Investing in bright ideas can be exciting. Startup companies can create disruptive new products and services which can help light up the economy. Although, as an investor, there can be a dark side to investing in a high risk asset class if you don’t proceed prudently and with your eyes open.
In order to make brighter investment decisions, there are several steps in the process that you should be aware of. This guide will walk you through the process of investing in startups.
Online platforms streamline the process of investing in startups, from due diligence to funding and execution, as well as accreditation verification. We believe that startup investing should be as simple and transparent as buying a share of public stock. The investment process can be broken down into some basic steps:
1. Due diligence
The online platform, angel group or other organization that you are investing through may have conducted their own due diligence on the company. You may be able to leverage that process to quickly find out the basic information to help you make an initial assessment of the company. You should also conduct your own due diligence by reviewing key documents, researching the company and asking questions of the management team.
2. Consider investing entity
To decide which legal entity you wish to use to make the investment, you may wish to consider factors such as your tax structure, existing investment portfolio and personal circumstances. Investments in startups may be able to be conducted by an individual or through a family trust, IRA (Individual Retirement Account), LLC or LP.
3. Legal paperwork
You may need to complete paperwork such as an accredited investor questionnaire and verification of your identity before making an investment into a private company.
4. Sign documents
To make an investment, you will normally sign an investment agreement that sets out the terms of the investment. In some transactions, the documents will be held in escrow until certain conditions are met.
5. Fund investment to escrow
Depending on the structure of the transaction, you may transfer your funds into an escrow account held by a third-party for safe-keeping until the funds are released to the company once certain conditions are met.
6. Release documents/funds on conditions being met
Once the conditions of the escrow are met the documents and/or funds will be released to the company.
SeedInvest streamlines the offline startup investing process by bringing the key steps online. The main steps in the investment process on SeedInvest include:
1. Begin Investment
Following your due diligence, the first step in making an investment on SeedInvest is to click the blue “invest” button on the company’s profile page. This will start the investment process.
Once you have chosen an investment, the first step is indicating the amount that you wish to invest. You can choose any dollar amount that is larger than the minimum investment or smaller than the total size of the round.
3. Investor Type
You will then select the investor profile that you which to use to make the investment. Most investors on SeedInvest simply invest in deals as an individual while others invest on behalf of a legal entity (ie. a trust, IRA, LLC, or LP). Our platform affords the ability to invest as an individual or on behalf of any legal entity.
If this is your first time making an investment, you will have to complete identity verification which is required by law for regulatory purposes. SeedInvest’s online identity verification system streamlines this process.
5. Accredited Investor Status
Certain investments (“506(c) deals”) require us to verify your status as an accredited investor. In these cases we must verify that your income or net worth is sufficient to deem you an accredited investor. The platform allows investors to verify their accredited investor status online through numerous means. In these cases the platform will walk you though the process of verifying your accredited investor status.
Your information will then be pre-populated into the company’s offering documents, which you can sign electronically through the platform. These offering documents cover the agreement between you and the company.
After signing the offering documents, you will be asked to input your funding information. In most circumstances, investors may choose to invest through an online transfer from their bank account or through a wire transfer. If you choose to fund through ACH, all that is needed is your bank account number and routing number. For first time investors we conduct a penny test (which usually takes 24-48 hours), your funds will automatically be transferred and placed into an escrow account. The funds will remain in escrow until they are released to the company that you are investing in.
Once you confirm your investment, the funds will be transferred to an escrow account for holding until the funds are transferred to the company that you are investing in. If you find that you are more comfortable reviewing the transaction process with us over the phone, please contact us using the chat function on the website or at email@example.com and we can discuss any part of the transaction including the option to transfer funds manually offline.
Once the fundraising round closes, you will receive confirmation of success and counter-signed legal agreements. In the case of an unsuccessful round or a canceled investment by yourself, the proposed transaction will be cancelled and the escrow agent will return the funds from the escrow back into your bank account.
In order to protect investors, Companies must reach a minimum funding target to have a successful fundraise. Therefore, investments are not finalized until the company raises enough money to meet its funding target and completes all other closing conditions. When investments are initiated through the SeedInvest platform, the subscription proceeds are held securely in an independent escrow account. Once the funding target has been met, the money is released to the company and investors will receive the applicable securities. If the minimum funding target is not met, subscription amounts are returned to investors by the escrow agent. SeedInvest does not ever receive or take custody of investor funds at any point during the investment process.
SeedInvest conducts independent due diligence on each of its investment opportunities. The SeedInvest Due Diligence process includes several stages. All companies marked as “Vetted” have successfully gone through our due diligence process, generally including:
1. Legal and Confirmatory Due Diligence
The legal and confirmatory due diligence is conducted by CrowdCheck. The legal and confirmatory due diligence conducted typically includes the following:
Organization of the company: CrowdCheck requires information that shows the issuer company has taken steps necessary to properly organize as a corporation, LLC, or limited partnership in its state of organization, is in good standing, and that the securities being issued will be duly authorized and validly issued.
