of small or inactive shareholders?
- Does the company have any debt that it may not be able to repay?
- Is there a co-founder/shareholder who is no longer active in the company that needs to be bought out?
- Carefully check the existing shareholder's agreement to see if any strong anti-dilution or liquidation preference is included.
- Check that all relevant IP (Intellectual Property) and URLs are owned by the startup in question. If they do have IP licenses do these have sufficient protection and scope?
It should be said that trying to plot the future of a startup with potentially high-growth projections is far more difficult than that of an established blue chip company and will require some degree of guesswork.
However, the more information you can gather about the startup in question, the better placed you will be when it comes to making a wise decision on whether to invest or not.
Diversify your portfolio
As an investor, investing exclusively in a particular market or sector can leave you open to exposure should there be a noticeable downturn in that arena. Portfolio diversification can help investors ride out macro-economic waves which can (and do!) affect sector-specific businesses
By spreading your investments across a number of startups you will be improving your chances of investing in one(s) that eventually provide very healthy returns. It is also worth considering diversification based on the stages startups are at.
By this, it means looking at early-stage, mid-stage, and late-stage startups. Investing in multiple companies at various stages of their life will help spread your chances of selecting ones that provide appealing returns.
In-depth research = A more informed decision
Thorough research, careful analysis, and seeking expert advice are key factors before deciding to invest in any opportunity. This is equally, if not more important when considering investments in startups.
Make sure your research takes precedence and only commit to providing funds when you are confident you have done all you can. Taking such an approach cannot 100% guarantee success but it does go a long way to ensuring that the opportunity you are investing in is right for you.
Consider post-investment involvement
This may not be for every startup investor but it is worth pointing out. Once you have invested it is often possible to make extra contributions. Ones that can increase your chances of higher returns.
This involvement can include such things as financially monitoring the company, mentoring the founder or a key management team member, introduction to other potential investors, and assisting with the establishment of business relationships that will further growth.
Patience can be Rewarded!
Would-be startup investors need to accept that patience is required. Many new startups will be focusing on stability and growth over the first few years. If that is the case, the result is likely to show a lack of liquidity in their stock during this period but with prospects of a significant payout several years down the line once an exit is achieved.
It cannot be stressed enough just what the upside of having patience can be. Choosing a successful startup to invest in can result in a feasible payback target on an initial investment of between ten and twenty times.
Seek Expert Advice
This is an exciting time for those interested in startup investing. Individual investors now have unprecedented access to these investment opportunities. Ones that were once only available to accredited investors.
That has led to various platforms, strategies, and different forms of research methods becoming available to ensure you are well-placed to make an informed investment decision.
Unless you are thoroughly versed in the startup world and what investing in these ventures entails it is highly recommended that you seek expert advice. This should come from a company with a very deep understanding of the startup environment.
One such company is WOWS Global. Our fully qualified professional team is ready to assist and advise any investor looking to put money into startups.
We offer startups a secure, online digital ecosystem that allows them to keep all essential information in one place and to share this with prospective investors. This investor insight will help you to understand the health and suitability of the startup you are interested in.
As for due diligence, this is a vital part of any startup and investor research. Our systems allow due diligence to be effectively and comprehensively carried out.
Yet another important strand of our services is the ability to match like-minded investors to startups in industries they are interested in. Through this service, you will find exclusive investment opportunities that fit your portfolio needs.
Our mission is to assist startups in their journey to growth and success while ensuring investors are fully equipped with all they require to make an informed investment decision. One that will greatly increase your chances of securing the startup investment that matches your requirements.
Any investor who would like to find out more about the services WOWS Global can offer is invited to reach out to us for an initial no-obligation discussion at: