The ins and outs of investing in startups (2024)

Small business startups have been on the rise in the United States ever since the beginning of the Covid-19 pandemic. All told, 5.5 million new startup businesses opened up in 2023, according to the US Census Bureau. That’s up 56.7% from the 3.5 million new businesses launched in 2019.

“The current startup landscape in the United States is thriving, presenting unprecedented opportunities for entrepreneurs,” said Keith Lauver, founder at Atomic Elevator, a launch marketing syndicate company in Billings, Montana.

While prospects exist across various sectors, businesses serving other businesses are particularly well-positioned for success. “Innovators who can develop products or services that enhance manufacturing processes or boost efficiency are in high demand, as companies increasingly rely on these solutions to stay competitive,” Lauver said.

Why invest in startups?

Yet starting a new business and successfully sustaining one are two different issues — and that’s where startup investments, the lifeblood of any rising company, come into play.

“Investing in startups offers the potential for exceptional growth,” Lauver said. “When the right idea is executed by a skilled team at the optimal time, investors can reap substantial returns. Moreover, supporting groundbreaking innovations transforming industries is a gratifying experience, as these startups are actively making the world a better place.”

Steering some portfolio cash toward startup enterprises also aids in the greater economic good, business experts say.

“Investing in startups drives innovation and job creation across the US, and the startup and entrepreneurial cycles have produced many if not all of the most innovative and large companies in our country,” said Mike Jones, co-founder and managing director of venture fund and startup studio Science Inc., which has a portfolio that includes brands such as Liquid Death, Dollar Shave Club (acquired for $1 billion by Unilever), MeUndies and Rover, among others.

“As an investor, you’re involved in the future of building the next generation of companies and the future of the US. On the downside, investing in startups can lead to a long cycle that requires financial commitment and comes with high risk,” he said.

Understanding startup investment platforms

An excellent way to break into the startup investment market is through platforms connecting investors with bootstrapping entrepreneurs.

Such platforms are usually specific to the type of investor drawn to startups and to the growth stage of a new company. Usually, that translates into several investment categories.

  • Equity crowdfunding: Equity crowdfunding platforms cater to retail investors looking for equity in companies in exchange for investment cash. The average funding amount in 2022 was $1,256, according to Space Funding.
  • Debt crowdfunding: Debt crowdfunding matches young startup company owners with retail investors on debt deals. Those investors will loan money to companies in return for premium payments and interest, also referred to as peer-to-peer financing, or P2P. Debt-based crowdfunding made up 60% of global crowdfunding revenue in 2022, according to business consulting firm Grand View Research.
  • Venture capital: This startup investment model allows rising business owners to sell a portion of their company to venture capital (VC) firms in exchange for a cash infusion. Total VC funding was nearly $250 billion in 2023, according to CB Insights. In 2023, the average median company funding for pre-seed deals stood at $600,000, according to accounting firm EisnerAmper.
  • Angel investments: Unlike venture capital, which multiple investors manage, angel investors are typically wealthy individuals who invest their own money in startups. Deal sizes are usually lower than venture deals, which makes angels especially attractive to startups just getting out of the gate. The average angel investment amount in 2020 was about $390,000, according to the US Small Business Administration (SBA).

“The best startup investment platforms are stage-specific or vertical-specific venture funds that allow investors to focus on particular phases of startup growth or industry sectors,” Jones said. “These are a great place to start because they offer deep expertise in a curated selection of investment opportunities. The only way to get started is to research funds that align with your interests and experience.”

Platform-wise, look for established startup platforms such as AngelList, StartEngine and Kickstarter.

“Each has streamlined the process for individuals interested in investing in startups,” Lauver said. “Each platform has its unique characteristics, so it’s essential to thoroughly research and understand their differences before investing.”

How to identify a good startup investment

Pegging a solid startup company for investment takes great research, discipline and commitment to proven startup assessment protocols.

For new investors, one good strategy is to simplify the review process by focusing on “red lights” and “green lights.”

“Focus on red and green lights on key factors like the company’s team, its opportunity and its product,” said Jay Kapoor, general partner at VSC Ventures in New York City.

