How to invest in a startup? Step-by-step guide

What is a startup?

Defining a startup can be tricky. It may refer to a company developing a new product or service under uncertain conditions, or one trying to solve a problem where the path to success is unclear.

Risks of startup investing

While potentially rewarding, startup investments carry significant risks. Most startups fail, so even with thorough research, there's a chance of losing your entire investment. Here's how to get started:

Popular startup investing platforms

Crowdfunding platforms allow everyday people to invest in startups, often with minimal buy-ins. Some top platforms include:

• Wefunder
• StartEngine
• Republic

"Thousands of companies apply to raise funds on our platform each year, and we accept only about 3%," says Kendrick Nguyen, CEO of Republic.

Some platforms let you start investing with just $100.

Accredited investor platforms

AngelList is another major platform, but it's exclusive to accredited investors with incomes over $200,000 ($300,000 for couples) or a net worth of at least $1 million, excluding the primary residence. AngelList’s minimum buy-in starts at $1,000.

How to profit from startup investments

When you invest in a startup through a crowdfunding platform, you enter into an investment contract with the company. These contracts generally fall into four categories, each offering different ways to generate returns:

• Debt: This contract treats your investment as a loan, earning interest. You may receive either a fixed return, such as double your investment, or a variable return. The timing of interest payments depends on the company’s performance.
  
• Convertible note: This is a type of debt that converts into stock when the startup meets certain milestones, such as securing additional funding. You profit once the company is acquired or goes public.
• Stock: Some later-stage startups allow you to purchase stock, similar to publicly traded companies. However, these shares cannot be sold immediately; you must wait until the startup is acquired or goes public to realize gains.
• Dividends: Established startups may offer stock that pays annual dividends to investors.

How much can you invest in startups?

For non-accredited investors, the SEC has set limits on how much can be invested in crowdfunding ventures within a 12-month period:

• Income or net worth under $124,000: You can invest up to the greater of $2,500 or 5% of your annual income or net worth.
• Income or net worth $124,000 or more: You can invest up to 10% of your annual income or net worth, with a maximum limit of $124,000.

Managing risk in startup investments

Just because you're allowed to invest a certain amount doesn’t mean you should. As Randy Bruns, a certified financial planner, advises, only invest what you’re comfortable losing if the startup fails or takes a long time to yield returns.

Diversification in startup investing

Experts recommend spreading your investments across multiple startups rather than going all-in on one. AngelList suggests that investors should have enough capital to back 15-20 startups. This diversification strategy helps mitigate losses, as even if most of your startups fail, one success could offset the losses. However, AngelList warns that overall losses are likely to surpass gains.

How to evaluate if a startup is a good investment

Startup investing is highly personal and should align with your financial goals. Experts advise conducting thorough research before committing funds. Here are key questions to consider:

What do you know about the startup?

Invest in areas you’re familiar with. Wefunder advises backing startups in industries or products you understand.

Is the team passionate?

Even great ideas can fail without a motivated team. Passion is critical for success, from communicating with clients to building strategies. A team lacking drive may allow competitors to gain an edge.

Does the startup have industry expertise?

The founders should have deep knowledge of their field. Many first-time entrepreneurs fail by attempting to replicate proven models without mastering the basics, giving competitors a head start.

How large is the market?

Startups need a sizable, expanding market. A niche product might win against competitors but still lack room for substantial growth, limiting the company’s potential.

Why this idea? Why now?

Consider whether this idea has been tried before and why it succeeded or failed. What makes this team or technology uniquely capable of making it work this time?

Should you consider investing in startups?

Deciding whether to invest in startups depends largely on your financial situation. Ask yourself if your finances are stable—are you managing debt well and meeting your savings goals?

“If the average American hasn’t saved enough for retirement, I wouldn’t recommend startup investing over contributing to a 401(k) or IRA,” advises Schryver, noting the high risk of loss. 

Historically, only accredited investors with significant income and wealth could participate in startup investing. Now that crowdfunding platforms have opened the doors to a broader audience, experts suggest following these guidelines:

• Consult a financial advisor: Most advisors won’t suggest investing in startups, so you may need to raise the topic yourself. Gage Paul, a CFP, explains that advisors may allocate a small portion of your portfolio to startups if it aligns with your goals.
• Limit your investment: Due to the high risk, experts recommend allocating only a small percentage of your portfolio to startups. “Keep it to 5% or less,” advises Dana Menard, a CFP.
• Be ready for potential losses: Startup investments shouldn’t come from critical funds, like those for retirement or college. Treat it as "fun money," meaning you’re prepared to lose it without harming your financial future.

Joel Cundick, a CFP, cautions that people who are behind on their savings may be drawn to startups in hopes of a big win. However, this risk could be too great for them, and they should focus on building a diversified portfolio first.

In fact, ETFs and mutual funds in diversified portfolios often invest in startups, so you may still benefit from startup growth through these channels.