How to Invest in Startups: A Beginner's Guide

Investing in startups is an exciting way to back innovate ideas and potentially achieve life-changing returns. From early-stage companies revolutionizing industries to more established startups on the path to IPO, investing in this dynamic space offers both financial and personal rewards.

In this guide, we’ll walk you through why people invest in startups, what you’ll need to get started, and the most common ways to invest—ranging from venture capital funds and angel investing to crowdfunding and secondary markets. If you’re ready to explore this high-growth asset class, this guide is your roadmap.

Why Invest in Startups

Investing in startups can be exciting, rewarding, educational, and lucrative. The excitement comes with following along with the ups and downs of disruptive startups as they scale. The experience can also be educational and, for those who enjoy coaching and mentoring, it can be intrinsically rewarding to help a founder and their startup flourish and create value, jobs, and satisfied customers. Last but most important, investing in startups can be lucrative. A meta-study of angel investing returns found a median annualized return of 24%, more than double the 11% long-term annualized return of the S&P 500.

Investing in startups does come with risks, though. One study of realized venture outcomes found that 48% of venture investments resulted in a loss for investors, which means that investors in startups should diversify in order to improve their odds of investing in a winner. Investing in startups and private markets in general is also very illiquid. Unlike with stocks, mutual funds, or ETFs where investors can usually sell or redeem their investment 5 days a week, investors in startups can't just redeem or easily sell their shares.

Startup investors should go into their investments with the assumption that it will take at least several years before a potential return on their investment and more like 10 to 15 years for early stage investments that eventually IPO. The returns for the big wins are worth the wait but it's important for investors to understand the risks and long payback periods involved with investing in startups.

What Do I Need to Invest in Startups

Money, patience, an appetite for risk, and accredited investor status. That's the short version. The longer version is that investing in startups usually requires both a high risk tolerance and financial capacity. More specifically, it usually requires being an accredited investor, which is a standard set by the SEC for investors who want to invest in certain private market investments including most startups. Basically, the accredited investor rule exists to make sure that private market investors have the financial capacity to take the kinds of risk that come with the territory.

Investors can attain accredited status through different tests but the most commonly referenced are around annual income for the last 2 years (either $200k+ for individuals or $300k+ for spouses or spousal equivalents) plus the expectation of meeting that threshold again in the current year or a net worth of more than $1 million excluding one's primary residence. Details and exceptions apply, plus the threshold change over time, so investors should be sure to check out the official details and thresholds from the SEC.

6 Ways to Invest in Startups

Investors have 6 main ways to invest in startups. We'll compare the relative advantages and disadvantages of each approach.

Venture Capital Funds

The easiest way to invest in startups is by investing in a professionally managed venture capital fund. The advantages of investing in a venture capital fund are that the investor gets to benefit from the manager's network and experience, the manager does all the work for the investor, and the investor gets a more diverse portfolio of startups than they might be able to cobble together on their own.

The main downsides of investing in a venture capital fund are that investors must pay managers in order to do all that work for them and that the minimum investment requirements for the fund might be higher than what it would otherwise take for the investor to make a few angel investments on their own. Also, as with all startup investments, venture funds are only a good fit for those with a high tolerance for risk and the patience to wait many years before reaping any rewards on their investments.

Angel Investing

Another popular way to invest in startups is by making direct angel investments into early stage startups. Angel investors usually invest at the earliest stages of a startup's life, oftentimes pre-product or pre-revenue, so the risk and potential rewards are both very high. 367,945 Americans made angel investments in 2022, according to the Center for Venture Research, so it's clearly a popular strategy.

The advantages of making angel investments are that investors can pick and choose the startups they back, ticket sizes can sometimes be smaller than investing via venture capital funds, and some angels can add value to their founders given their own operating experience. A lot of angels also enjoy the intrinsic benefits of investing in startups including learning about new technologies, supporting job growth, and just being along for the ride.

Angel investing does have its downsides. Individual angel investments are high risk, building a diverse portfolio takes up a lot of time and capital, it takes many years for winners to pay off, and angels usually have a sourcing disadvantage relative to professional managed early stage venture capital funds. Building a diverse portfolio of well researched angel investments could take hundreds or even thousands of hours of time, which is akin to a full-time job. Also, with a typical angel check in the ballpark of $25,000, constructing a portfolio of 15+ startups would eat up $375,000 or more of personal capital, and that's not leaving any money for follow-on investments. Ironically, that's far more capital than the minimum commitment required by many venture capital funds.

