Startup Investing 101

by Andrew Gordon
Co-founder, Early Investing

Introduction

Tired of putting all your money into the same old large companies whose glory days have come and gone… and hoping against hope that loose money policies will continue floating these slow-growth stocks to higher prices?

That’s not an investment strategy. It’s the Alamo, waiting for a reprieve that will never come.

But unlike the brave American soldiers doomed in the battle of the Alamo, you have a way out.

Choosing to ignore it… to stand pat… would be doing yourself a grave injustice. Because, right now, you could be taking advantage of the emerging and exciting sector of startup investing.

So open your eyes and take a look around you.

What you’ll see is an investing landscape that is at once transforming and broadening your range of options.

Individuals just like you have discovered a new and exciting way to invest. They’re putting a portion of their investable savings into a part of the market that has traditionally been reserved for professional angel and venture capital (VC) moneymen.

Like them, these individuals are willing to accept a fairly high level of risk for the possibility of huge rewards from the country’s thousands of young and up-and-coming companies.

Before I explain how you can take advantage of this new and exciting way to invest, I need to fill you in on a few things.

For one, the opportunity to make these kinds of investments has recently become available to individuals making (or worth) above a certain amount.

The techniques outlined in this guide apply only (for now) to “accredited investors,” as defined in the pertinent government regulations this way…

1. An income of at least $200,000 per year for the last two years (or at least $300,000 with a spouse).
2. A net worth of at least $1,000,000 (excluding your primary residence).

To understand how the government’s slow and cautious rollout affects you and your investments, you’ll need a bit of background.

For the past 80 years, dating back to the passage of the Securities Act of 1933, the vast majority of investors were prevented from investing in America’s most promising young companies.

In fact, there wasn’t much blowback about these restrictions until recently.

But in the past few years, companies have been waiting longer and longer to go public. By the time they did, their shares weren’t the bargains that characterized earlier IPOs.

In the meantime, the growth of new businesses was being stymied by lack of funding. Banks, in particular, stepped back from lending to small businesses.

Even the companies that grew and had valuations that climbed tended to nurse their cash.

These developments shone a bright light on how America’s companies were malnourished in their infant, fragile stages. The result?

The clubby world of early investing was opened up to include millions of non-professional investors.

To reach these individual investors, thousands of young companies took to advertising their financing needs online. It used to take a great deal of money or time to find out just the basic facts about these infant firms.

That’s no longer the case. It’s really no big deal today. To get detailed information on their products, technology, management teams and growth plans, you need only go on your computer and visit one of these startup “portals.”

It’s a great place to start your research. With a couple of clicks, you have access to reams of information.

In late 2013, the SEC published its proposed rules for the millions of new investors who do not qualify as “accredited investors.” It is hoped that sometime in 2014 they will be allowed to invest in startups alongside accredited investors. We don’t know yet what the final rules will look like. But they’re sure to carry restrictions on how much non-accredited investors will be able to invest each year.

The SEC is moving very deliberately on this front. They’re trying to figure out what protections they can put in place without making the process overly cumbersome for either the investor or startup.

In the meantime, we’re also waiting for all the new rules for “accredited investors” to be finalized.

But sitting back and doing nothing while waiting for the regulatory environment to clarify would be a big mistake. The good news is, you can begin investing right now in startups. If the government decides to add more restrictions, you won’t be retroactively penalized for not following them. The fact is, hundreds of startups have begun securing investments from you. And thousands of individuals have begun buying shares in these young companies.

So, no excuses. It’s time to find out how you can become an angel investor from the convenience of your kitchen or living room.

All you need is a computer and, of course, some spare cash.

You won’t regret taking the time to get up to speed on this exciting new investment strategy.

Proving You’re an “Accredited Investor”

Anyone can view the basics on a startup that is raising money. But to get all the details, or an introduction to the founders, you’ll need to prove that you’re accredited. Don’t worry, it’s not too bad of a process.

As I’ve mentioned, the final rules haven’t been nailed down yet. But it’s likely you’ll have to provide some sort of documentation such as tax returns or a document signed by your accountant or lawyer to qualify. Most startup portals are already doing this.

