Investing in unlisted startup companies was previously only a possibility for business angels, venture capitalists or wealthy individuals. With the rise of crowdfunding, or more specifically equity-based crowdfunding, the process has been democratized and is now a possibility for everyone.
How does Startup Equity Investing Work?
All businesses need money to start, grow and live out their mission. With the rise of the internet, a new way for companies to raise the capital they need has emerged making it possible to fund money from a lot of people instead of just a selected few – the crowd. If you invest in startup equity via crowdfunding, in return for their cash, you will get shares in a company. As a shareholder you will have partial ownership of the company. Hence, if the company does well, it is possible for you to profit on the ownership; and if the company fails, you will lose what you have invested. Most investors will therefore benefit from spreading their risk by building a diversified portfolio.
Choosing the Right Platform to Invest in Startups
The first step in getting started with early-stage investing is to pick out the right platform. In startup equity crowdfunding there are two types of platforms: Platforms with investment opportunities led by a co/lead-investor and platforms with investment opportunities led by the company/entrepreneur.
On investor-led platforms, the investment terms will be concluded based on a negation between a lead investor and the company looking for financing. These terms include the legal agreements and the company valuation. As an outside crowd investor on this type of platform, you will invest alongside the lead investor meaning you will get the same class of stock at the same price as him/her. The fact that an experienced investor is willing to risk and invest a large amount on the terms you are given, gives smaller more inexperienced investors a security that the deal is good enough for that investor.
On company-led platforms, the entrepreneur/company raising finance will set its own investment terms. This means you will need to be extra careful about choosing the right projects as the company will, unsurprisingly, try to get the best possible valuation and rights for themselves – just as you would as an investor. However, that does not mean it’s not possible to find interesting projects on this type of platform as crowdfunding, on top of funding, can bring other benefits such as marketing for the company looking for funding. Also, entrepreneurs can lack experience in raising funds, which might cause them to valuate their business higher or lower than the market would. To offset these problems, some company-led platforms will allow the crowd to make a counter offer on the valuation of the company.
Risks Involved When Investing in Startups
Before you get started, it’s important to realize that investing in startup equity crowdfunding carries high risk as many startups will end up failing. Here, data from the US shows that the survival rates of businesses with employees are as follows:
- About 80 % survives their first year.
- About 70 % survives their second year.
- About 50 % survives their fifth year.
- About 30 % survives their 10th
These rates are surprisingly consistent over time but varies from country to country and industry to industry. Digging deeper in the statistics can therefore provide you with useful insights before you invest in a startup. That being said, when done right, investing in startup equity via crowdfunding can be highly profitable as well as an existing and rewarding venture. Besides the risk of the startup failing, there are several risks to be aware of when investing in startups. Below you will find some of the most important ones:
Depending on the platform, the shares you receive can be highly illiquid
If you invest on equity crowdfunding platforms without a secondary market you will probably have to keep your shares until the company is listed on an exchange (IPO or ICO) or the whole business is sold to another company (trade sale). Also, even though a secondary market is available, it is no guarantee you can sell the shares and if so, at a reasonable price. This results in most crowdequity investors end up owning the shares until a larger acquisition deal is put in place or the company is listed on a coin or stock exchange.
Returns are usually from stock value appreciation
Before you can see your shares increase in value you will need patience and the ability to cope for some time without the invested money. Most venture funds and angel investors work with a 3-5-year investment horizon, but sometimes it can take much longer before you see any stock value appreciation. Usually startup companies expand by growing revenue and not necessarily the net profits – it is common to see tech startups at high valuation that have never had a profit yet. This also means that you shouldn’t expect any dividends because of low or no direct net profits in the company.
Your shares can be diluted
Dilution means the total cake gets bigger and cut into more pieces. Almost all unlisted startup companies will raise more capital along the way. Normally, this is done by issuing new stock to the new investors. With more stocks outstanding, each existing shareholder will own a smaller percentage of the company. Thus, this will result in a decrease of your ownership percentage. Also, the new shares might contain stock options that can dilute your percentage even further if exercised. Therefore, make sure you have the right investor protections in place before investing.