May 14, 2021

6 Things to Consider Before Investing in a Startup

By Marcus by Goldman Sachs

What we’ll cover:

You might have seen startup investors cash some pretty big checks and wondered what it takes to invest in an up-and-coming company. Maybe you want to be a part of the next “unicorn” (a privately-held startup valued at more than $1 billion) or are looking for a new income stream or have been hit up by a relative with “the next big idea!” who just needs a little funding to get started.

Regardless of what exactly has brought you here, funding is likely one of the first considerations when it comes to investing in a startup. According to Fundera, the average small business requires approximately $10,000 of startup capital. However, a third of small businesses start with less than $5,000, so there’s a pretty wide range in terms of how much the typical startup gets started with!

And while we’re on the topic of funding, we also want to mention that when discussing “investing” in a startup, that can mean providing funding in exchange for a specified rate of return, or gifting an amount of cash as funding to assist a business or idea you believe in.

All that being said, investing in a startup can be much more involved than what you take from your piggy bank (and potentially put back in). Beyond the amount of cash you’re thinking of putting in, here are some things to keep in mind before you invest in an up-and-coming business.

1. Decide what type of investor you are

If you’re planning on investing in a startup (or just noodling around with the idea right now) you’ll want to know that there are a few different ways you can contribute funds.

  • Venture capital: A venture capitalist is a private equities investor, meaning they directly invest in private companies. In exchange for providing funds (aka venture capital), they typically get an equity stake (the percentage of the company they own or how much money they would get if the company’s assets were liquidated). As an example, a venture capitalist might provide $250,000 in funding in exchange for a 10% equity stake. If the startup is sold down the line for, say, $10 million, you’d receive $1 million. You may hear the words “venture capital” thrown around a lot, but this type of startup funding can actually be pretty rare – only about 0.05% of startups raise venture capital.
  • Angel investing: An angel investor is usually a bit more of a “personal” investor. They’re a high-net worth person who might be investing as a way of supporting a family member or close friend in a new venture. The exact funding and what they get in exchange will vary depending on the arrangement, but this type of startup investor is a little more common: Angel investors invest in more startups than venture capitalists.
  • Crowdfunding: This type of investing refers to raising small individual amounts of funding from a large pool of friends, family, private investors and customers. Startups can use this money-raising strategy to raise money via resources like social media and specific crowdfunding sites. If you choose to go the crowdfunding route as an investor, there are smaller buy-in costs than what might be required of venture capitalists or angel investors.

2. Think about how involved you want to be

Investing in a startup isn’t always just about helping with funding. Depending on the type of investor you are and/or your relationship with the founder(s) you might have additional responsibilities in the budding business. So it might be helpful to think about what kind of role and level of involvement is ideal for you.

Of course, you could change your mind but having an idea of the role you desire ahead of time is a good idea – it can help you set boundaries and define your responsibilities from the get-go.

Your level of involvement may also depend on what kind of investor you plan on being.

  • As you’ve probably guessed, venture capitalists are involved in the financial side of a startup because of the large amount of funding they usually give. They might also contribute their experience and knowledge, in operations, marketing or sales, helping startup founders to develop a strong sales strategy.
  • If you’re an angel investor, your level of involvement might depend on what your relationship with the founder is or why you’re choosing to invest in the company. If a close friend or relative has asked you to provide funding because they know you have the cash needed, your role may not extend much beyond financial benefactor. On the other hand, if a startup has sought you out for funding and your experience in the industry, you may be asked to provide managerial experience, or some other kind of expertise.
  • When it comes to crowdfunding, typically your only responsibility is to provide the funds. This could be a good option if you’re really just looking to make a donation to a business idea you feel passionately about, or are a friend or family member trying to help a loved one get an idea off the ground.

3. Vet the founder and their business plan

One of the first steps you may take as a potential startup investor is setting up a meeting with the founder(s) to learn more about their idea and see if it’s something you want to put your money into. You’ll likely come across some pretty passionate people who are going to sound very excited and convincing.

As a potential investor, though, it’s a good idea to set emotions aside and carefully think things through. (If you’re a seasoned stock market investor, you can think about this similarly to how you can’t let your emotions get the best of you during a market downturn!).