How Much Money Do I Need to Invest?

This is where it gets interesting. In yesterday’s investing world, early-stage investors would offer anything from $100,000 to well over $5 million.

But in today’s online investing world…

You can buy shares in startups for as little as $1,000. And that figure will probably come down in the years ahead.

The maximum amount? That’s up to you. You may be tempted to invest a bundle of money in the companies that excite you the most. Listen, no startup is going to turn away your cash. But I’d advise against it. It’s just too risky. I’ll be telling you a much better way to manage your investments in just a moment.

Right now I want to tackle an important question, one that I suspect is weighing on your mind…

Is This New Way of Investing Suitable for Individual Investors Like Me?

Or might it be too risky for investors who don’t have the time or expertise to do all the homework required?

No doubt about it, it’s risky. To say otherwise would be misleading.

So it’s not for everyone, but the potential rewards are substantial. A study by the Kaufman Foundation found that the average return of angel investments is 2.6 times the investment in just 3 1/2 years – that’s an internal rate of return of about 27%.

One of its other main conclusions is that the more hours of due diligence (research) you put in, the better returns you get.

My team and I take due diligence very seriously. We look at all aspects of a startup – from the executive team to pre- and post-revenue progress.

What you also need to know is that there are additional ways to ratchet down risk and invest smartly.

I’m going to give you some tips in just a minute.

But before I do, I want to address those of you who are skeptical about the risk-reward equation.

First off, there’s nothing wrong with a healthy dose of skepticism. As a private equity investor, you’re going to be bombarded with “can’t miss” stories. In fact, most of those “can’t miss” opportunities will miss. Others will exaggerate their upside. And some may prove to be patently false.

So you should be skeptical. You need to determine whether a startup’s idea makes sense… fills a real need… and that the founders have the wherewithal to make it all happen.

Fortunately, these startups don’t operate like hedge funds, where investment decisions are made behind closed doors.

Professor Ethan Mollick of the Wharton School of Business says, “You want what happens in crowdfunding to be as public as possible.” He adds that what stops fraud is “having a lot of eyeballs that look at a project.”

Given all this, I’m not buying what some of our “big brothers” on Wall Street are saying. They think angel investing should be left to the professionals. Right…

It’s not as if they’ve been setting the world on fire. Far from it.

Hedge funds averaged just 3% returns in 2012. That’s 92% less than the 18% they could have earned by investing in a garden-variety ETF following the S&P 500.

So, if you haven’t heard about these investment opportunities, don’t assume it’s because angel investing is a bad idea. That’s not it at all.

Other factors have helped mute the buzz.

For one, traditional money managers aren’t likely to encourage their clients to take advantage of startup opportunities. Why should they? They have nothing to gain by urging their clients to go online and make these investments without them.

Another reason? The emerging “equity crowdfunding” market is so new, many people simply haven’t heard about it.

Then there are the naysayers. The market pundits who think the “Wild West” is about to be unleashed on poor unsuspecting American investors.

Gimme a break.

Americans can do day trading without public protest. They can play the dollar, invest in penny stocks or lose a bundle at the casino. They’re even encouraged to put their hard-earned savings into government-sanctioned scams like Powerball.

But our own startups pose too big a risk?

I don’t buy it.

Especially not when I can let you in on some simple strategies that would reduce your risk. Here are three that work great…

The Three Best Ways to Reduce Risk

1)    Play the Waiting Game to Hit Your Numbers.

Startups span the full breadth of the U.S. economy itself, from cutting-edge tech to real estate. I suggest focusing on the company first and not worrying too much about the sector.

Of course, you shouldn’t have all social media or biotech companies in your portfolio. As a rule of thumb, no one sector should monopolize your portfolio.

Beyond that, I wouldn’t worry about sectorial diversification. Here’s my take…

Great companies can flourish in mediocre sectors. But bad companies usually don’t ultimately succeed in great sectors. And, remember, a great startup can change the fortunes of the sector it’s in. Consider what Facebook did for the social media sector.

