How to Start Investing in Privately Held Startups?

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(Last Updated On: November 2, 2015)

Most business journalists love to cover startups and tell their stories as they raise millions of dollars from investors, while earning billion dollar valuations (Uber  comes to mind). Eventually they go IPO and early venture capital investors get their share price for a fraction of the price that becomes available to general public. As an average, individual investor, you may think that the whole system is not stacked in your favor. Fortunately, this is changing and most individuals in the US are now eligible to invest into early stage private startups with JOBS legislation. The “only” trick to significant financial return on your investment is to recognize a unicorn that is currently a pony.

Getting a piece of startup before they go IPO is no longer reserved only for sophisticated institutional investors with deep pockets. With equity crowdfunding, most people can invest as little as a thousand dollars into a startup.

What is Equity Crowdfunding?

Equity crowdfunding pools money from a group of investors via internet platforms, using social media. In exchange for money, investors get an equity stake in the company. In the mist of the Great Depression in 1933, SEC has banned private companies from publically advertising their intention to raise money in order to protect individuals from potential scammers during this deep economic crisis. That rule has been a law for a long time, but it has changed in 2012 with JOBS Act. Unfortunately, the legislation regarding equity crowdfunding is still not straight forward.

flat style - new business model - funding project by raising monetary contributions from crowd of people
crowdfunding concept

Just do a quick search for Reg A Tier 1, Reg A Tier 2, Reg D: Rule 506(c) Regulation and you will see a lot of legal web sites trying to simplify the rules. As a reference, download the PDF version of the Comparison of Equity Crowdfunding Regulations from Seed Invest.

Without going into too much detail about the current state of legislature regarding equity crowdfunding, we recommend this simple rule of a thumb:

  • If you are an accredited investor, or high net worth individual, you can use any investing portal currently available, or invest directly into a startup.
  • If you are non-accredited investor (aka most people in the US), use online equity crowdfunding platform that operate within your state because they will ensure legal compliance for your transaction.

Who’s an Accredited Investor or Angel Investor?

Accredited investors are individuals whose net worth is greater than $1million (excluding a primary residence) or whose individual income exceeded $200,000 ($300,000 for couples) for the past two years with the expectation for that income to continue in the current year. Companies must take reasonable steps to verify that investors are accredited through an attorney, CPA, investment advisor, or broker-dealer. In some cases, accredited investors can self-certify their status.

It is estimated that there are around 9M accredited investors under SEC rules in the USA or 4M high net worth individuals with assets over $2M. However, only 3% of these eligible individuals (about 270k)actually invest in startups. On the other hand, they bring to the table more than money. They typically advise, mentor, join the board if the financial investment is significant, are passionate advocates for the company.

Startup Investing for Non-Accredited Investors

If you do not quality to be an accredited investor, you can still invest in early stage companies  where local legislators have allowed for Intrastate Trade. That means that you can only invest into a startup that is registered to do business in your state. The goal of this exemption is to encourage local economy and support small businesses.

Currently (as of Fall 2015), non-accredited investors can invest in local business in the following states:

Intrastate equity crowdfunding map
Intrastate equity crowdfunding map

A number of other states currently are debating in the legislature to support intrastate exemption.

October 2015 update: equity crowdfunding for non-accredited investors expected in 2016

The Securities and Exchange Commission on 10/30/2015 voted 3-1 to approve equity crowdfunding rules to take effect sometime in 2016. That means that everyone will be able to invest in small businesses and startups, however some limits are put in place to protect small investors. If both your net worth and annual income are less than $100,000, you’ll only be able to invest $2,000 (or 5% of annual income or net worth) in each 12-month period. If your net worth and income are above that threshold, you would be able to invest the greater of 10% of annual income or net worth (but not to exceed $100,000). Companies raising $100,000 or less will only need to provide financial statements certified by their own financial officers. Those raising between $100,000 and $500,000 will need to have their finances reviewed by an outside accounting firm. Those raising between $500,000 and $1 million would need their finances reviewed by an outside auditor but would not need to obtain audited financial statements (so long as this is the issuer’s first time selling equity via crowdfunding).

