Investing in a startup is risky, but 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 new company that is usually not older than five years. Additionally, a startup is typically innovative on some level. This can be because they use new technology, have 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 as an investment.
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 millions worth of revenue, or even more. That said, it is not rare that a startup does not make a profit for a while, since 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.
Types of startup investing
There are different types of startup investing. Which way is best suited to your needs depends on your investment style.
Since startups make a lot of costs without making a profit for the first couple of years, these companies are usually funded by buying shares. This means 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 investing in startups with smaller amounts.
Another popular way to fund startups 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 startup 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 startup investing. 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 the startup succeed. 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 angel investors usually fund companies alongside other investors, you can start with smaller amounts.
Venture capitalists are a step above angel investors: they invest large amounts (between 500 thousand and 5 million euros) and usually are more professionally organized in a venture capital fund. VCs usually invest in early stage companies for a period between five and ten years in exchange for shares.
Startups are a high risk investment, since there is no way to tell if they will be successful down the line. This means it can be very difficult to value your investment upfront. Early stage companies have no track record yet, so there is no built up equity and revenue is low. In addition, it can take years before a startup makes a profit. The majority of startups fail, and so it is possible that you will lose your investment. But when a startup turns out to be a success, however, the returns can be very high.
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 startup 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 high risks of startup investing. 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 spreading your investments. Instead of putting all your eggs in one basket, make sure to distribute smaller amounts between different types of startups.
With startup investing, 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 you can sell your share for a higher value than what you invested at the start. For companies that go public, 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. Startup entrepreneurs usually want to invest all the funds in their company and it takes time before they see results. This means there will be no returns for at least a few years. The investment horizon is at least five years and sometimes longer.
Is startup investing for you?
Because startup investing has high risks, it is not for everyone. First time investors will usually not choose this type of investment. Startup investing is more suited 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.
In addition, when investing 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.