The trick to investing in startups isn’t in sectorial diversification; it’s in investing in a lot of these companies. Why?

Because more startups fail than succeed.

But the startups that turn into great companies all have their own magnificent stories to tell. Each tale offers a unique set of lessons and inspiration on how to overcome challenges and sustain growth.

What you get at the end of the day is something very exciting: Companies go from being worth less than a million bucks to having valuations in the tens and hundreds of millions.

When startups succeed, oh boy, they can do so spectacularly.

So the way to play startups is not to invest in one or two or three, but at least 10 and preferably 15 to 20.

Again… It’s likely most will fail. That’s to be expected.

But you only need one or two to hit it big. That will more than offset your losses and should result in a huge boost to your retirement savings.

The company (not the sector) should be front and center in your investment decision. That means you need to exercise patience and wait for the extraordinary startup opportunities to come your way. Out of the dozens, if not hundreds, of new ones that are listed on the portals every month, you get to play the waiting game and invest in only the startups that represent extraordinary investing opportunities.

Patience is the key. Some months you won’t see any. Other months you could see more than one. You are investing across time and sectors. At the end of a given 12-month period, ideally you should have around 20 to 25 startups in your portfolio. If you have fewer, don’t sweat it. If you have more, it must mean you’ve seen a healthy share of impressive startups. Nothing wrong with that.

As a general rule, you should set aside no more than 5% to 10% of your savings for these startups. And you shouldn’t put more than 10% to 15% of your set-aside capital into any single deal.

[Editor’s Note: If you’ve signed up for my recommendations, one of these days you might not like the sector of the startup I’ve selected. Please read the recommendation anyway. It could be that the company is doing something so exciting, it trumps your disdain for the sector. Or the sector may be embarking on transformational changes you weren’t aware of. Or perhaps the startup is changing for the better the fortunes of its sector (think Facebook).

2)    Treat the story as a first, small step.

By all means, feel free to like a company’s story. Just try not to like it too much.

Treat the story as something that should whet your appetite for more information. It could be the intoxicating aroma of the best meal you’ve ever had. Or it could be the highlight of the disappointing meal to come.

Remember that “what’s your story” is the soft question that a founder of a startup should answer with verve and conviction. You should reserve the full measure of your excitement for the answers to harder questions. For example, what is the management team’s range of experience and expertise? The size and potential growth of its customer base? The timeline of its projected revenue and profit? How realistic is its business plan? Does its main product represent breakthrough technology or fill a big (as opposed to a niche) need? Has the company patented its technology? What is its current and future competition?

I could go on. But you catch my drift. Getting answers to questions such as these will give you a good idea of the company’s risk-reward equation.

What is too much risk? What is too little reward? It’s all very subjective. But if too much risk for too little reward is what you’ve calculated, then don’t invest. On the other hand, if you think the equation is tilted more toward reward and less toward risk, you may indeed want to invest.

And if you don’t have the time or inclination to do the due diligence, then find a third party to do it for you. No matter what, don’t invest blindly or because the company’s story pushes your emotional buttons.

3)    Let the online sites weed out the bad apples.

There are tens of thousands of companies that would gladly take your money. That’s not your universe. You only have to pay attention to the hundreds of startups listed on the online portals.

Most of these portals have lawyers who specialize in corporate law and securities. They will make sure the startups listed on the portal are compliant with SEC regulations governing the solicitation of funds from “accredited investors.”

Some portals, such as AngelList, go so far as to not allow any companies that did not properly follow all the regulations or make all the required filings in previous fundraising activities to list on its site.

These portals serve an important function because they substantially shrink one of the biggest risks you have, that of fraud and misrepresentation.

Some of these sites also tell you where the big-name investors are putting their money. One of the better ones at doing this is AngelList. It shows the lead investor, with background information, in all the companies it lists.

For example, you can see that Greylock Partners is a recent investor on AngelList. Click on the name, and discover that it invested pre-IPO in Facebook (Nasdaq: FB) and LinkedIn (NYSE: LNKD), and also invested in Instagram. Then you can decide whether you want to follow Greylock in the startups it’s currently investing in.

