Investing in Startups
Posted on July 16, 2009
There comes a time in the lives of most investors when they hear—or overhear—talk about a hot startup, often one just getting off the ground. The question many investors have is whether they can get in on the action before such a company goes public. The answer is: "Yes, but...." Opportunities for individuals to get in on these private capital deals are very limited, both because there's often great interest from large venture capital funds and because regulations all but prohibit small investors from taking part.
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Of course, knowing someone on the inside, such as a founder or board member, is the best route to participating in a private fund-raising. Short of that, some advisers say it's worth trying to contact the firm's investor relations representative. To gain credibility, some companies may be eager to attract a particular type of investor, such as those who work in the field where the products will be sold. William Doyle, CEO of Duluth (Ga.) startup Vystar, which raised three rounds of private capital to develop an allergy-free latex product, Vytex, sought investors in the medical profession. "It lent validity to our project," he says.
Don't expect financial advisers to get you in on these opportunities—and don't expect them to embrace the prospect of your doing so. Experienced advisers often treat the idea of investing in a single, private company with deserved skepticism. After all, they see many fads come and go and know the returns on major venture capital funds come from a few winning selections amid a sea of failures. Milo Benningfield, a San Francisco adviser, says private startups are like baby sea turtles that must rush across the beach past predators to survive. "If a good tech idea can even hatch, it has merely won the right to try to cross the sand and then faces even greater threats in open water," he says.
Also keep in mind that most private companies require that investors meet the Securities & Exchange Commission's definition of an "accredited investor." That includes a person who makes at least $200,000 a year (or $300,000 jointly with a spouse) or has a net worth of at least $1 million. Those levels will likely be raised as regulators tighten rules in the wake of the many fraud schemes exposed since the market crash, says financial adviser Keith Springer, president of Sacramento's Capital Financial Advisory Services. "After Bernie Madoff and [Allen] Stanford, it's going to get much harder for individuals to invest."
If you do qualify as an accredited investor but lack connections, some alternatives gaining popularity may provide access. These include SecondMarket in New York and SharesPost in Santa Monica, Calif., which function something like stock exchanges for trading shares of private companies. SharesPost operates like an automated eBay auction, allowing buyers to bid directly on shares. SecondMarket offers several purchasing options, including the traditional method in which a human go-between matches up buy and sell orders.
Because shares of private companies are subject to a host of restrictions that don't apply to shares of public companies, the process of buying and selling can take much longer to complete. "We may be talking to investors for days or weeks before shares are sold," says SecondMarket Chief Strategy Officer Jeremy Smith. Sellers are often employees of private companies, such as Facebook, who have been awarded shares as part of their compensation. Since a lack of information can make valuing shares tough, SharesPost offers free research reports on companies it lists. SecondMarket sells reports.
If you get in early, be prepared to wait. In the case of "most small companies, you're looking at a five- to seven-year investment before you could profit," says Vystar's Doyle.
GETTING IN EARLY
Things to consider before investing in a hot growth company that hasn't yet gone public
1. Do you qualify as an "accredited investor" under the current SEC definition?
2. Do you have reliable information about the company's finances?
3. Can you gain entrée through personal connections to the company, its existing investors, or its board? Do you work in the same field as the company, which could make you a more attractive investor?
4. Have current shareholders listed to sell on one of the secondary market platforms?
By Aaron Pressman