One thing to take a look at is the founder’s background and experience. While a great, innovative idea can be exciting for any investor, you want to make sure the founder is not only passionate about the company, but also has the general knowledge and know-how to execute on their idea.

No matter what kind of investment you’re considering, there’s likely still going to be risk involved.

So if you’re looking into a startup that, say, has an idea for new hardware that will help self-driving cars, you might want to see a founder with experience in the type of sensors needed.

If the startup you want to invest in doesn’t have a technical expert as a founder, that’s not necessarily a deal breaker. In that case, you’ll want to be sure they have someone like a strong chief technology officer, i.e. someone on the executive board who has the technical expertise to make sure the product is a success.

4. Ask about the startup’s financial picture

Yes, talking about money can feel taboo. But as a startup investor, it’s a pretty standard conversation. Think of it this way: Before you sign a loan or get a credit card, the bank often combs through your financials before deciding if they want to take you on as a client. You’ll want to perform a similar money audit for the startup. That could include asking how much capital they will need to run or how much debt they have.

And finally, there’s the money question that’s probably top of mind: What’s the rate of return on my investment going to be? The answer usually depends on the type of investment involved, as well as what type of investor you are (or plan to be!).

Angel investors, for example, typically anticipate an annual return of 30-40% on their investment. On the other hand, venture capitalists often assume a higher degree of risk and therefore expect a higher rate of return. (Of course, keep in mind that while investors may anticipate these type of returns, nothing is guaranteed).

For crowdfunding folks, or friends and family contributing funds, it’s difficult to determine what kind of returns, if any, you might see, since any capital you’re providing may be seen more as a gift or donation.

Of course, no matter what kind of investment you’re considering, there’s likely still going to be risk involved. According to Investopedia, 2019 saw a failure rate of 90% for startups, with 21.5% failing within the first year. Now we’re not trying to discourage you from investing in a startup by throwing those statistics your way – hopefully, though, you see how important it can be to do your due diligence before investing!

5. Scope out the potential market

A business’ potential market is whatever part of the market they can capture in the future – essentially knowing that customers are out there wanting the business’ product or service (and knowing who those customers are!).

Some things to think about are how saturated the existing market is – are there already a dozen similar offerings out there? Or does this idea truly address a need that hasn’t been addressed?

Investing in a startup can be much more involved than what you take from your piggy bank (and potentially put back in).

Before you invest, be sure to ask these kind of questions to ensure the company has a clear idea of their market share.

The founder and leadership team should be able to answer the questions you throw at them, and be able to tell you the specific market share they plan to capture within a set period of time.

6. Ask about the company’s 10-year plan

This might seem like a question pulled straight from a job interview, but it applies to startups too! What’s the company’s 10-year plan? If you’re considering pouring some of your hard-earned money into a company, you want to know they have a long-term plan, not just a lot of excitement and a seemingly good idea.

You’ll want to ask about the vision for the future: what profit does the team expect long-term, where they see the company heading in the next ten years, plans for expansion, and so on.

This is also an opportunity to understand where the founders see themselves next, and what role they do or don’t want to have down the line. If the founder is a serial entrepreneur (or wants to be) and doesn’t intend to stay at the startup long-term, make sure there’s a clear exit plan written up, i.e. agreements and paperwork are in place to ensure a smooth exit and company turnover to the next successor

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ABOUT THE AUTHOR

Marcus by Goldman Sachs

marcus.com

United Capital Financial Advisers, LLC d/b/a Goldman Sachs Personal Financial Management (“GS PFM”) is a registered investment adviser and an affiliate of Goldman Sachs & Co. LLC and subsidiary of The Goldman Sachs Group, Inc., a worldwide, full-service investment banking, broker-dealer, asset management, and financial services organization.

The information contained herein is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. GS PFM does not provide legal, tax, or accounting advice. Clients should obtain their own independent legal, tax, or accounting advice based on their particular circumstances. Please contact your financial adviser with questions about your specific needs and circumstances.

Information and opinions expressed by individuals other than GS PFM employees do not necessarily reflect the view of GS PFM. Information and opinions expressed in this article are as of the date of this material only and subject to change without notice.

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