Investing in start-ups: The dos and don’ts

Johannesburg, 29 Apr 2024
It's wise for investors to select start-ups in industries where they have personal background experience and working insights.
It's wise for investors to select start-ups in industries where they have personal background experience and working insights.

Investing your hard-earned money into brand new start-up companies sounds wildly exciting, doesn't it? Just picture getting in on the ground floor of the next huge thing before it absolutely explodes into a multi-billion-dollar unicorn.

Your small initial investment could balloon into millions if you're one of the lucky early backers of the next Facebook, Uber, or viral smart app like Trader AI. Scoring a piece of the next big start-up sensation would be the ultimate adrenaline rush!

We're diving deep into the thrilling potential upsides of start-up investing as well as the costly downsides. We'll also cover mission-critical tips for protecting yourself and playing it smart if you do decide to take the high-risk, high-reward plunge.

Upside #1: Mega money-making potential

Let's not kid ourselves here. The number one reason folks want to back start-ups is that tantalising prospect of scoring an absolute money truck if they hop on the rocket ship early enough.

Unlike more traditional investing in public stocks and bonds, getting a stake in a fledgling start-up gives you a real shot at pure explosive returns that can turn your modest stake into millions or tens of millions if it becomes the next world-conquering Uber, Airbnb or Trader AI app.

Upside #2: Backing world-changing innovations

Look, scoring epic lottery ticket paydays is obviously incentive #1 for start-up investors. But many are also drawn by the opportunity to play an instrumental role in bringing genuinely innovative, game-changing ideas and technologies to market that can positively impact billions of lives.

It's just plain cool being an early backer and supportive ally of visionary founders working to disrupt outdated industries through smart apps like Trader AI and other new products or services. You're "investing in the future" as cheesy as that sounds! Even if the start-up journey ultimately goes awry, you can still feel pride in championing bold entrepreneurial dreams and being part of the creation story.

That perspective of driving societal progress is vastly different than throwing a bunch of money into stodgy stocks of some faceless corporation. It's exciting getting to collaborate with start-ups attacking problems in novel ways.

Upside #3: Sweet tax breaks, baby

Savvy start-up investors also know to take full advantage of the slick tax benefits and incentives available in many jurisdictions for funding new businesses. These lucrative tax credits and deductions can meaningfully boost your overall investment returns by reducing Uncle Sam's cut.

For example, the US federal government offers juicy perks like a 100% tax exemption on all capital gains from Qualified Small Business Stock held over five years. States frequently pile on with their own sweet incentives to spur local start-up investment as an economic driver as well.

Of course, navigating the full byzantine depths of all these tax loopholes and staying compliant is best handled by a seasoned accountant. But for many investors, scoring those legal tax advantages is basically like getting the government to fund a portion of their start-up fun money.

Upside #4: Portfolio diversification

For investors already loaded up on traditional stock/bond investments, allocating a modest chunk towards higher-risk, higher-potential plays like start-ups can provide valuable diversification benefits. It's unwise keeping 100% of your money in any single asset class's risk bucket.

While any individual start-up could detonate spectacularly, spreading calculated bets across a handful of promising start-ups creates some upside exposure that can boost your overall portfolio's long-term total returns. As long as the high-risk allocation size remains reasonable, failed start-ups can be shrugged off as "tuition" for any huge winners unearthed.

Still on the fence but intrigued by the upside possibilities? Then let's cover some absolute must-follow rules for start-up investing...

Smart start-up investing rules

Rule #1: Don't go broke

Start-up investing is a high-risk, probabilistic gamble, period. Even the most accomplished investors lose far more often than they win with individual deals. You cannot invest rent/bill money or funds needed in the next five years. That money needs to be off the table from day one.

Sound overly conservative? Maybe. But it's better than losing your shirt then crying over spilled milk later. Smart investors will have a separate dedicated "angel portfolio" play account stocked with only legitimate risk capital from diversified income streams. Forget dumb YOLO'ing!

Rule #2: Diversify like crazy across deals

An extremely rough general rule of thumb is 15-25% of your total start-up allocation could go into an individual company. But many savvy investors keep maximum single-deal sizes even lower around 5% or less given the asset class's ultra-high risk levels.

Rule #3: Do your due diligence!

Seriously, no skimping here. Put on a forensic accountant's green shades and scrutinise every piece of diligence:

  • Founders' backgrounds and relevant expertise.
  • Product specs, marketing strategy.
  • Competitive landscape analysis.
  • Comprehensive financial modelling.
  • Valuation and deal terms.
  • Exit timeline/path projections.

Rule #4: Invest in what you understand

It's also wise for start-up investors to place their bets into sectors and industries where they have personal background experience and working insights. Crypto-currency traders should look for fintech plays. Doctors may focus on digital health start-ups.

Rule #5: Partner with experienced scouts

Finally, becoming a prosperous start-up investor almost invariably requires partnering up with far more experienced scouts and pickers already deeply immersed within top-tier deal flow networks.

For relative newcomers, that means joining respected angel groups, attending pitch events, and getting your foot in the door with proven accelerators or seed funds. You'll need these "scenes" to gain early access to compelling deal opportunities in the first place.

So, should you invest in start-ups? The honest verdict...

For most inexperienced retail investors though? It's smarter sticking to steadier, more liquid and lower-fee investing vehicles that don't require full-time operational oversight. Markets are already volatile enough without tying up funds in illiquid start-ups that'll probably fail anyway.

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