So let’s now examine five top-tier startup portals, beginning with AngelList.

Five Quality Crowdfunding Sites for Accredited Investors

1. AngelList (angel.co)

AngelList is the biggest of the startup sites. It lists thousands of newbie companies looking for funding (go to https://angel.co/startups). The biggest doesn’t necessarily mean the best. But AngelList is the king of the startup portals, at least at the moment.

You also can select your favorite company from a full range of fundraising stages, from the earliest (seed money) right through Series A, B and C.

You can also choose to invest in more than 100 syndicates offered on the site. Syndicates deserve their own report. But while I can’t go into detail here, I can briefly note three major advantages of joining one…

• The investor who heads up the syndicate does much of the heavy lifting for you. He’ll research the startup thoroughly. And he’ll make a sizable contribution to the company to back up his research.
• Aside from the exposure the startup gets from its site listing, it’s also actively marketed by the syndicate leader. So there’s a better chance of the startup reaching its funding goals in the present and future.
• The syndicate will likely share its expertise with the startup. This isn’t always a critical feature, but many startups value the help they get from their big investors.

And if you like your investment to give you an immediate cash return, then the site also has startups offering convertible shares. These securities are called “hybrid” because they begin as debt instruments that give you interest payments but can later be switched to equity, once certain conditions are meant.

AngelList’s portal is well-organized and easily navigated. It shows you all the investors, its main customers, the CEOs and their management teams, along with their advisors. Heck, you can even see who a company’s attorney is, if you want.

Most of the names mentioned are clickable, so you have the option of digging deeper for more information.

You can also see how much the startup is raising and how far along the startup is with its funding efforts. You may be more comfortable investing toward the end of a fundraising round than at the beginning, when it’s unclear if companies will reach their target.

AngelList has a wealth of information, but the site itself doesn’t verify any of it. And it isn’t responsible for the accuracy of press reports attached to listed startups. None of this is surprising. The same goes for all the other startup sites.

That means you have to constantly double- and triple-check the facts you find online. But overall, this is a stellar site. So far, it has helped raise over $200 million for the startups listing on its site.

2. Wefunder (wefunder.com)

The founders of Wefunder helped spearhead the passage of the Jobs Act, which is the enabling legislation behind equity crowdfunding’s new legal status.

Its website is small, and Wefunder uses that to its advantage. It says it will be offering just one startup a week for interested investors.

This company’s approach is also a little different. It considers the fundraising transaction as the first step of an ongoing process. Just as important is the support provided after the funds have been raised. Wefunder helps startups make introductions to not only potential investors, but potential partners as well. It also helps with publicity through social media. And it helps promote product launches. “We’re designed to enable all Americans to invest in startups,” says Wefunder, “even grandmas in Kansas.”

The site lists hundreds of companies and has signed up thousands of potential investors. But I could only find a few startups prominently displayed. And when I messaged them a question, they never responded.

It seems the site will need further development as this sparkling new market finds its feet and grows.

Wefunder focuses on exploiting the synergy between everyday investors and small startups that need championing as much as they need money. It’s a valid approach that deserves a place of its own in the world of online early equity investing.

3. CircleUp (circleup.com)

The CircleUp folks specialize in consumer product companies. They focus on high-growth products and brands. The sectors they pay most attention to include food, beverage, personal care, pet products, sporting goods, apparel, household products, retail and restaurants…

One of the best things about this site is CircleUp’s high standards. It says only 2% of startup applicants end up on its site.

Another thing that appeals to me: Companies must have at least $1 million in annual revenue.

Not only real revenue but they also must have real products (or retail outlets). You also have access to their financials and third-party data. And, upon request, you’re sent free samples to try out yourself.

The portal also arranges conference calls and online forums with the company’s management team.

CircleUp aims to please. “Want more details?” it says. “Just ask and we’ll get it for you.”

The minimum investment varies by deal. But it can be as low as $1,000.

