How to invest in startups – Forbes Advisor

It can be difficult to give a precise definition of a startup. A startup can be a business that creates a new product or service under conditions of great uncertainty, or a company that seeks to solve a problem where the solution is not obvious and success is not guaranteed.

Regardless of how you define a startup, investing in one used to require both wealth and good connections. That’s no longer the case, and even the average investor can easily use crowdfunding sites to get involved in attractive startup opportunities.

It's important to understand that investing in startups can be profitable, but it also comes with big risks. Most startups fail. Even if you do your research, you may end up with nothing. Here's what you need to know to get started investing in startups:

A platform for startup investment

The public can invest in startups through crowdfunding sites. Startup investment platforms offer a carefully selected range of companies and the minimum investment amount varies. The main players in the crowdfunding startup space are:

“Thousands of businesses apply for funding on our platform every year, but only about 3% are approved,” says Kendrick Nguyen, CEO of crowdfunding platform Republic.

Some sites allow you to start investing in startups with as little as $100.

AngelList is another leading startup investment platform, but it only accepts accredited investors with an income of at least $200,000 ($300,000 or more if married) or a net worth of at least $1 million, excluding their primary residence. AngelList's minimum investment is $1,000.

How much can you invest in a startup?

Non-accredited investors should be aware that, pursuant to SEC guidelines, there may be limits on the amount they can invest in a crowdfunding business over a 12-month period.

• If your annual income or net worth is less than $124,000, you can invest up to the greater of $2,500 or 5% of your annual income or net worth.
• If your annual income and net worth are $124,000 or more, you can invest up to 10% of your annual income or net worth, whichever is greater, but this amount cannot exceed $124,000.

Just because you can invest a certain amount in a startup doesn't mean you should put it all in. “A good allocation should be no more than you're comfortable losing if the startup goes bust or takes a very long time to become successful,” says Randy Bruns, a certified financial planner (CFP) in Naperville, Illinois.

Experts generally recommend making multiple small investments in several different startups rather than one big investment in one startup. In fact, AngelList's investment guidelines even say to “only invest if you have enough money to invest in 15-20 startups.”

This provides diversification: if you invest in five startups and four of them fail, you'll still have one successful company, so some of your capital may be protected. However, “you should be prepared for your total losses to exceed your gains,” AngelList points out.

Related: Find a Financial Advisor in 3 Minutes

How to make money investing in startups

When you invest in a startup through a crowdfunding site, you enter into an investment agreement with the company. Broadly speaking, there are four different types of investment agreements, each with different ways of making a return on your investment:

• debt. In this type of agreement, your money is treated like a loan that accrues interest. The agreement may pay a fixed rate of return, such as two times the amount invested, or a floating rate of return. When you receive your interest payments depends on how well the business performs over time.
• Convertible bonds. The agreement doesn't earn interest, but is a type of debt that converts into equity when the startup achieves certain goals, such as raising a new round of funding. You can earn a profit on your investment if the company is acquired by another company or eventually goes public.
• stock. In later-stage startups, you might be able to buy stock in the company, just like you would buy stock in a public company. But keep in mind that you can't sell your stock in a startup. To make a profit, you'll need to hold onto it until the startup goes public or is acquired by another company.
• Dividends. Successful late-stage startups offer investors the opportunity to buy shares that pay annual dividends.

Why invest in startups?

Investing in startups gives you a first-hand look at solutions to tough problems and the development of new technologies.

• Potential for growth. Large-cap stocks in the S&P 500 are much less risky than startups, but they also have little room for rapid growth. But if you pick a successful startup, the possibilities are endless. “There's a lot of opportunity for expansion,” says Tom Schreiber, a professor of entrepreneurship at Cornell University's SC Johnson School of Management. “There's a huge multiplier effect that could be very large. That's part of what investors are buying.”
• Belief in new ideas. Startup investing may appeal to you because it involves entrepreneurs pursuing new ideas. “People often invest in things they want to see in the world, like sustainability improvements or a really cool sneaker company,” says Elias Staal, founder of eco-friendly shoe company HILOS. “There's no better opportunity to see something you want to see in the world and support it.”
• Connections. Maybe your brother has a great new product coming out, or maybe it's your neighbor. It seems like an innovative idea, and you want to fund your friend or relative's project. “Many people invest in startups because they're part of a network and they're backing projects they know,” says Schreiber.
• Sense of fulfillment. Some investors say they invest in startups for the feeling they get from helping someone get started, watching something new come about, learning about different industries, and being part of something exciting from the beginning. “If someone is motivated, nothing beats just getting started,” Schreiber says.

