How to Protect your investment in a startup – A detailed guide for first-time startup investors

Introduction 

Investing in startups is an attractive prospect for a lot of people not simply because it has a high potential rate of return but also because it provides you with the ability to help someone create their dream by funding them. But since so many businesses fail each year, it is also one of the riskiest moves one can make. Investors should approach each venture with caution and make all their investments wisely so as to avoid ruining their prospects and incurring huge losses. 

Initially, you needed good wealth and connections to invest in startups. This is not the case anymore as an average investor can easily grab a piece of an exciting startup opportunity using crowdfunding sites. 

As a startup that is just venturing out into the world, they might be hesitant to approach banks for loans due to the legal hassles involved in such situations. The banking red tape makes everyone hesitant to approach them. As a result, they’re keen on gaining the attention of investors and also rely on seeking capital investment from their friends and family while also putting in their own money. 

Startup investing is potentially advantageous, but it’s important to understand that it comes with big risks. The vast majority of startups fail—even if you do your research, you could end up with a pocket full of nothing. That is why as an investor before parting with your funds you need to carefully assess and measure what you’re investing into. 

Ways to carefully invest in startups

1. Reviewing the venture’s business plan 

A business plan dictates the founders’ intentions with the company and where they intend to take it in the future. To protect an investment, then, an investor is well advised to carefully analyze the plan to determine if the owner’s projections are practical. An investor should also ask to have a look at the company’s finances as well as take periodic updates from them to continuously safeguard their investment and keep an eye on it.  

Make sure to look for small or inactive shareholders present, how the cap table is formalized, does the company have debts it hasn’t paid off if there is a co-founder/shareholder who is no longer active and needs to be bought out, if there is a shareholders’ agreement containing a strong anti-dilution or liquidation preference or if all the relevant IP and URLs are owned by the company. 

Every company is different and every startup has its own details that you need to understand and get a good understanding about.

These terms can be unmasked with the help of a lawyer so you have a better idea of where you’re putting your money. 

2. Consider the business structure

In order to protect your investment, it’s important to understand the different IRS and legal structures of a new company. If a small business fails, an investor could be liable for unpaid bills or liabilities. Because small businesses do fail very often, it is important as an investor to protect yourself from liability for these expenses. However, you can consider creating a limited liability corporation (LLC) in order to protect personal assets should the business fail. Never invest in a business based on a mere handshake and unofficially, no matter how close you are to the person you are going into business with. Always draft official documents and put things in writing to protect yourself and the startup you’re investing in.

3. Ensure you communicate with the startup in a timely manner

Startups work hard and every moment they spend talking to investors to give updates means that they lose valuable time that they could spend on their business. At the same time, the startup has to build a relationship with its investors. You can’t build trust in an instant. Investors should seek updates once a month from the beginning. Startups will usually use the updates to ask for advice, introductions, and support. And if you are a good investor you will stand ready to give that support.

It is very important for you as an investor to stay updated. Before you decide to invest, you can ask the startup to send over an example update and make arrangements about updates that you are comfortable with.

4. Understand why the startup needs your investment

Most times, startups are trying to raise money from investors because they are unable to get financing through traditional sources, such as a bank loan. It is important to learn why the entrepreneur is not seeking traditional financing. However, it is also important to remember that just because a startup isn’t using banks and loans it does not mean that the company cannot succeed. Financing for startups is extremely difficult to obtain and even businesses that have been operating well for several years report difficulty with bank financing. In addition, some business owners try to avoid starting a company with too much debt, believing that investors may provide them with more solid financial backing than a loan with high interest.

5. Ask other investors for advice

Startup investing is a skill that you can learn. Always be on the lookout to learn more, and try to educate yourself. For any topic, it is likely that you can find an expert that knows more about that particular matter than you do. Perhaps you have some friends that have invested before and which you can learn from. There are also places that offer angel investment training. These can be found online with an angel investment platform. If you get to know more angels, you will be able to share your potential investment opportunities, learn from each other’s way of looking at things, and perhaps decide to invest as a syndicate.

Surround yourself with investment friends whom you can ask for help. Perhaps you can get into the habit of investing alongside them. Expanding your network is pivotal. 

6. Have an exit strategy

One of the most important things to keep in mind when investing in a startup is to have an exit strategy. A startup company could use all the capital investment even before it starts functioning properly and it could take years before they begin turning a profit. Even when the company is successful and you begin receiving dividends, you may have difficulty withdrawing the original investment. Therefore, when preparing to invest in a startup, discuss what your exit strategy may be. An exit strategy not only protects your investment but also protects the company owner from damages should you decide you no longer want to be part of the business.

Thus as an investor, you want to be sure that the startup you choose to invest in is valued properly, that you have an exit strategy and that your liability is minimized should something go wrong.

An investor should know the mechanisms and risks involved in startup investing, and that the rewards don’t always have to come in the form of a financial return. Investing in startups can be rewarding because of the direct relationship you get with the startup. You can actually learn a lot from a startup, have a direct impact, and you can watch your investment grow. The only way to figure out if you’re good at startup investing is by venturing into it. 

Author Bio: Namita Gupta is a content strategist and author with a keen interest in financial topics. She has 5+ years of writing content for different publications. In her free time, she loves to play badminton. You can catch her on Twitter at @namita_g30

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