Startup Investing Guide

Startup Investing Guide

Defining Startup Investing

Startups are early­-stage companies that need funds in order to be able to serve their markets and to grow. These companies are usually willing to exchange a stake of their equity capital in order to access the necessary investment capital. Startups are usually innovation-­driven businesses targeting sectors with exceptional growth potentials.

Startups Investors  

For many decades investing in startups was an exclusive privilege of Venture Capitalists. Nowadays, crowdfunding offers everyone the chance to invest in promising startups with as low as a few thousand US dollars. Early-stage startup investors are usually called Angel investors.

Accredited investors / Non- Accredited investors

This is a classification according to the US legislation. Accredited investors in the US must be able to meet certain levels of wealth as defined by the SEC (?). For example, an accredited investor is holding 1 Million USD in assets (excluding the main residence) or he is earning an annual income of more than 200,000 USD. Accredited Investors gain access to top Deals on many crowdfunding platforms. Non-US investors can enjoy similar privileges when investing in startups as long as their country of residence permits it. Of course, note that it is always up to the discretion of the entrepreneur to allow/disallow any investor taking a stake in their company.

Forms of Startup Investment

Startup investment can take many different forms:

(1) Equity

Equity as in the case of stock provides a stake of ownership in a startup. These shares may be Common or Preferred Shares (the difference between those two mainly concerns liquidation preferences)

(2) Convertible Notes

Convertible notes are actually loans that pay annual interest to investors but with the addition that at a predetermined time in the future provides the option to be converted into equity.

Example: A startup pays a 5-8% annual interest to convertible notes holders. After 2 years, the holders of the convertible notes have the option to convert their notes into equity at a specific price. The price of converting will be usually formed according to a future valuation minus a discount (for example 10-30% discount).

(3) Safe Notes (Equity priced rounds) 

Safe Notes are almost the same as Convertible Notes except the fact that they don’t pay annual interest. Safe Note holders will be provided with the option to buy equity at the next Equity Round (when it occurs). Safe notes will be converted into equity like Convertible Notes but they will be converted in better terms than Convertible Notes. 

How can Startup Investors Make Money?

Investing in startups is not the same as investing in shares, bonds, and currencies. Investing in startups is not a liquid market, and angel-investors usually must wait for at least 2 years in order to be able to capitalize on their stakes. Startups create value on behalf of their shareholders in the same way as every other company does. Over time, startups create value by expanding their customer base, achieving high growth, generating positive cash-flows, creating net profits, and distributing high dividends.

Here are some events that may trigger payouts on behalf of startup investors:

Events Triggering Startup Investor Payouts

(a) The startup closes successfully a qualifying round. A qualifying round of financing may allow investors to achieve early payouts.

(b) The startup commence paying dividends to its shareholders.

(c) New investors are willing to buy out the stakes of Angel-Investors at an agreed buyout price.

(d) The whole startup gets acquired by a larger company.

(e) The startup goes for an IPO (initial public offering).

Note: Startup investing is a long-term practice and usually needs 2-6 years in order to lead to high growth as seen in the (d) and (e) cases

Minimizing Risk When Investing in Startups

Even the most promising startup investments can lead to a complete failure and even to the loss of the entire investment capital. Therefore startup investors must be prepared for every scenario and manage their portfolio with extreme caution. The main tool of minimizing risk when investing in startups is portfolio diversification, here are some tips:

(1) Invest no more than 2-10% of your total portfolio value in an individual startup

(2) Invest in startups operating in different sectors/industries, not in the same business

(3) Invest in startups located in different countries

(4) Don’t invest in startups capital that you may need in the following 2-6 years

And some broader tips..

(5) Invest in companies managed by experienced teams with a proven record (check also how many full-time human resources are already involved in a startup)

(6) Prefer to invest in startups that already have an established customer base and that are already able to create positive cash-inflows. Many ideas seem great but they will not be able to be transformed into cash-inflows

(7) Evaluate the likelihood of a future acquisition by a larger company or the likelihood for an IPO

(8) Examine the future growth potential of the industry, the competitive advantage of the startup in that industry, and the barriers to Entry/Exit of the business sector

(9) Investigate who else is investing in that particular startup (empirical investigation)

(10) Check any legal issues emerging after the documentation you will be required to sign (best along with your lawyer)

 ◘ Startup Investing Guide

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