Would you like to invest in the next Airbnb, Dropbox, or Uber -- one of the so-called unicorns of Silicon Valley?
Investing in early stage businesses is risky, but it can be extremely lucrative. Between 2011 and 2017, Uber grew its valuation from $50 million to $70 billion --that's a 140,000% increase. In 2005, venture capitalist Peter Theil invested $500,000 into Facebook. Seven years later, he sold off more than two-thirds of his shares for $400 million -- that's 800 times his initial investment.
Investing in start-ups can make VCs and angel investors a truckload of money. But what about the layman? Until very recently, investing in start-ups was reserved for the elite. You needed to have the right connections and a ton of spare capital to boot. However, now the JOBS Act has opened up start-up investing to everyone.
Introducing the JOBS Act
The JOBS Act was a President Obama initiative aimed at jump-starting the funding of small businesses following the Great Recession of 2007-2009. For investors dreaming of investing in start-ups, Title III of the Act was of keen interest.
Before the JOBS Act, you had to be an accredited investor to invest in early stage companies. An accredited investor is anyone with a net worth of at least $1 million or an income of at least $200,000 in each of the last two years. Title III, which came into effect in October 2015, made it possible for anyone to invest in start-ups -- not just the small fraction of Americans who qualify as accredited investors.
Red light or green light?
Equity crowdfunding is all the rage right now.
Many companies offer equity crowdfunding services today. Platforms like SeedInvest, FundersClub, and Wefunder all offer slick websites and the chance to invest in the next Facebook -- or the next flop. However, it's not clear that it's time to jump on the bandwagon.
If you want to invest in early stage ventures because you want to turn $10,000 into $1 million, then you'll probably be disappointed. The kinds of companies that can generate those types of returns are still generally out of your reach, because the best start-ups have no trouble finding well-connected venture capitalists to fund them.
Start-ups need capital, but they also need the relationships that well-known VCs bring with them. The cream of the crop link up with VCs and don't bother with crowdfunding, so ordinary investors are left picking through the scraps they can find on crowdfunding sites.
Then there's the threat of shareholder dilution, which is when your ownership stake in a company gets reduced. If management decide to issue additional shares, it's possible that your stake will become reduced; your piece of the pie could be halved overnight. Bigger VCs can stave off dilution because they have the influence that comes with owning and controlling large tranches of shares. Crowdfunders don't have the same luxury.
The last thing to consider is the limitations imposed by the JOBS Act. Non-accredited investors whose income or net worth is under $107,000 are only allowed to invest the greater of $2,200 or 5% of their income annually. Those smaller investment limits mean that unless you land a true unicorn, you won't be making off with lottery-sized returns.
If you must invest in start-ups, know that it is a gamble. Many new companies fail, and optimistically speaking, just one in a hundred businesses that receive VC funding go on to become billion-dollar "unicorns."
If you must gamble, embrace the intelligent gambler's mindset: Only invest what you can afford to lose. For most people, that works out to between 1% and 5% of their net worth. Even if your investment goes to zero, it probably won't hurt too much.
The best way to invest in anything is to follow a value investing philosophy, given that value investors always seek to pay less for a company than what it is intrinsically worth. While it's harder to apply a value investing framework to start-up investing, it is still possible, though you will have to get creative when attempting to value the company or find other companies to compare it to. After all, you may have nothing to go on but some Kickstarter revenue and a big promise.
Finally, it's best to follow the lead of more experienced investors. Some recommend only investing in companies that venture capitalists with a proven track record are involved with. At the very least, you can use them as a screener. For example, Sequoia Capital is one of the most successful firms of all time, with a reputation for being a particularly adept unicorn hunter.
Many VCs extoll the virtues of investing in the management team. In fact, a 2014 experiment by a pair of Stanford professors and AngelList found that "on average, angels are highly responsive to information about the founding team, whereas information about the traction and current investors does not lead to a significantly higher response rate."
Look for teams or founders that have experience in bringing products to market and generating meaningful sales. Taking a venture from idea to exit is a skill honed over time, and if you invest in people who have done it all before, you give yourself the best chance at growing your portfolio.
The final word
Investing in start-ups is extremely risky, but if you moderate your expectations, you will start to understand what real success looks like in this realm. Don't expect it to be an easy journey, either. It's more than likely that you will have to reject fifty proposals to find the one perfect company you think deserves funding. Do that a few times, and you will have a robust portfolio of start-ups, one of which will hopefully take off and make you a wealthy investor.
The Motley Fool has a disclosure policy.