Investing in startup companies has significant risk, yet if you happen to be an early investor in a successful startup, you may also reap substantial rewards.
Some financial professionals called venture capitalists (VCs) specialize in investing in the early rounds of a startup company. With a self-directed retirement account, you have the opportunity to consider startup investing as part of your alternative investment portfolio strategy. If you hit it big on a successful startup, the gains are tax-deferred until you reach retirement age and must take some withdrawals.
Startup Investing is Very Risky
Before you get all excited about investing in a startup, which becomes as successful as Apple or Amazon, you need to understand some risks.
The potential for a startup investment success may depend on the stage of the company when you enter into the investment.
The possible stages are:
Pre-seed: This is the earliest stage when an investment is the riskiest. The company may not yet exist. This stage may only be having an idea. Founders usually put up their money at this stage to get things started.
Seed: This is the exploratory stage and usually includes a market analysis and the development of a business plan. Friends and family members of entrepreneurs may help with the seed money.
Angel: An angel investor may put up the money to get the company operating.
Round 1 (Series A): This is a capital raise based on the company's valuation and revenue projections.
Round 2 (Series B): This is a capital raise to expand activities and create more value.
More Rounds (Series C, etc.): A company may continue to raise private equity money as additional rounds.
Pre-IPO: Investing money in a company right before an IPO may be the safest stage if the IPO turns out to be successful.
Going Public: When a company goes public, it can raise money from being listed on the stock market as an initial public offering (IPO). A company may also go public via a direct listing.
Secondary Offering: A secondary may allow the founders and early investors the opportunity to sell some of their shares through the stock market.
Company Sale or SPAC Acquisition: Instead of going public, the company may be sold or acquired by a special purpose acquisition company (SPAC), which may give early investors a chance to sell some or all of their shares.
Startup Investment Failures
The majority of startups fail. Two-thirds of startups do not make it past the seed stage.
Venture capitalists expect nine out of ten investments to fail to reach IPO, and they are usually better at picking startups than the average person. The successful startups in a VC's portfolio might be only 5% of all the startups that the VC invested in over many years. That 5% accounts for a huge portion of the total value of all the VC's startup company investments.
Most failures happen when a startup runs out of cash. This problem occurs when there is insufficient cash flow to cover operations and the capital raised is not enough to cover the cash burn until the operations are profitable.
One way venture capitalists avoid this failure is by being prepared with deep pockets to continue supporting their investment decision until they succeed.
An Exit is Far in the Future
It is easy to put money into a startup. If you have a self-directed retirement account, you can simply write a check to the startup company. However, it is much harder to get your investment money out of a startup.
A typical exit for the early investors is either when the company goes public with an initial public offering or on sale of the company. This exit event might be many years in the future. In the meantime, the investment is illiquid. It is usually not possible to sell the investment during this period.
One advantage of using self-directed retirement funds for startup investing is that you do not plan to need that money for a long time anyway. Depending on your age, you may have decades until retirement, so it would not matter if a startup took many years to pay off as long as it finally does pay off.
Why invest in startups?
With all the risks and disadvantages, why would you consider startup investing? The main reason is financial return. If you pick a winner, you may receive many multiples of your initial investment.
Other reasons investors give for startup investing include wanting to positively impact society, having a love for technological advancement, and enjoying supporting young entrepreneurs.
Different Ways to Invest in Startups
Besides investing directly in a startup, there are other ways to invest in startups. You might want to invest in a venture capital fund as a limited partner to diversify your startup investments across all the fund's investments. This strategy might increase your chances of catching a winner.
Another way is to make an investment through crowdfunding offerings of startup companies.
You may also choose to become an investor/member of a limited liability company (LLC) set up as a special purpose vehicle (SPV) to invest in startups.
You might invest in the publicly-traded shares of a special purpose acquisition company (SPAC) that plans to acquire startups.
Indirect investment in startups is possible by investing in an incubator company that provides seed capital and support services for startups in exchange for some equity ownership in the startup companies.
Think you are good at picking startup investments?
WhatsApp - Sequoia Capital made $3 billion from the investment, a 50x return.
Facebook - Accel Partners and Breyer Capital turned a $12.7 million Series A investment into $9 billion at the IPO.
Groupon - Eric Lefkofsky invested $1 million in seed money for a value of $2.8 billion at the IPO.
Cerent - Kleiner Perkins Caufield & Byers' $8 million investment in Cerent was worth $2.1 billion when Cisco acquired the company.
Snap - Benchmark Capital Partners Series A $13.5 million became worth $3.2 billion at the IPO.
It is good to know that you have the freedom to make an investment in a startup with a self-directed retirement account. If you decide that investing in a startup is worth considering, make sure you do your due diligence to find a great investment opportunity..