All companies have to start somewhere. Whether it's a $100 billion bank that's been around for 150 years or the hottest smartphone-app start-up, every company must go through a start-up phase.
The first step in the incubation from idea to business is funded by cash called seed money. It's an essential part of the entrepreneurial journey. However, if you're an investor thinking about taking a shot at "angel investing," understand that there's a high chance you're going to lose your money.
What is seed money?
Seed money is the initial money a start-up uses to get the business going. It's usually a small amount of money and often comes out of the entrepreneur's own pocket. Seed money is used to set up the business, begin developing a product, and potentially allow the founders to bring in some extra help if needed.
Family and friends are another common source of seed money, and there are even some professional venture capitalists willing to provide seed money in the right situation. It's probably going to be much easier to get seed money from loved ones instead of from a venture capitalist, though.
There are also government programs that supply early-stage start-ups with seed money, but as with venture capital, those programs can be difficult to qualify for and are highly competitive.
Why is seed-money investing so risky?
Seed money is invested in a company essentially at its birth. There are no customers. There's probably not even a product or service yet. There's almost certainly no revenue.
The business at this point in its life cycle is probably not much more than an idea or a concept.
It is still yet to be seen whether consumers will accept the product or service, and even if they do, it's still too early to know whether the business can operate profitably.
In other words, at this point there are millions and millions of things that could go wrong and cause the start-up to fail. Most experts estimate that more than 90% of start-ups fail, and when they do, the investors who provided the seed money lose their investment entirely.
Why do investors offer seed money if it's so high-risk?
When friends or family contribute seed money to a loved one, that support isn't necessarily driven by purely financial motivations. That seed money could just be to help a loved one follow a dream.
Other investors though do expect a financial benefit. Knowing that there is such a high likelihood that the start-up will fail, investors don't expect to make 5% or 10% returns on their seed investment. They make these investments to make 1,000 times or more of what they put in.
Seed-money investors get in on the ground floor, meaning that if the company does go on to become a great success, their relatively small check could turn into a fortune. One seed investment could mint a billionaire. Most don't, of course, but occasionally they do.
It's high risk and very high reward. Some specialized investors do these types of investments for a living. They have experience, knowledge, and connections that increase their odds of success. They also have enough capital that they can afford to lose money on most of their investments but still survive to find that one home run.
Should you consider adding seed-money investing to your portfolio?
Without special expertise, investing in early stage start-ups is almost a guaranteed loss. The simple reality is that most start-ups fail, so unless you're committed to learning the ins and outs of venture capital in a particular industry, then you're probably going to fail along with your bankrupt investments.
It's a great story to read when someone hits it big with a start-up and makes a billion dollars in a short time. But that reality is exceedingly rare. Wealth is much likelier to be built slowly and over time. That's a formula that can work for anyone, not just Silicon Valley's elite.
So my advice is to stick with a value-based approach in the public markets. Take the slow and steady path to building your riches.
That said, if you have the means and a loved one approaches you to help fund a dream company, you may be willing to help that person out. Make no mistake, though: There's a high probability you'll lose that money.