WHAT IS THE ASSET?
A startup is when a new private company that has a limited track record but high profit potential seeks capital from investors to help scale their idea. In exchange for a capital infusion, the investor receives a share of ownership—typically a limited partnership—in the company. These investments are typically done in escalating stages, with a revalue of the company occurring after each stage.
Startups have a very high risk/reward profile: If the company turns out be profitable, the investor is able to participate in the upside. If the company loses money or goes out of business, the losses are limited to the investor’s initial investment. This is similar to how other syndications work.
There are three paths for investing in startups:
Invest through a VC firm — Since the JOBS Act, there has been an increase in online VC firms that perform the same duties as traditional VC firms but also offer an easy-to-use online portal. Most of these online VC funds are only open to accredited investors.
Invest via crowdfunding platforms — There is a section in the JOBS Act that permits non-accredited investors to invest in startups subject to certain restrictions. The investment amount can be very small compared to the majority of typical minimum investment amounts presented in this book—some as low as $100!
Direct investment — This typically happens when you personally know the founder(s) and/or if you’re a professional angel investor.
PRO TIP: A word of caution: Just because you can invest in a shiny object doesn’t mean that you should. Just like any other alternative investment, you should focus on the operator rather than the platform. I have personally been burned in the past by confusing this issue. But when I invested in my startup, I personally knew the operator from the real estate world. And while the deal ultimately landed on a crowdfunding platform, my partner had already vetted the deal, and we both had multiple calls with the operator prior to investing. So prior to considering any investment, make sure it’s not the portal that’s selling you the deal—instead, it’s your background or your partners background that helps the deal make sense to you.
In the startup space, as in other asset classes, the ability to sell your ownership is referred to as liquidity. The first liquidity event occurs if the startup goes out of business.
In this case, calculating your return is very simple: You walk away with nothing. The second liquidity event occurs if the startup is purchased privately, which usually yields great returns on your investment. The third and largest liquidity event occurs if the company is taken public on the stock market; this usually represents a considerable multiple on your returns.
Ideally, you want to hold on to your highest performers in this class. And most of the time, between the investment and the liquidity event, there really isn’t a major market in which to sell your equity anyway unless the company is clearly moving toward an initial public offering (IPO), like we’ve seen with Airbnb and Uber during the last few years. But keep in mind that over the last decade, some of the most well-known companies—including LinkedIn, Yelp, Facebook, and Twitter—created tremendous multiples privately that were never matched publicly. Twitter, in particular, provided an 800x return privately, but has only doubled in value once since its IPO in 2013 (at the time of this publication).
In terms of liquidity in this asset class, the best defense is a good offense—which means avoiding over-allocating your portfolio to this space in the first place. And if you decide to place a small percentage of your total assets into a portfolio of startups, then you need to give that “slice of the pie” a chance to accomplish its intended purpose.
At the end of the day, you should look to invest in an operator that you or the person vetting the deal can trust. The odds of hitting a home run are low, but you should be able to at least swing for the fences with an honest pitch. If the company turns out be profitable, you will be able to participate in the upside. If the company loses money or goes out of business, your losses are limited to your initial investment.
The Pros and Cons of Tech Startup Investing
- There is a potential for outsized returns
- Great for investors that have a background in the relevant startup industry
- Can invest with a very small amount through online platforms
- Potential for 100% loss
- Can take years to materialize
If you liked this article and wish to continue on your path in learning about alternative investments, please make sure to check out my other educational articles as well as my book, The Alternative Investment Almanac: Expert Insights on Building Personal Wealth in Non-Traditional Ways.
Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.