What to Know When Funding a Startup
Investing in startups can be a sensational way to grow money. With a little due diligence and a dab of luck, a modest $20,000 buy-in can mushroom into several million within a matter of years. The operative word, however, is “can.” After all, 90 percent of startups fail.
To mitigate risks, successful angel investors stick to a few tried and true basics.
Angel Investing 101: The 10 Percent Rule
Angel investing — also known as seed investing and private investing — is how most startups turn on the proverbial lights. Usually, angel investors are family and friends, but increasingly, armchair traders using the practice to grow private equity.
Sometimes, angel investing can invite a welcome windfall. Right at this very second, the initial investors of Airbnb, Uber, and Instagram are living large on Easy Street. But the hard truth is that most startups fall flat on their faces. Twenty-one percent fail in the first year, 30 percent in the second, 50 percent in the fifth, and 70 percent by the tenth year. As such, it’s never wise to allocate more than 10 percent of your portfolio to angel investing.
Three Foundational Rules to Understand Before Angel Investing
If you’ve never angel invested, there are three things to know before getting started.
- It cannot be said enough: angel investing is risky. If you don’t have enough money stashed away for a comfortable retirement, do that first.
- If you’re an early investor, it’s wise to demand a seat on the board in addition to equity in the business.
- Solid contracts can mean the difference between a successful and terrible experience. Make sure you have one!
Risks and Benefits of Angel Investing
The high-risk-high-reward principle applies to angel investing. If you pick the right horse, a $2,000 bet could net you $20 million down the road — but it could also amount to bupkis. So a good rule of thumb is to never invest more than you are willing to lose, especially if you’re new to the startup funding game.
Above all, be strategic and don’t dump your whole nut into the initial funding round. And remember to hold back for the “pro rata” stage.
What does that mean?
Let’s say you invest $20,000 in a startup with a $2 million valuation. That will buy you one percent of the company. If the business takes off, and analysts value it at $10 million in the second round of funding, you’ll likely want to keep your one percent ownership stake, which means ponying up another $100,000. According to Money Morning, “But when researching angel investment opportunities, choosing the best startup companies to invest in may be tricky due to the risk involved. After all, research shows that about nine out of ten startups fizzle prior to achieving successful gains.”
Startup Funding Strategies and Tips
Before dipping your duckets into angel investing, do research, and set limits.
Consider the company carefully. Do they have early traction? What is the proof of concept? How about the competition? Are they formidable? Also, think long and hard about the team. Do they have experience? Do they work well together? Are they genuinely passionate about the project, or will they split at the first sign of something better?
And don’t forget to consider scalability. Countless startups fail because they don’t have solid plans that allow for both growth and shrinkage.
The last bit of advice for successful angel investing is simple, but it’s also the most important: only invest in what you understand. The strategy has worked for Warren Buffett, the world’s most successful investor, and it will work for you too!
If the money is available, angel investing can be a boon to any portfolio. Doing it smartly just takes some due diligence, common sense, and educated strategizing.