Where to Find Startups Raising Money? On Equity Crowdfunding Platforms

Traditionally, angel investors would organize themselves in angel investing groups so they can spread the work necessary to source deals and do due diligence among its members.  Some groups are highly private and they are hard to get a hold off, others are more open. Generally speaking, angel investors, in a traditional sense of the word, prefer that startup founders network within local entrepreneurial community first and so they can get a warm introduction before they agree to a meeting. Needless to say, this process is time consuming and ineffective for a time strapped founder. Fortunately, this old fashioned process is now being disrupted with a pleura of equity crowdfunding platforms. Both startup founders and all investors (not just angels) can find each other quickly online, on any of the equity crowdfunding platform.

Partial List of Equity Crowdfunding Platforms:

    1. · AgFunder
    2. · Alchemy Global
    3. · AngelList
    4. · angelMD
    5. · BlazeFund
    6. · CircleUp
    7. · CrowdAlliance
    8. · Crowdfunder
    9. · DarcMatter
    10. · EarlyShares
    11. · EquityNet
    12. · fairstreet
    13. · FlashFunders
    14. · Fundable
    15. · FundersClub
    16. · Ingress Capital
    17. · JoinVestor
    18. · JumpStartFund
    19. · MicroVentures
    20. · OneVest
    21. · OpenRound
    22. · OurCrowd
    23. · PennStarter
    24. · Portfolia
    25. · Retire America
    26. · SeedInvest
    27. · Seedups
    28. · Slated
    29. · StartupValley
    30. · Sterling Funder
    31. · VentureHealth
    32. · WeFunder

If you are new to startup investing, we recommend using one of the equity crowdfunding platforms because they will ensure legal compliance and provide all necessary paperwork to record the transaction. Otherwise, legal bill can be expansive if transaction is done directly between an investor and a company.

When choosing an equity crowdfunding platform, keep in mind that these companies are startups themselves. Most of them have been in business for few years, if that much, as are still working on raising money themselves to fund their operations, hire more staff and iron out any kinks in their process.

How much money should I invest in a startup?

If you are non-accredited investor, the legal constraints in most states will not allow you to put in more than $5k per year, cumulatively across all your investments in this asset class; or no more than 10% of your net income. No matter what is the limit, diversification is they key; spread your budget across dozen companies in different industries. Even the most experienced venture capital managers do not put a lot of their own personal money into early stage startups. Most will put several thousand dollars, some will go up to $25k or so. If professional investors are not risking huge amounts of money from their own personal savings, neither should you.

Startup equity represents the most risky asset class, where probability of losing all of the money invested is really high. For example, out of 10 startups in venture capital portfolio, few will fail, most will just break even in 5-7 years and if lucky, one company will provide 10X ROI or higher. With such financial performance, the US venture capital fund index was able to historically outperform S&P500 index; but just barely.

If startup investing is so risky, why bother? Because it’s not all about money. Entrepreneurs are disrupting status quo, they are building new business models, hiring new employees, and ultimately making our community better.

How do I Evaluate ROI for a Startup?

Publically traded companies and other financial instruments come with thick prospectus and scores of analyst reports that will benchmark that particular security against comparable. That’s not the case with private equity. Recommend to start with the industry you are familiar with, or you have worked for years because then you will know challenges in that particular sector and if the idea startup is commercializing is big enough to disrupt that sector.

Startup founders that are very serious about raising money for their company will have an online that will stand out from the crowd in terms of quantity and quality of information presented. The information should include social capital: biographies for all members of the management and founders, advisors and current investors. Publically visible pitchdeck or a pitchbook is an absolute requirement. Opening statement focuses on the value proposition, followed by market opportunity, addressable target market, competitive advantage, go-to-market strategy, , financial projections, milestones and fundraising amount.

Get an Investor-Readiness Scorecard

We have seen thousands of pitches over the years and helped countless entrepreneurs improve their elevator pitch, pitchbook, and presentation, so they have raised money from investors. Because of that, we have developed a detailed 45+ point scorecard evaluating investor-readiness level for a startup. As an investor, we encourage you to use our advising services and get our assessment score before you invest into the company. All you have to do is to send us a name of the company you are interested in and a link to their equity crowdfunding campaign.

IMPROVE YOUR PITCH DECK AND GET TRACTION WITH INVESTORS
Pitch Deck Consulting Services

Weather you are an individual investor looking to diversify your portfolio by investing in private equity asset class via equity crowdfunding, or you are startup looking for investors, call us or email us to schedule a 30-minutes complimentary consultation.

About Dragana Mendel 85 Articles

Dragana Mendel is a President and Principal Consultant at ANAGARD, LLC. In her role, she provides management consulting services to small and medium size businesses on the best strategy to achieve their short and long term goals.