The Risks And Rewards of Startup Investing
The Risks and Rewards of Startup Investing
The Securities and Exchange Commission (SEC) established the accredited investor criteria so that issuers of unregistered offerings will "ensure that all participating investors are financially sophisticated and able to fend for themselves or sustain the risk of loss, thus rendering less necessary the protections that come from a registered offering." The SEC feels that if you have more money, you have the ability to take more risk (not that you should).
Startup investing and private equity may be difficult, if not impossible, to sell. You will need to wait and see if they do well, need to raise more capital, or fail. Therefore, would-be investors should want to learn about the risks and be willing to ask questions before writing any checks.
Who is an Accredited Investor?
To qualify as an accredited investor, you must meet at least one of the following requirements:
- Have an annual income exceeding $200,000 (or $300,000 jointly with a spouse) for the past two years, with a reasonable expectation of maintaining the same income level in the current year.
- Have a net worth over $1 million, either individually or jointly with a spouse, excluding the value of your primary residence.
- Hold certain professional certifications, designations, or credentials demonstrating financial sophistication.
This definition aims to ensure that participants in private offerings have the financial means or knowledge to understand and withstand potential investment risks.
Is It Legit or a Scam?
Let's say a friend from high school reaches out through Facebook Messenger and tells you they have an exclusive opportunity to get in on the ground floor of an AI company that plans to go public. You'll get a guaranteed 5% annual dividend, and when they IPO, you will get 20-50 times your money back. They named several other friends from high school who were also investing and tells you that the offer will be closing soon. Do you want in? Hold on. First, consider the 10 Red Flags that an Unregistered Offering May Be a Scam.
- Claims of High Returns with Little or No Risk
- Unregistered Investment Professionals
- Aggressive Sales Tactics
- Problems with Sales Documents
- No Net Worth or Income Requirement
- No One Else Seems to be Involved
- Sham or Virtual Offices
- Not in Good Standing
- Unsolicited Investment Offers
- Suspicious or Unverifiable Biographies of Managers or Promoters
Why or Why Not Invest in a Startup Business?
Once you've determined that the offer is not a scam, not you must discern whether it is the right investment for you. In general, there are rewards (tangible and intangible) and risks to consider.
Rewards
- High return on investment (potentially) - more risk more reward
- You believe in a cool new idea - if you don't like it, it might not be the right investment
- Personal connections - friends and family are often sources for a first round of investment.
- A sense of fulfillment - helping an entrepreneur get their business and seeing their success can provide a great deal of personal satisfaction.
Risks
- Illiquidity - Your money will be tied up for three to five years or more. It will take time for you to see a return on your investment, if you ever do.
- High risk - 90% of all startups fail, including 75% of venture-backed companies.
By limiting who can invest, the SEC aims to safeguard less experienced investors from risky and illiquid private (unregistered) investments. This system balances between protecting the general public and allowing new companies access to capital. If you want to learn more about startup investing and what it means to be an accredited investor, consider joining our Mastering Startup Investing as an Accredited Investor Webinar on October 16. Speaker Gerry Hays, JD, QAI, Founder of Doriot, author of "The First-Time Founder's Equity Bible," and Finance Professor at Indiana University Kelley School of Business will review the risks and rewards of startup investing and strategies for evaluating investment opportunities.