How to Consider Startups as an Alternative Investment Strategy
Many investors think their options are limited to stocks and bonds, either directly or via a 401(k) or IRA. There are, however, many alternative investment options available.
For some investors, startup companies are a good choice. Startups feature hungry entrepreneurs looking to build an idea into a profitable business.
Startups are an attractive consideration for alternative investments options. Investors, however, should do their homework and invest carefully. Knowing what to look for in an investment and the questions to ask are important steps. Learning how to protect your investment can make startups an enticing choice for investing your money.
Your Risk Tolerance Plays an Important Role
Startups can seem like an enticing possibility. Silicon Valley giants all started as small companies running out of garages and dorm rooms. It was investors who believed in the ideas and gave those fledgling companies a start.
Yet for every Apple, Microsoft, and Facebook, there are hundreds of other businesses that did not make it.
There’s a high-risk, high-reward element to alternative investments, especially startups. Federal regulations have relaxed when it comes to investing in these businesses. However, the Securities and Exchange Commission still places some restrictions on how much investors can invest in a 12-month period.
If your annual income or net worth is less than $107,000, the SEC guidelines allow you to invest up to the greater of $2,200 or 5 percent of the lesser of your net worth or annual income.
If it is greater than $107,000, you can invest up to 10 percent of your annual income or net worth, whichever is less, up to $107,000.
Alternative names for startup investing include venture capital and angel investing. For personal investors, the concept is enticing. Help an ambitious, young entrepreneur get over the funding hump and make a go at it. Just know that many companies do not make it.
Know how much you’re willing to risk before you get involved in startup investing.
Smart investors think of startups like other investment categories. Instead of putting all their funds in one asset, wise investors diversify their portfolios. Taking the same approach with startups is a good choice.
Develop Your Investment Strategy
Build an investment strategy before you take the plunge into any alternative investments. Begin by deciding how much you are going to invest and how many deals you are going to invest in. Having 15-20 investments gives your startup portfolio the diversity needed to protect the financial commitment.
Do you want to give equal weight to all of your startup investments? That’s one approach to diversification. Another is to give yourself the latitude to invest more in companies you strongly believe in. Either way, it’s best to know you plan to allocate your funds prior to investing.
What are you interested in investing in? Consider the kinds of companies you want to commit to. Are you looking to support an idea that has a great team working on it? Would you rather invest in a more mature startup that has a working product or service and, perhaps, some revenue?
You can also specialize in a business sector and spread out your investments within that niche. You may want a mix of investment stages in your first foray.
Finding Your Sources for Deals
With the stock market, investors have access to all available publicly traded stocks. Such is not the case with startup companies. Finding companies looking for funding is not as obvious as alternative investments. Getting access to startups requires a bit of legwork.
Various crowdfunding platforms provide access to startups seeking angel investors. The platforms offer different levels of access and offer a modicum of due diligence. These sources offer access to multiple companies across sectors, while others focus on a niche investment area.
Joining an angel investing club is another option. There you will find like-minded investors interested in identifying strong potential investments. They also can be a good sounding board for making decisions about your investments or hunches about companies. Often, members pool the research responsibilities and make decisions on where to invest their funds.
Understand the Financial Instruments
Investments in startups come with various investment options. Convertible notes are one popular investing instrument today. Convertible equity is essentially a loan that gathers interest over time. Eventually, the note is converted into shares.
Conversion is typically tied to a major event, such as the first major financing round. Convertible investors get shares at the price offered for the financing round, for example.
For investors, the convertible approach can mean a substantial payoff when the company gains the right attention. For startups, these deals allow them to work and invest the money contributed without worrying about paying back debt. They are a straightforward way to raise money while fine-tuning the business.
Other options include debt financing, where you loan the company money. The contract pays a fixed or variable return, based on how the business performs.
If you invest in later-stage startups, you may be able to buy shares, like with a public company. You may need to hold onto the shares until the company goes public.
How to Research Startups
Looking at business plans and financials are important factors to use in choosing whether to invest. Also consider whether you have expertise in the startup’s field, allowing you to apply that knowledge to your decisions.
If you meet with the team, are they passionate about their work and seeing its success? Do they have the expertise to lead or are they learning as they build?
Also, get a sense of the size of the market. A large and growing market is essential for startups to be successful. Finally, ask whether the time is right for the idea – why this product or service right now?
Startups can be an exciting way to invest and see the possibilities. Learning about companies and being a part of their success has its unique rewards.