4. Realty Mogul (realtymogul.com)

Interested in real estate? Then you should check out Realty Mogul. Its site helps accredited investors pool money online to buy property.

You also have a choice of joining a syndicate acquiring property.

First question you may have (if you’re like me)…

How is this different from a real estate investment trust (REIT), which is a publicly listed company anybody can invest in?

To refresh your memory, REITs are required to give shareholders 90% of their profits. In return, Uncle Sam promises not to tax them (but the shareholders are taxed on the income they get from these companies).

REITs allow people without a great deal of money to invest in real estate and earn a nice income stream, courtesy of the dividend REITs pay. And, like all publically traded companies, there’s also the possibility of capital appreciation.

So, what does Realty Mogul do better or differently?

The main thing is, when you invest in a REIT, you, along with a few thousand other investors, put money into a fairly large portfolio of properties. You hope the portfolio has more good properties than bad.

But checking them all out individually is not practical.

I’ve invested in my share of REITs and I’ve also sat down with CEOs of REITs, so I know how this game is played.

Instead of a property-by-property assessment, you find out how the REIT chooses properties… how it adds value to them… and how much income and profit the REIT has given shareholders in the past.

If you’re lucky enough (or a big enough investor), the REIT company will also show you its trophy properties. (From personal experience, I can attest that there are worse ways to spend an afternoon.)

With Realty Mogul, you have more control and knowledge in the property you’re investing in. You’re not plunking down money in a big portfolio of properties like you do in a REIT. Rather it’s a single, specific property you can easily check out.

For another thing, many of the properties aren’t as big as your typical REIT property. Profitable but small retail centers, for example, aren’t dismissed just because of their size.

REITs also don’t invest in small-scale fix and flips, but Realty Mogul does. Now, “flipping” got a bad name as the housing market crashed a few years ago. But, there’s nothing terrible about flipping. Buying an asset to which you add value before selling at a nice profit is a legitimate and effective way to make money.

Whether it’s flippers or an investment company heading a syndicate, Realty Mogul tries to make sure it sponsors what it calls “established, reputable operators.”

It spends serious time sourcing real estate investments so you don’t have to.

As usual with these sites, it adds the caveat that each investor should do his own due diligence.

So far this year, Realty Mogul has raised millions of dollars. About half is from flipping.

If you’re looking for a quick return, flipping is where you should invest. A typical investment lasts six to nine months. The other half is through syndicate lending where your money is tied up much longer, for three to five years.

Real estate has come back in this country. Prices are rising and should continue to do so for the next several years. For as little as a $5,000 stake, you can invest in the pooled-investment opportunities available at Realty Mogul.

5. RockThePost (rockthepost.com)

RockThePost is the only startup portal I’ve come across that provides elevator pitch videos to potential investors. It’s a great feature as long as you ignore the production values.

These are basic, quick-and-dirty presentations, mostly by millennials with baseball caps on. My advice? Listen to the message. Don’t worry about what the messenger looks like. And keep in mind that these pitches are meant to look and sound off-the-cuff, mimicking a real elevator pitch.

This site goes the extra mile in providing customized service. You’re encouraged to call and speak to a live person from the site who will help you invest or raise funds (if you’re a startup).

RockThePost says it will “match you [as an accredited investor] with high quality startup investment opportunities.”

“As an investor,” it adds, “all you have to do is let us know what industries you’re interested in, what stage of company you’re looking for, as well as any other pertinent desires, and we will personally deliver respective investment opportunities for you.”

The site has dozens of startups listed on its site and has raised millions of dollars. Typical amounts fall between $100,000 and $5 million. The bulk is around $500,000.

RockThePost’s customized approach (“Tell us your preferences and we’ll do the rest”) goes beyond what most other portals offer. And they also offer webinars on selected startups, which give investors the chance to see and hear founders talk about their companies.

The site needs some tweaking. The video pitch rating system has to be more transparent. Those showing a small number of views tend to get higher ratings. How could it be otherwise? (The first 50 ratings, I assume, are from family and friends!) There’s also no information on how long the pitches have been posted.

