This is a topic I generally shy away from due to the regulatory implications attached to the question. Also, different jurisdictions treat the question differently. Yet, it is a question I receive alot and interested persons seem to go ahead and invest anyhow so I believe it welcome to at least provide a primer on what considerations ought to be made. Any lawyers or regulators reading this are invited to include qualifications I may have overlooked in the comments section…I will be glad to correct any sub-optimal statements A layperson is normally referred to in the investment world as a retail investor. In theory you have a right to buy what you like, but advisers, issuers and platforms have a responsibility to make sure you understand the risks involved and may refuse you access especially if they are authorised and regulated. My generic definition of a retail investor is:
i) someone who cannot afford an investment of up to $100,000 investment to be completely wiped out; and
ii) someone who does not have work experience, or academic qualifications that allow them to understand high risk investments
Please research the correct definition for your region. A good resource is usually a reputable angel investor network or the financial services authority website. It is strongly advised that you discuss with your financial advisor or lawyer.
So [disclaimer concluded], what are the common circumstances in which you may be presented with an opportunity to invest in a startup? Friends and Family Rounds - this is when you are investing simply on the basis of your familiarity and social connection to the founder of the startup. Many times the degree of due diligence is negligible and never undertaken by professionals. Such investments carry the highest risk of complete failure. Main benefit: helping out a friend or a family member Main Risk: super high chance of losing all my funds Personal position: only if I believe in the extraordinary abilities of the person and they have previous outstanding achievements that add to my belief
Equity Crowdfunding Sites - nowadays such platforms are required to be licensed to operate or at least are subject to authority oversight. These platforms will place restrictions on the amount of investment made by a single person via the platform.
The platform will conduct generic due diligence, mostly to ensure that the opportunity will not result in a fraud, but little effort is done on understanding its growth potential and value.
Some of these sites allow lead investors to manage the due diligence process, and therefore are peer lead. Again these are not professional investors and have significant limitations on the resources and thoroughness implemented during the due diligence.
Note: many crowdfunding sites stop their relationship with the startup post investment, and therefore do not participate in the monitoring exercise post investment.
Some crowdfunding sites are borrowing from the best practices of angel investor networks and implementing better oversight controls - see below for more detail
Main benefit: can invest as little as €50 in an idea or initiative I would like to see come to fruition Main Risk: not enough market research goes into these projects, high risk of losing all funds Personal position: I regularly contribute to initiatives, especially those with social purpose and artistic projects.
Angel Investor Networks - (in some countries a retail person will not be able to participate in an angel investment, however if there is active oversight by the network or other lead investors, the investment may be possible for a restricted amount).
Usually due diligence efforts are conducted by a lead angel investor or a committee of such, each having expertise in relevant aspects relative to the investment rationale. Critically, such persons remain closely connected to the investment even after the investment is made, either as a board member or close advisor to the team, thereby maintaining a sense of oversight throughout the investment and in case of follow-on investment rounds. Many times these investments are organised as syndicates so that one representative is in charge of all matters for the benefit of the group of investors participating in a round.
Again, such lead investors may not be professional financial advisors and therefore the relationship is of a peer. The lead investor should act cautiously and not solicit the investment but simply limit their oversight and due diligence to a fact finding mission.
Tip: the lead investor should not be earning a commission for soliciting investments as this may place them in a position of conflict, especially if undisclosed. If they are linked to rewards from the investment, make sure their interests are aligned with yours and they too have “skin-in-the-game”.
Main benefit: the social aspect of analysing an investment opportunity with peers and people you truly respect and want to build a long-term relationship with Main Risk: on any individual investment, high risk of 100% of your funds being lost. Using a portfolio strategy, joining a group/network can help increase your chances of success. Personal position: I spent 5 years as an employee of GoBeyond Investing, an angel platform. This allowed me to test my knowledge of market opportunities and learn by doing not merely offering professional or financial advice.