Put the effort, risk, and capital required together and it's understandable why value of angel deals in the US fell by 64% between 2015 and 2023 according to The Wall Street Journal.

Angel Networks

Angel networks are a path for individual investors to source and diligence startup investments in a club-like atmosphere. Tracxn estimates there are 532 angel networks in the US with groupings centered around themes, alumni networks, local communities, and more.

Angel networks are a good way for beginning investors to learn more about investing in startups, invest on a deal-by-deal basis, and ease their way into the experience via a friendly social setting. It's a little bit like a country club where you invest in startups instead of playing golf or squash. Angel networks also usually have some formal structure around sourcing and diligence, both of which are helpful for new angel investors.

Angel networks usually involve paying some fees, though, and have a relative sourcing disadvantage relative to venture capital funds. Founders prefer to work with venture capital funds over angel networks because angel networks tend to move slowly and lack the platforms, networks, status, and check sizes that venture capital funds can offer.

Syndicates

Angel syndicates are growing in popularity as a way for individual investors to invest in early stage startups. The way angel syndicates work is that a syndicate lead, usually working through a platform like AngelList, will actively source and diligence startup opportunities and present deals to their syndicate of followers that individual investors can choose to invest in on a deal-by-deal basis. It's a good option for beginning angel investors who want to start easing their way into the asset class with some help and have the ability to invest very small check in such rounds. They're somewhat of a middle ground between angel investing and venture capital funds.

Angel syndicates are not free, though, and investors pay fees to the syndicate lead and administrator. Investors through syndicates usually aren't able to directly connect with the founder, which might disappoint some angels who enjoy engaging with founders. Investors in syndicates also have limited information about the starting they're investing in, so they're placing faith in the syndicate lead to do have done a lot of homework for them, and the investor usually only has a few days to decide whether or not to invest. Also, while the syndicate lead does a lot of the heavy lifting for their followers, it is still on the individual investor to make the choice of the deals they do and to build out a properly diverse portfolio.

Crowdfunding

Startup crowdfunding platforms like WeFunder have opened up startup investing to a broader audience. Investors can invest as little as $100 to participate in crowdfunding and don't need to be accredited. The platforms cover some of the sourcing and diligence, both of which are helpful for beginning investors as far as finding potential deals and putting in minimal effort.

Crowdfunding has major weaknesses, though, with the biggest that the most promising startups and founders rarely choose crowdfunding as a capital source, instead usually preferring to work with venture capital networks or angel investors. The result is that a lot of Crowdfunding deals are more like the Island of Misfit toys relative to the quality of startups you'll see in most venture capital funds.

Secondary Markets for Startup Shares

Secondary markets like Forge and EquityZen allow individual investors to buy equity in private companies from existing shareholders, providing access to more mature startups closer to IPO or acquisition. This can reduce some of the risks of early-stage investing while offering the potential for faster liquidity.

Investing in secondaries of startups has many downsides. Investors usually have limited insight into the current financials and state of play at the company, so it's hard to diligence secondary opportunities or establish a fair price. Investors are also usually investing in these companies long after their early breakout success, so valuations are higher and closer to public market levels but without public market liquidity. Fees are also a factor -- these platforms don't offer their services for free -- plus investors oftentimes find themselves buying common stock on these platforms rather than preferred stock. Common stock is further down the capital stack than preferred stock and thus has less protection and more downside risk.

Summary: How to Invest in Startups

Investing in startups is an exciting and rewarding way to diversify your portfolio and support game-changing businesses. While risks like illiquidity and long time horizons exist, the potential rewards—including significant financial upside and the satisfaction of backing visionary founders—make it a compelling opportunity for many investors.

By understanding your options, from venture capital funds to angel networks, syndicates, and crowdfunding platforms, you can find an approach that fits your goals and risk tolerance. With the right strategy and patience, startup investing can be an enriching part of your financial journey.

The Investing in Startups Podcast

One more thing. We host a podcast called Investing in Startups. The show is hosted by Joe Magyer, founder and managing partner of Seaplane Ventures, and features interviews with top early stage venture capitalists. The show is available on Apple Podcasts, Spotify, Amazon, and YouTube.

Investing in startups is very risky. This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. Investors should seek the advice of their financial and tax advisors before investing in startups. Please invest responsibly.