It is risky to invest in a startup, but it can offer huge returns when the company turns out to be successful. Investors usually fund startups by buying shares. You can do this through equity crowdfunding or a convertible loan, for example.
What is a startup?
A startup is a company that is usually not older than five years. Additionally, it is typically innovative on some level. This can be because the company has created new technology, a fresh idea or an innovative business model. Because of their innovative nature, startups usually have a lasting impact on the market and are able to scale internationally. In other words, they have a lot of growth potential, which makes them interesting investment opportunities.
Startups have a lot of growth potential.
Ambition is another feature that separates a startup from a regular company. A startup aims to grow fast and pursues million euros worth of revenue, or even more. That being said, it is not rare that a startup does not make a profit for a while, as its costs are very high in the beginning. Startups will need to invest a lot in production, prototypes and hiring staff. This is also the reason why startups are keen to find seed capital from investors.
There are different ways to invest in startups. Which way is best suited to your needs depends on your investment style.
As new companies have a lot of costs without making a profit for the first couple of years, these companies are usually funded investors by buying shares. This means that you buy a small part of the company and become a co-owner along with other shareholders. If the company performs well, your share will increase in value. The easiest way to buy a share as an ordinary investor is through equity crowdfunding platforms. Here you can easily start to invest in startups with smaller amounts.
Another popular way to fund early stage businesses is by investing in a convertible business loan. This type of loan can be converted into shares later, and there is no payback in the first few years. Once the company shows results, the loan can be converted into shares. If the business does not perform well, however, you can get a payback of your loan plus interest. This can be a good way to mitigate the high risks of investing in a startup. Some equity crowdfunding platforms will also offer this option.
Angel investors are investors that often have been entrepreneurs themselves. They use their own net worth to fund companies, usually by buying shares. An angel investor can be more personally invested, for instance by offering their experience and connections from their own industry. In this way they can help startups gain future results. You can become an angel investor by investing your own money, either through equity crowdfunding or by joining an online network of angel investors. Because these investors usually fund companies alongside other investors, you can start with smaller amounts.
Venture capitalists are a step above angel funders: they invest large amounts (between 500 thousand and 5 million euros) and usually are more professionally organized in venture capital funds. A venture capital fund usually invests in early stage companies for a period between five and ten years in exchange for shares.
Startups are high risk investments, since there is no way to tell if they will be successful down the line. This means that it can be very difficult to correctly value your investment upfront. Early stage businesses have no track record of past performance yet, so there is no built up equity and revenue is low. In addition, it can take years before a business makes a profit. The majority of startups fail, so it is possible that you will lose your entire investment. But a successful startup can generate high returns on your investments.
The majority of startups fail, it’s possible that you’ll lose your investment.
Another risk is that a startup can have many shareholders. The upside of this is that the company does not overly rely on a handful of big investors. The downside, however, is that there are a lot of smaller shares. And if the company needs growth capital later down the line, the amount of shareholders can grow. As a result, your percentage of ownership can be diluted.
Luckily there are a few ways to manage the big risks of investing in startups. Firstly, you can use a delayed convertible loan that will turn into shares once a company proves to be successful. If the startup fails, you will get a payback plus interest for your loan. That way, not all will be lost. Another way to mitigate risk is by having a diversified portfolio. That means spreading your investments. Instead of putting all your eggs in one basket, make sure to distribute smaller amounts between different types of startups.
When you invest in startups, your main source of returns is usually not dividends. This is because startups will not make a profit for a while. Instead, your returns are based on capital gains from the increased value of your share. This means that you can sell your share for a higher value than what you invested at the start. For companies that go through an initial public offering (IPO), your return on investment can even be one thousand percent or more.
You can sell your shares once a company is sold or goes public on the stock exchange. This can take a long time and not all startups will even make it to this stage. Alternatively you can sell your stake on an equity crowdfunding platform that also offers reselling. Keep in mind that there may be platform-specific restrictions when reselling shares.
The investment horizon in startup investing is at least 5 years.
Lastly, funding a startup is a long-term investment. Entrepreneurs usually want to invest all the funds in their company and it takes time before they see results. This means that there will be no returns for at least a few years. The investment horizon is at least five years and sometimes longer.
Is investing in a startup suitable for you?
Because investing in a startup is a high risk investment, it is not for everyone. First time investors will usually not choose this type of investment. It is a great investment opportunity for investors with some experience. It is even better when you have knowledge of a certain industry or some entrepreneurial experience, because it can inform your startup investment decisions.
You will have to wait at least 5 years for your returns.
In addition, when you invest in startups you have to be okay with potentially not seeing any returns. And if you make a return, it will not be for at least five years. Therefore you are ideally a long-term investor with enough money to spend.