Why I don't want to invest in startups

Investing in startups isn’t for everyone, with investors looking for low-risk, steady income.

• Startups are very risky. About 90% of startups fail due to a lack of product-market fit, marketing issues, team problems, or other issues. “You could lose it all,” says Schreiber. Generally, startups are only a good investment if you're prepared to lose 100% of your investment. The majority of your investment capital should ideally be invested in index funds, exchange-traded funds (ETFs), or individual stocks.
• Startups are illiquid investments. If you buy shares today and change your mind tomorrow, you can easily sell them. Startups, on the other hand, have very low liquidity. If you invest in a startup, you should be prepared for your money to be tied up for at least three to five years, and possibly longer. “While there are opportunities to cash out in secondaries, it's not a guarantee, and it will probably take years for your investment to mature and materialize,” says Ammar Amdani, partner at early-stage venture capital firm Adapt Ventures.
• It will take time to see results. Even if the startup is successful, it can take years for the investment to show results. “You need to be patient and have the ownership to give your portfolio companies time to grow,” Amdani says.

How to tell if a startup is a good investment

Your approach to startup investments depends on you and your financial situation. Experts recommend doing plenty of research before putting your money into them. Before investing in a startup, make sure you have answers to the following questions:

• What do you know about startups? Is it a sector, industry or product you are familiar with? Wefunder encourages you to only invest in things you understand.
• Is your team enthusiastic about their idea? Even the perfect idea can fail if the team isn't passionate about it. “We've seen so many companies where there was a lot of potential for growth, but they let their guard down and other competitors entered the market,” Amdani says. “Whether it's communicating with customers, hiring a team, or creating a strategy, passion is essential to being a successful entrepreneur.”
• Does the startup have domain expertise? Startups need to be familiar with the ins and outs of the sector they operate in. “I've seen many first-time entrepreneurs identify a proven business model and try to replicate it in a new geography,” Amdani says, “and then fail because the entrepreneurs were trying to learn the fundamentals of business while their competitors were quickly getting up and running.”
• What is the market size? For startups, having a large and growing market is crucial. Because companies target niche markets and develop very focused products, there's no way they'll become a big company, even if they beat their competitors. “At that point, no matter what you do, it's nearly impossible to educate customers and grow your market size,” Amdani says.
• Why this? Why now? Has this idea been tried before? If not, why? If it has been tried, why did it fail? “There is no such thing as a good original idea,” Staal says. “Why should you be the only one who can make this happen? Is it your expertise? Is it your technology? Why should this be out there, and why hasn't it been out there before?”

Should you invest in startups?

Whether or not you should invest in a startup will depend a lot on your situation. Are you in a good financial position? Are you struggling to pay off debt or reach your savings goals?

“The average person in the U.S. probably hasn't saved enough for retirement, and I wouldn't recommend investing in startups instead of putting money into a 401(k) or IRA,” Schreiber says, because the potential for loss is just too high.

As a result, in the past, investing in startups was only available to accredited investors who already had significant income and a high net worth.

Now that crowdfunding platforms allow anyone to invest in startups, experts recommend keeping the following principles in mind:

• Please consult a financial advisor. Your financial planner isn't the one to bring up investing in new, highly speculative private companies, so you need to start the conversation. “We're not necessarily encouraging the startup investment conversation, but if it's really important to them, we'll carve out some of their satellite holdings and dedicate it to this investment strategy,” says Gage Paul, a CFP in Hudson, Ohio.
• Invest only small amounts. Because of the sector's volatility, advisors recommend limiting your investments to a small percentage of it. “I wouldn't recommend allocating more than 5% of your portfolio to this sector,” says Dana Menard, a CFP in Maple Grove, Minnesota.
• Be prepared to lose everything. The money you invest in startups should not be money you've set aside for your kids' college education or your retirement. Wherever possible, you should invest this as “fun money,” meaning you won't lose your home or mortgage your future if the investment fails.

“My biggest concern about startups is that they are often most appealing to people who are behind on saving toward their goals,” says Joel Kandick, a CFP in McLean, Va. “They may feel like a startup could be a home run to help them catch up. These people may not be able to afford to take that kind of risk, so they should focus on building a diversified portfolio first and do most of the heavy lifting.”

Maybe the companies in the ETFs or mutual funds in your diversified portfolio invest in startups and could provide you with some of the exciting startup growth you're looking for anyway.

Forbes Advisor contributor Kate Ashford and Investment Editor John Schmidt contributed to this article.