How to Invest in Startups

Startup investing is a compelling option for investors willing to accept significant risk in exchange for outsized returns and the satisfaction and thrill that come with backing innovative, cutting-edge businesses.

Because of the risk involved in knowing how to invest in startups, it was once available only to accredited investors. But thanks to federal regulatory changes, technology, and the emergence of equity crowdfunding and online platforms over the last few years, retail investors now also have access.

Successful startup investing is challenging but possible with meticulous research and knowledge about how to find opportunities for retail investors. This guide will get you started.

How Does Investing in Startups Work?

Before you can know how to invest in startups, you need to know what startups are.

Startups are new to early-stage companies. They’re small and founded by an individual or small group of individuals with an innovative product or service. 

Unlike typical small businesses that aim to sustain themselves with gradual if modest growth, startups have rapidly scalable business models. They’re privately owned but seek outside funding to accelerate growth and scaling.

Startup investing is also very different than investing in publicly traded companies.

Public companies are transparent because they must publish public filings about their operations and finances. But as private companies, startups have no such obligation and far less is revealed to the investing public.

Because of the lack of transparency and high risk intrinsic to startup investing, federal regulations have traditionally allowed only accredited investors to invest in them (more below on what it takes to be an accredited investor). In recent years, however, new rules permitting crowdfunding platforms have emerged that permit retail investors to gain access to opportunities.

Two other key factors in the differences between public companies and startups are liquidity and time frame. Public company investors can easily sell or trade their shares, which makes them liquid. Because startups are private, their shares are generally difficult or impossible to sell, making them illiquid.

Investors in public companies can also sell shares whenever they want, but investors in startups must wait for an “exit event,” such as being bought by another company or going public on a stock exchange, before seeing returns.

But it’s the potential of those larger-than-typical returns of double or even triple-digit multiples that make illiquidity, years of waiting, and high risk acceptable sacrifices for the startup investor.   

Ways to Invest in Startups

As mentioned, federal rules have changed in recent years to allow non-accredited investors to invest in startups through various platforms and mechanisms. Some of the most common are: 

• Equity Crowdfunding: On platforms such as StartEngine, Wefunder, Republic, and MicroVentures, non-accredited investors can invest in startups. On some platforms, investors can invest as little as $1,000, or even $500 and $100, into startups that have been vetted by platform managers. 
• Angel Investing: Angel investors provide capital to startups in exchange for convertible debt or equity in the company. Traditionally and by definition of the Securities and Exchange Commission (SEC), angel investors are accredited investors, but that is changing. Traditional, accredited angel investors can invest in startup businesses directly or pool their money to invest. Non-accredited investors also have a pathway to angel investing, thanks to the SEC’s Regulation A+, which went into effect in June 2015. Reg A+ allows startups to conduct unregistered public stock offerings if they file disclosure statements, so-called Offering Circulars, that are approved by the SEC. These public offerings are initial public offerings called mini-IPOs.
• Venture Capital Funds: A venture capital fund pools capital from high-net-worth individuals and entities for investment in startup ventures. Like angel investors, venture capital investors are by rule accredited investors. While Regulation A+ and equity crowdfunding provide non-accredited investors a door to startup investing usually reserved only for accredited investors, there is no such option for venture capital funds. 
• Startup Accelerators & Syndicates: Other avenues with which accredited investors can fund startups include platforms such as AngelList and accelerators such as Y Combinator. At AngelList, accredited investors form syndicates that then target startups in which to invest. Y Combinator is a startup accelerator with an ever-growing network of founder alumni that backs new cohorts of startups with capital, expertise, and other resources.

How to Start Investing in Startups

The first step that investors interested in startup investing need to take is determining whether you are an accredited investor or not, as that will determine how broad or narrow your early-stage investment platform landscape is.

To qualify as an accredited investor, an individual must either have a minimum annual salary of at least $200,000, or assets of more than $1 million, not including the individual’s primary residency. To qualify as an individual with a spouse, the minimum annual salary required is $300,000, or assets of at least $1 million, not including the couple’s primary residency.

After determining their investor accreditation status, investors must next decide their investment platform, whether it’s through equity crowdfunding, an angel network, or a venture capital fund.

After choosing a platform, investors can begin identifying and researching potential startups to invest in. Important factors to research include the quality of the leadership team, the potential of the business model, and whether the business has already demonstrated any traction.

Just one startup success can result in double- or triple-digit multiples for investors, but at the same time, most of them fail. That’s why it’s important that startup investors have a diverse portfolio of startups that will hedge-in potential losses.

Finally, make sure you understand your startups’ exit strategies such as an IPO, acquisition, or buyback, as well as the time frame it could take before you see any returns. 

Risks and Rewards of Startup Investing

Startup investing is high risk and high reward. Statistics vary, but the vast majority of startups eventually fail, most of those within the first few years of existence. 

Other downsides include a lack of liquidity, because once investments are made, they are locked in with the company until there’s an “exit event” such as an IPO or acquisition, or if shares are sold on a secondary market. And because it takes years before a startup experiences an exit event, it’ll be years before investors see any returns.

If a startup should survive the gauntlet of challenges, however, the return for investors could be outsized. Consider the early backers of companies like Uber and AirBnB. 

In short, most startups in a startup portfolio will fail, but the small number of winners could eclipse those losses and turn investors into millionaires. For that reason, make sure your portfolio is diversified, to better the chances of investing in a winner that will offset the failures.

Taking the Startup Plunge

While investing in startups has become more accessible to non-accredited investors, it still may not be for everyone. The vast majority fail sooner or later, and if investors can’t counterbalance losers with winners, they could find themselves in financial peril.

That’s why thorough research into potential startup companies being considered for investment is essential. This includes verifying that there is a market demand for the products or services being offered, trusting the leadership team, understanding how the business model is scalable, and being prepared to wait years before seeing any returns. 

If you’re willing to do rigorous research and place your money selectively in a portfolio of diverse startup businesses, startup investing could prove lucrative for you.  

Frequently Asked Questions

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