Initial Coin Offerings [ICOs] - I have never participated in one and read a few whitepapers that were not for me from a governance and ownership rights perspective. Make sure you know and trust the people behind the issue and your are participating very very cautiously. Trying to be objective, ICOs allow participants to build communities around the issuer, and one can enjoy benefits around the utility of the coins/tokens being sold that traditional fundraising does not grant. There are also technology related aspects surrounding the blockchain and smart contract elements of these offerings that given the early stage of these innovations are both presenting new risks as well as adding novelty and opportunity. As they can be sold to anyone over the internet, this means that there is little centralised due diligence review around the issue and little monitoring oversight after the investment. Ensure the documentation and the legal process is supported by a professional and reputable law firm or financial advisor. If it sounds too good to be true, be especially cautious.
Main benefit: front-line access to new technologies and ideas Main Risk: too little oversight and increase avenues for fraud. Underlying technology is relatively new and needs time to mature. Personal position: not for me, at least for now. I read about the space and attend events run by reputable professionals and lawyers who seem to believe that this is the future of investing. A time may come when these are the norm so its best to be educated.
Venture Capital [VC] funds (very rare) - You may happen to be familiar with a venture capital partner and they may allow you to participate in the fund as a friend and family participant. Depending on the legal structure, such funds may not be legally allowed to take on retail investors, but there are limitations and exceptions. In this format, you will not have a direct interest in the startup, but you will be a partner in the fund, which in turn invests in the underlying startups.
Ensure this is a trusted person, with a track record. The documentation and the legal process must be supported by a professional and reputable law firm or financial advisor.
VCs firms conduct a professional due diligence, have a duty of care [i.e. legal responsibility] towards the investors in the funds (known as LPs) and have a vested interest in the success of the startups they invest in.
Main benefit: investment decisions are deferred to professionals in their field, sometimes with unique access to connections and market knowledge. Main Risk: given the portfolio approach, lower overall risk, yet still high probability that all funds are lost as in order to achieve high targets they set for themselves, the fund managers must take very aggressive risk stances. Personal position: will be keen to participate as a limited partner [LP] in a fund when the right opportunity presents itself and I can afford the ticket price.
Financial Advisors/lawyers (very rare) - a financial advisor who may know your risk profile and who is a verified and trusted person to you may from time to time point you towards a startup investment opportunity. Make sure this advisor has a previous track record with startup investments and understand what is in it for them, i.e. are they earning a commission and therefore have a conflict of interest?
Financial advisors are usually familiar with corporate assets, like listed equities, funds, bonds etc… and may not understand entrepreneurship, technology and startups.
Main benefit: Advisor should know your profile and your investment appetite and history and therefore will only present such opportunities when it makes sense. Main Risk: Given that their professional focus is elsewhere although they are highly educated and qualified persons, they may not know the particularities and nuances of what will make the startup successful. Don ́t assume the invite is genuine and investigate if driven by commissions or fees. Personal position: I will take an introduction from a trusted advisor, especially if I know they are truly passionate about startups or the market the startup is addressing. I will however always make my personal due diligence assessment and ask for other opinions.
General realities about startups
The general language around startups is that only 1 in every 100 startups can expect to be considered a success.
A professional startup investor, angel or VC will generally invest in circa 2%-5% of all the opportunities presented to them.
Of every ten startups investments made by an angel or VC, only 1 is expected to earn a return that is considered as positive:
- For an angel, this is if the startup returns 3x - 10x the amount invested within 4-6 years
- For a VC, this is if the startup returns 10x + the amount invested within 4-6 years
Therefore the odds are truly stacked against any startup being considered a success in the eyes of an experienced investors. Startups are damn interesting, they are entertaining too [look at the success of shows like SharkTank and Silicon Valley] but the money you may choose to invest in them is very real, and so is the very high risk of those funds being lost.
In conclusion, I was taught that angel investors should seek to Do Good, Do Well and Have Fun! Doing good means that investing in startups allows budding entrepreneurs to turn their opportunity into a reality and truly test out a solution in a field that you have an interest to explore. Doing well is the critical aspect against which your investment will be assessed, be it return on financial investment or other measure like impact or new scientific discoveries made. Finally its about having fun as well. The risk involved is unmistakable, but it allows investors to venture into fields that otherwise are simply unapproachable for most.
I personally have had the luck to witness and be part of projects involving emerging technologies like drones, autonomous vehicles, cancer research, biotech, blockchain and AI amongst many others, and have met a bunch of excellent people along the way, who wanted to take risks in the right way, with the right approach.