3 Major Advantages of Investing in Startups

Retail investors can now access startups thanks to platforms like Republic and Wefunder. While it's a high-risk asset class, startups offer investors some significant advantages.

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Managing Director at CAPVEE
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Up until the last few years, startup investing was limited to the ultra-wealthy and hard-to-access investment funds. For one thing, regulators imposed restrictions that were designed to protect smaller investors from complex investments or, worse, scams. Those protections are well-intentioned, but, as investors became acutely aware that much of the gains in high-growth companies come before the IPO, they demanded a more equitable system. The most widely available solution to this is equity crowdfunding.

Platforms like Republic and Wefunder allow nearly anyone to invest as little as $10 in startups that they support and believe will grow to become something big. It's a win-win, as investors now have easy access to thousands of interesting startups, and entrepreneurs have a new, powerful channel to raise early-stage capital. Startup investing is much riskier than, say, an S&P 500 ETF, but the asset class also gives investors benefits that stock-market investing struggles to provide. Here are three.

Social capital

Someone may invest in Netflix because he or she thinks it's going to continue its domination of the streaming world and that its stock price will go up. There's nothing wrong with that, and he or she may be right, but the invested isn't going into a bank account to help The Notebook 2. By contrast, when investors put money into a startup on an equity crowdfunding platform, that money is going directly to helping the company achieve its mission.

Many of these startups are pursuing goals that help humanity in one way or another. Agora, for example, aims to help compete with the online giants by making local shops' inventory available online for consumers to find and buy. Leah Labs is a canine-focused biotech developing treatments for currently incurable diseases. Investors can find companies that align with their values and passions and directly contribute to those efforts. Investing this way allows for more than just financial gain.

Related: How and Why Startups Must Protect Their Intellectual Property at All Costs

High risk, high reward

Investing in a startup is much riskier than investing in a blue-chip stock, and investors should only put in what they can afford to lose. Betting the farm on a 6-month-old company that's burning $100,000 per month is a good way to lose a farm. But, as is often the case, the risk pairs with the potential for a major win. Here's an eye-popping figure: 6,000 times. That's investor Garry Tan's return on his $300,000 investment in from 2012. His stake was worth about $2 billion at IPO. 

Most won't see that kind of insane return, but it's certainly an incentive for funding a small startup with big plans. Investors should approach these opportunities with the goal of turning one dollar into $50 or $500. Or, if you're Tan, $6,000 dollars (before dilution). 

It takes a different set of tools to evaluate startup investments as opposed to public equity, but many lessons apply to both asset classes. One of the biggest differences is that startups require investors to imagine what could go right, whereas a big part of stock-market investing is understanding what could go wrong. 

Related: What Does the Coinbase IPO Mean For Traders and Investors?

Liquidity, or lack thereof

This last one could be spun a couple of ways, but we'll take the optimists' view. When an investor puts money into a company he or she found on an equity crowdfunding platform, the shares he or she receives are highly illiquid. That means there is little to no chance that the investor will be able to convert those shares back to cash in the next few months, years or even longer. Startup investors need the company to experience a liquidation event in order to see cash back. This could come from an IPO or an acquisition, or a less exciting outcome like a wind-down or merger with another startup. 

First and foremost, this reinforces the point that folks should only invest what they can afford to lose. Even if they do eventually see a return, it'll be a long time and only when someone else makes the decision. 

This is a good thing, believe it or not. The illiquidity prevents investors from making emotional or rash decisions and allows the investment to achieve its full potential. Some of the most common mistakes that stock-market investors make is over-trading: buying and selling based on short-term fluctutations that do not materially alter the company's course.

Think of it this way: An investor may have put $1,000 into Amazon stock in January 2015 when it was trading between $300 and $400 per share. By August 2018, the stock was up above $1,800 per share and then pulled back by 20 percent. Some people undoubtedly sold at that point, seeing the negative price action and thinking the big gains were behind them. Of course, it recovered, and the stock trades at nearly $3,500 today. That's the difference between making five times your money and ten, which can be life-changing.  

When an investor puts money into a startup, those funds are locked up. This forces the investor to take a long-term approach, which is almost always a superior tactic compared to short-term trading.

Related: What Is the Secret of Amazon's Huge Success? Jeff Bezos 

A new horizon

As recent regulatory changes and technological advancement have opened up these new asset classes to retail investors, it's worth spending some time to learn about these opportunities. CAPVEE recently wrote about dozens of interesting equity crowdfunding campaigns currently live on Wefunder. While it by no means should replace stocks or bonds, alternative assets like startups may warrant a small piece of the average investor's portfolio. That small allocation could end up yielding bigger results than the rest of the portfolio combined. 

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