Investing in Startups

Back in the dark days of the financial crisis, investor confidence slumped to historic lows – for instance, the State Street Investor Confidence Index dropped to 82.1 in …

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Back in the dark days of the financial crisis, investor confidence slumped to historic lows – for instance, the State Street Investor Confidence Index dropped to 82.1 in October 2008, after having been as high as 107.0 just three months previously. The impact of this was felt across many sectors, as investors looked for safe havens for their cash. Startups were particularly affected, as VC investment in the US dropped from a peak of $8.45 billion in Q4 2007 down to $3.84 billion by Q1 2009. However, investment in startups has started to rebound as growth in the United States begins to accelerate again, reaching $7.77 billion in Q3 2013, according to PWC’s MoneyTree report.

While this is no guarantee that startups are now a good investment, it is an encouraging vote of confidence. Software is still the primary focus for VCs, but increasingly they are putting their money into other sectors as well. Biotechnology attracted $852 million of investment in Q3, with the number of deals rising 10% to 123. Other leading investment areas included Medical Devices – which saw investment go up by 12% – and Media and Entertainment, which received $541 million in investments in Q3.

Of course, this rise in investment is no guarantee that any individual startup is a good prospect. Choosing startups is a bit like the NFL draft – you can read about this on Francesco Corallo’s blog site. Some of your top picks aren’t going to live up to expectations, while others lower down the draft turn into dependable performers. Any good VC knows that they need to pick a promising lineup – but also knows that only a relatively small proportion of players will turn into winners. This is why VCs are typically looking for exits that are in the $100 million plus range – anything smaller is not worth it, given the risk involved.

Why does this matter to the small investor? After all, investing in startups has typically been the domain of the big players. Given the amounts of money involved and the fact that startups aren’t publicly traded, no small investor can hope to obtain a significant stake in even one startup, let alone achieve the diversity that is needed to make the investment model work. Or can they?

Back in 2012, the Federal government passed the Jumpstart Our Business Startups (JOBS) Act. This act mandated the SEC to revisit the existing rules on capital formation, disclosure and registration – which were sufficiently burdensome to stop small investments from flowing into startups. Under the act, these restrictions are reduced and simplified, enabling new investment models that make startups accessible to small investors.

For example, startups are now able to raise up to $1 million dollars through crowdfunding sites such as Kickstartrer, Indiegogo and Fundable. Prior to the JOBS Act, crowdfunding was possible, but only in a very limited sense – any investments were considered to be donations and investors could not receive equity shares in return. The JOBS Act changed that, making crowdfunding a legitimate vehicle for equity investment – and creating an opportunity for small investors to include high-growth startups in their portfolio.

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