Financial Poise
Share this...

When Should You Invest in a Startup Company?

My prior installment explained why you should be wary of investing in startups. I didn’t explain what a startup is because I assumed most readers knew. I received a number of emails, however, that pointed out that there really is no single universally accepted definition of a startup.

What Is a Startup?

You can see the way various founders define the term in this Forbes article, but they tend to be less useful from an investor’s perspective (which is the only perspective I write from and for here) and more fanciful/poetic.

From the investor’s perspective, a traditional small business, no matter how new, is not a startup in the sense that people in the investment community use the term.

A startup, by practical definition, is a business that is:

  • Designed to grow very large, i.e. it can “scale.”
  • Seeking and will likely continue to seek investment capital (from individual angel investors, angel groups, VC funds and through on-line funding portals and platforms).
  • Planning the way its investors can “exit” (i.e. cash-out) from the start.
  • Likely technology oriented.

The Different Points in Time You Might Invest in a Startup

So, the title of this installment, “When Should You Invest in a Startup Company?” does not refer to when you should do so as it relates to your life.

That’s very self-centered of you, by the way…

The question refers to when in the lifecycle of a company should you invest in that company (if at all, of course – a question I don’t address in here). In other words, maybe you would like to invest in a startup:

  • Right out of the gate, based on the idea and identity of the founders alone.
  • After the startup is able to prove in some manner that its idea makes sense.
  • After the company has some actual revenue, even if not profitable.
  • Only after the company actually starts making a profit (leaving aside for now that there are many ways to define “profit”).

The first installment of this column began explaining the differences between angel investing, venture capital and private equity investing.

The thing is, however, the line between angel and VC investing is gray. And, there are subdivisions within each.

It’s easiest to conceptualize by forgetting for the moment that angel investing and VC investing are two separate “things” (and they really are not, totally separate anyway, which is sort of my point).  Let’s take a step back and look at it this way: there are, give or take, five different points in time an investor can (either directly or through a fund, indirectly) invest in a startup:

Progress Likely Investors
Early seed stage Concept or product development Personal savings, family, friends
Later seed stage Operational but still developing product or service; no revenue; less than18 months Personal, family, friends, crowdfunding; small angels
Early stage Product or service in testing/pilot production; maybe revenue; less than 3 years Angels, VCs, equity crowdfunding
Expansion stage Significant revenue growth, maybe profit; more than 3 years VCs and VC funds
Later or mature stage Positive cash flow, profit; typically, more than 10 years PE groups and funds, family offices

This chart is borrowed heavily from one created by my friend, Dave Freedman, in this article, which is well worth the read.

In a nutshell, as the chart also suggests, the newest startups tend to be self­funded and/or are funded by investments by “friends and family.”

As a startup progresses and gets closer and closer to becoming profitable, it can look to different types of investors; younger startups have tended to look for money from angel investors whereas VC funds tend to invest in slightly more proven startups. But, the line of demarcation, which was never that bright, grows duller all the time and will soon become downright hard to see because of the changes the JOBS Act will bring.

Recap

Take a moment to tie these five stages to the differences between venture capital (VC) and private equity (PE). The critical point for you to understand is this: today’s VC? investment is tomorrow’s PE investment?.

If you are an investor and you do not have investments in these asset classes you owe it to yourself to take the time to understand them, even if it is only to make the conscious decision they are not for you.  Leaving aside in the low-interest rate environment, diversification into such alternative assets can help with overall diversity and lower the overall risk of your investment portfolio.

 

 

About Jonathan Friedland

Jonathan Friedland is a partner with Sugar Felsenthal Grais & Hammer, a law firm with offices in Chicago and New York City. Born and raised in a New York suburb, Friedland graduated SUNY-Albany magna cum laude in three years and then earned his law degree from the University of Pennsylvania Law School. Friedland clerked for…

Read Full Bio »   •   View all articles by Jonathan »

follow me on:
Advertisements
Heroes & Horses
>