Corporate structure and ownership: CrowdCheck works with the issuer company to disclose its organizational structure, affiliated entities, and current capitalization.
People behind the company: CrowdCheck helps the issuer company disclose who is behind the operations and strategy of the company, along with their previous related experience, and Bad Actor Reports to provide evidence that the company is not disqualified from proceeding with its offering.
Information provided to investors: CrowdCheck checks that the issuer company is providing clear disclosure of its financial situation, business origins and operations, and legal authority to engage in its business activities.
Investor information and terms of the offering: CrowdCheck reviews for consistency in each instance where the issuer company describes the offering terms, identifies to investors how the issuer company reached its current valuation, and will track and keep in touch with its security holders.
2. Review of Legal Documents
An independent law firm engaged by SeedInvest typically performs a review of the transaction documents to check for red flags and conformance with stated terms. For transactions using standard documents such as the 500 Startups KISS Note this legal review is sometimes waived because the investment terms conform to accepted industry norms.
3. Business Due Diligence
We conduct research and due diligence on each company before it is able to accept investments on the SeedInvest platform in order to determine: (1) its viability as an investment opportunity and (2) the key risks associated with that opportunity.
We take a dynamic, multi-faceted approach to evaluating individual offerings. We will typically conduct over 30-40 hours of due diligence per opportunity, which often requires the satisfactory completion of 100-150+ individual questions and data requests.
Particular focus is typically paid to the following issues throughout the due diligence process:
- Problem or inefficiency being addressed
- Product / service overview, stage of development and anticipated milestones
- Demonstrated traction (e.g. revenue, pre-sales, purchase orders, signed contracts, media coverage, awards, etc.)
- Data to support claims made in marketing materials (e.g. user / customer metrics, signed contracts and agreements, product demonstrations, etc.)
- Growth strategy
- Employees and advisors (including ownership structure)
- Addressable market (e.g. size, growth, penetration, etc.)
- Competitive landscape and industry dynamics
- Exit opportunities
- Intellectual property
- Historical financials
- Financial projections (including error-checking, evaluation of key assumptions and reconciliation to stated growth plan)
- Reference checks (e.g. previous investors, advisors, etc.)
- Investment overview (including determination of key terms, uses of funds, and current and previous investors)
Note that we do not necessarily focus on each of the aforementioned areas for each investment and that investors are expected to perform their own due diligence of each opportunity.
4. Investment Committee
The findings of the foregoing review are presented to an internal investment committee comprised of senior executives, which may approve, reject, or require additional information for the offering. Upon approval by the investment committee, an offering can be listed as “vetted” and can begin accepting investments online.
Notwithstanding the foregoing, these investments are illiquid, risky and speculative and you may lose your entire investment. Additionally, the foregoing process does not guarantee that any company will be successful or that you will receive a positive return on your investment. Rather, this is intended to summarize our standard process. Each diligence review is tailored to the nature of the company, so the aforementioned process is not the exact process for every issuer.
Completing the vetting process not guarantee that the company has no outstanding issues or that problems will not arise in the future. While the foregoing process is designed to identify material issues, there is no guarantee that there will not be errors, omissions, or oversights in the due diligence process or in the work of third party vendors.
Each investor must conduct their own independent review of the offering documents and perform their own independent due diligence and should ask for any further information required to make an investment decision. The due diligence undertaken by others (including SeedInvest) can supplement but should not be a substitute for each investor’s own due diligence. You should take the time to understand and analyze the factors of the business that you consider important to your investment.
Factors to consider
Common factors that are reviewed by seasoned investors, that you may wish to include in your own due diligence when you assess a company include:
- Management team backgrounds
- Differentiation and defensibility
- Business model
- Market size and dynamics
- Competitive landscape
- Historical financial performance
- Financial projections
- Unit economics
- Capitalization table
- Use of proceeds
The cornerstone of startup investing is diversification. Diversifying your startup investments across multiple investments can help to spread the risk of losses and improve the likelihood of generating higher overall returns. Individual startup investments are highly risky and should only be made as part of a larger portfolio approach.
Modern portfolio theory suggests that investors should diversify across different asset classes. Early stage investments should generally form no more than 10% of your overall investment portfolio. This type of asset class diversification seeks to minimize the impact of under-performance in a particular asset class. For example, you should invest no more in startups than you can afford to lose.
Within the early-stage asset class, you may wish to consider diversifying your investments across multiple startups. Investment returns from an individual startup can vary widely, as a result and the overall return of an entire startup portfolio can be driven by a small number of companies within the portfolio. Research from the Kauffman Foundation’s Angel Investor Performance Project found that larger portfolios of startup investments generally performed closer to the mean than smaller portfolios and that larger portfolios also generally performed better than smaller portfolios.
This post was written by seedinvestedu on October 28, 2016
How To: Invest in Startups