That’s an important missing piece. The longer these video pitches languish on the site without attracting many viewers, the less likely that I, for one, will be willing to invest.

The portal also invokes “crowdsourced due diligence” as a reason to feel confident in your investment choice. As far as I can tell, the “crowdsourcing” due diligence refers to the company’s flawed video-rating system.

But I don’t want to be too critical here. This is a new site doing a nice job of addressing the needs of a market in its infant stages. I like what it’s accomplished so far. I’m a little concerned that with such a customized approach, scaling up may prove a challenge. But RockThePost has two resourceful co-founders who are good at overcoming challenges. I like the site and I think it fills an important niche in the online world of startup investing.

Final Say

Sound good?

It should. You don’t need much money. These online portals do a lot of the initial filtering for you so you don’t have to stay up at night worrying about being scammed. And the range and breadth of startups listed on these portals are quite impressive.

They say America produces the best entrepreneurs in the world. I’ve been all over the world doing business deals. So I can attest that it’s absolutely true.

It’s a big part of what makes America the economic powerhouse it is.

Yet, until recently, this exciting and high-growth part of the economy was cordoned off from all but the richest and most well-connected investors.

Most Americans were left with just stocks and Wall Street’s booby prize: money-market funds and government bonds.

Stocks have done well recently, and so have some bonds. But for how much longer?

Investors now have a choice. They can invest in America’s future and, by putting money into young and up-and-coming companies, help their own portfolios generate more profit at the same time.

This is a world of high risk and high reward. But if you follow my tips, you can reduce that risk and make smarter choices. And you only need one or two hits to really make out well. Out of the 20 to 25 startup holdings I hope you accumulate in your portfolio, that’s a reasonable objective.

Not everything new is worth doing. But this is. I encourage you to check out the online sites mentioned above. Take a look at some of the startups. Some will grow into powerful corporations, at which point your friends might be willing to “take a chance” buying shares.

You can get in years before an IPO, when the upside is many times greater.

Is that something you’d be interested in?

Many of you might say no, and that’s your right. This kind of investing isn’t for everybody. But those of you who say yes, you’re about to find out for yourself a poorly kept secret…

That early investing – helping yourself by helping newly minted companies – can be the most rewarding way of all to invest your money.

Thanks for reading. Watch your inbox for upcoming issues or browse all of our articles here.

-Andy Gordon

About the author

Andrew Gordon is an entrepreneur and investor with over 30 years of experience at building wealth for himself and others.

He graduated from the London School of Economics a year after the bicentennial. By the way, this is the same school that produced 34 heads of state, including John F. Kennedy… and another 18 Nobel Laureates…

The truth is, his education barely scratched the surface of how the real world works.

But Andrew’s diploma did help put him on the “fast track” in Washington, D.C. There, he worked with the U.S Department of Commerce, the CIA and a K Street firm that monitored World Bank activities.

But he soon grew tired of D.C. politics and pandering. So he took a chance and became an international entrepreneur.

And that’s when he learned how money is really made.

Gordon consulted on infrastructure in Indonesia… helped develop firefighting technology in China… optimized oil tanker production off the coast of Sumatra… consulted on port development in Russia… and became a power plant technology expert in Taiwan.

By the time he returned to the United States, he was sought out by well-known companies like Dow Chemical, Lockheed Martin and Bethlehem Steel to increase their profits.

He was also brought on as the economic advisor to the governor of Maryland, Governor William Donald Schaefer, “the best governor Maryland ever had,” says Gordon.

From there, he joined an investment advisory service based in Florida. Gordon used his industry knowledge and experience working with American and overseas companies to delve into the financial records of hundreds of firms. He then recommended the ones with the best fundamentals and values.

He also tracked the U.S. and global economies and put some of his thoughts down on paper.

One of the things Gordon said was that private equity would replace lowering levels of bank lending. He was proven correct. The Cleveland Fed reported that small-business lending dropped 78% from the summer of 2007 to the end of 2012. Little did he know when he made that comment back on Oct. 7, 2011, that it would lead him to a place where he would be encouraging individual investors to make up the difference by investing in promising young companies.