Start your research and analysis with a startup’s management team. “Do the founders have a unique insight about the customer or problem in the world?” Kapoor asked. “What life experience led them to this unique insight? Are they the best person to build this company? The earlier a startup’s journey, the more team and market opportunity matters.”

By and large, the later the startup stage, the more product and how sticky it is with the target customer matters. “Team and market still matter, but they will be de-risked to a greater extent as the startup matures and has some proof points of success, which is what experienced investors call ‘traction,’” Kapoor said.

That’s where a red light and green light strategy can really help, with these benchmarks topping the list.

  • Green light: Founders who obsess about their customer’s problems. “They love spending time with their customers,” Kapoor noted. “They’ve taken hundreds of customer calls before they even started the company.”
  • Red light: Identifying a buzzy or seemingly novel technology can be tricky but necessary. “That particularly means companies without a clear idea of their customer or what problem is being solved,” Kapoor said. “Without those attributes, those companies will fail in the long run.”

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Key steps to investing in startups

Executing a successful business startup investment campaign also means setting goals before taking specific steps.

“You need to understand key investing concepts like portfolio theory,” Kapoor said. “Then use those concepts to pick winners.”

Setting goals also means aiming for a “winners list” and monitoring cash outlay.

“Every good VC or angel investor knows that between 30% and 50% of your startup investments won’t return the money they’ve raised from you,” Kapoor said. “Your goal is to build a basket of diverse startup investments where the winners, which could amount to as low as 10% of the portfolio, more than cover the losses.”

“From 1994-2020, an average of 67.7% of new employer establishments survived at least two years. During the same period, the five-year survival rate was 48.9%, the ten-year survival rate was 33.7%, and the fifteen-year survival rate was 25.6%.”

The US Small Business Administration

Be conservative with spending, and make sure to diversify investments.

“Lower your average check size to where you can write a minimum of 12 to 15 checks over a couple of years versus writing three to four larger checks,” Kapoor advised.

Past that, include these key steps when investing in business startups, said Joel Wolfe, president at HiredSupport, a start-up business customer service and outsourcing firm in Fontana, California.

  1. Listen intently to the startup’s pitch.
  2. Ask questions and exchange relevant information.
  3. Conduct venture maturity evaluation.
  4. Look for founders with a growth mindset.
  5. Validate ventures to determine the amount of time you spend on the business.
  6. Set investment criteria, and tick boxes as you go.

Investing in technology startups

Given the astronomical success of companies like Amazon, Google and Nvidia, it’s no wonder most startup investors start their search in the technology sector.

“A factor to consider when investing in a tech startup is determining the company’s competitive advantage. Businesses with a competitive advantage can make all the difference when deciding to invest,” Wolfe said. “Some great opportunities to invest in tech startups today are artificial intelligence and education technology (EdTech). The former has recently taken off after the introduction of ChatGPT whereas the latter surged post-pandemic as remote learning accelerated.”

Artificial intelligence (AI) is especially popular with startup investors looking for the next OpenAI, the company behind ChatGPT.

“AI is revolutionizing how we approach knowledge work, significantly disrupting traditional methods,” Lauver said. “With this transformation comes a wealth of exciting new opportunities for investors to explore.”

Frequently asked questions (FAQs)

There’s no limit on how much you can invest in startup companies. Experts advised taking a cautious approach as you’re starting out, however. Consider limiting your startup investment budget to about 5% of your total portfolio assets, and increase your budget as you earn money and gain more experience.

The vast majority of startup companies don’t make money in their first year in business. In fact, according to government data cited by the SBA, just “67.7% of new employer establishments survived at least two years” between 1994 and 2020. “During the same period, the five-year survival rate was 48.9%, the ten-year survival rate was 33.7%, and the fifteen-year survival rate was 25.6%,” according to the SBA.

As noted, platforms like AngelList, StartEngine and Kickstarter allow people to start investing in startups online. Focus on a company’s management team, the power of the product or service being sold and the problem that product or service solves.

