6 Things to Consider Before Investing in Startups

One of the most popular forms of investment is company stocks; these are essentially forms of partial ownership of a company, and usually a very small piece. Investing in an old, gigantic company is a relatively safe investment that will probably guarantee you a small, yet reasonable and predictable path of profitability over the years. Investing in a younger, smaller company or one in a new industry is riskier; these stocks are frequently cheaper and have a higher potential growth rate, but are also more prone to volatility and price crashes.

The Startup Angle

Investing in startups is a viable option for the savvy investor, as these are the youngest, smallest companies you can imagine. They haven’t yet emerged on the stock market, but are desperate for cash, turning to private investors (and sometimes crowdfunding) to get off the ground.

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If you invest wisely enough, you could see a tremendous payoff—but is it worth the risk?

What to Know Before Investing

Before you invest in a startup, there are a few things you should consider:

1. The pitch is everything. As illustrated by Slide Heroes’ rundown on pitch decks, the pitch for a startup is everything. It’s going to tell you what the startup is, who the target audience is, what research the main entrepreneurs have done, and what the projected revenue growth is over the next several years. Ask to see the pitch before even considering an investment, and do a thorough check to see if the business owners have done their due diligence. If there’s any missing information or data that seems misleading, don’t put any of your money in it.
2. There’s no single way to invest in a startup. There are dozens of different ways to invest in startups. You could offer a bit of money to a friend or family member as a kind of glorified loan, you could sign on as a partner in a budding enterprise, or you could purchase partial ownership like you would purchase stock in a bigger company. Learn the advantages and disadvantages of each before you settle on a single method for the startup you’re considering.
3. Equity crowdfunding exists but comes with lots of hoops. Equity crowdfunding is just like regular crowdfunding, except you’re all contributing to become owners in an emerging startup. The problem is that there are lots of hurdles to overcome with this investment method. For starters, you have to be pre-qualified as an investor before you can get involved—equity crowdfunding isn’t as openly available to the public as traditional forms of crowdfunding. There are also important rules and regulations with the SEC, and complicated tax rules you’ll need to know. For the average investor, this is enough to warrant avoiding equity crowdfunding altogether.
4. Partnerships are often demanding. When you know the person or people starting the business, a partnership may seem like the best option—after all, you’ll have a guiding hand in how the company develops. But be aware that partnership in a startup is often incredibly demanding, and will likely take hours of your time every week—even if you’re not directly involved with day-to-day management. For some, this is an enriching experience, but you need to be prepared for the stress and time required.
5. Early IPOs can be misleading. Initial Public Offerings (IPOs) are a tricky business. When a startup has gotten to a certain level of stability and met a number of prerequisites, it can offer partial ownership of the company to private stockholders for an initial set price. Sometimes, this price explodes due to market excitement, but other times, it can crash. Be wary of this initial volatility, and only invest in companies you believe in for the long haul whose prices seem fair compared to projected revenues and cash on hand.
6. The fine print is important. There are many ways to strike an investment deal with a new startup, so make sure you negotiate, read, and understand the fine print. This will tell you how much ownership you’ll have, what rights you have as an investor, what you are and are not allowed to do, as well as how and when you may be paid. Since this could theoretically make or break your investment (and potentially cause headaches for you later one), it’s vital to know.

If you can clear all six of these major considerations and still come out confident that investing in this startup is right for you, go for it. However, it’s important to remember that no matter how sure your investment seems, it’s always a good idea to diversify your portfolio. Every investor’s assets should be divided among several realms, including stocks and bonds of various grades, and other investments like real estate.