The ins and outs of investing in startups (2024)

FAQs

The ins and outs of investing in startups? ›

“Every good VC or angel investor knows that between 30% and 50% of your startup investments won't return the money they've raised from you,” Kapoor said. “Your goal is to build a basket of diverse startup investments where the winners, which could amount to as low as 10% of the portfolio, more than cover the losses.”

Is it a good idea to invest in startups? ›

Investing in startup companies is a risky business. The majority of new companies, products, and ideas simply do not make it, so the risk of losing one's entire investment is a real possibility. The ones that do make it, however, can produce very high returns on investment.

How risky is investing in startups? ›

Principal risk: Investing in startups will put the entire amount of your investment at risk. There are many situations in which the company may fail, or you may not be able to sell the stock you own in the company. In these situations, you may lose the entire amount of your investment.

Why investors don t invest in startups? ›

Startups are high risk investments. By definition, a startup is a company in its early stages of development. These companies are often unproven and have yet to generate significant revenue. As such, they can be very volatile and may not be suitable for all investors.

What happens when you invest in a start up company? ›

Startup investors are essentially buying a piece of the company with their investment. They are putting down capital, in exchange for equity: a portion of ownership in the startup and rights to its potential future profits.

What is the success rate of startup investing? ›

First-time small business owners have a success rate of 18%. Business owners who failed in the past have a slightly higher startup success rate of 20%. Business owners who started a successful startup in the past have a business success rate of around 30% when starting a new venture.

What is the average return on startup investments? ›

In the early stages of a startups life, investors expect to see a return of 3 to 5 times their initial investment within 5 to 7 years. However, this is only a rough guideline, and actual returns will vary depending on the company, the stage of the company, and the amount of risk the investor is willing to take.

Why are startups so risky? ›

A startup that grows too quickly could end up losing money due to staffing costs or a lack of market demand. At the same time, growing too slowly will allow your competitors to gain an advantage in momentum and it will also make you less attractive to venture capital firms.

What happens to VC money if startup fails? ›

The Consequences of a VC Backed Startup Failure

For starters, VCs may lose the money they invested in the failed startup, as well as any fees that were associated with the investment.

What is the failure rate of startups? ›

Approximately 75% of venture-backed startups fail – the number is difficult to measure, however, and by some estimates it is far greater. In general, a startup can be said to fail when it ultimately falls short of reaching an exit at a valuation that would provide a return to all equity holders.

Why Warren Buffett doesn t invest in startups? ›

He believes tech companies often lack a competitive advantage. Plus, many fail to live up to Buffett's oft-quoted advice: “Never invest in a business you cannot understand.”

Do startups have to pay back investors? ›

Though you aren't officially obligated to pay back your investor the capital they offer, there is a catch. As you hand equity over in your business as a portion of the deal, you essentially are giving away a portion of your future net earnings.

Can you get rich investing in startups? ›

Whether you're just kicking off your career as a venture capitalist or starting out in angel investing after making money through other ventures, investing in startups can be a very lucrative activity. In fact, data has shown that well-positioned angel portfolios can return two-and-a-half times over a 4-year period.

How do startup investors get paid back? ›

Share Transfers. You can repay a loan by swapping the debt for equity shares, giving the investor a proportionate ownership of the business equal to their investment. Consider paying dividends to your stockholders. Dividends would be cash payments made to shareholders and would be paid from the company's net income.

How are investors paid back in startups? ›

The most common is through dividends. Dividends are a distribution of a company's earnings to its shareholders. They are typically paid out quarterly, although some companies pay them monthly or annually. Another way companies repay investors is through share repurchases.

How do startups pay their investors? ›

Startups agree to pay the total of the loan back to the investor, along with all interest accrued at a fixed rate, over time. While debt investments typically carry less risk and can be fulfilled quickly, equity has the potential for greater long-term profits.

Are startups actually profitable? ›

Virtually no startup business is profitable in the first year of business. In their lifetime, only 40% of startups are actually profitable. 30% of startups will break and fail, and the last 30% will continue to lose money.

Should I invest in early stage startups? ›

Exponential Growth Potential: Early-stage startups possess the capacity for explosive growth, often yielding returns that far exceed traditional investments. A tracxn report reveals that early investors in India's Unicorns experienced a remarkable 130x multiple on their invested capital.

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