How to invest in startups: It’s all about knowing your market

Cynthia Bent Findlay
David Hunegnaw

Do headlines about venture-backed tech companies making giant exits such as Dropbox and Spotify give you investor envy? Want to get in on that startup action? Experts say be cautious—it’s not all rainbows and unicorn companies.

Risk is the name of the game in startup investing, says David Hunegnaw, a former partner and entrepreneur at Loud Capital, a Columbus-based venture capital partnership.

“I think the key is managing that risk,” Hunegnaw says. “First thing’s first: Identify what percentage of your portfolio you want in startup investments, and stick to that. And before you write a single check, due diligence is incredibly important.”

Hunegnaw says educating yourself on the market—beyond what you think you know—and the founder is critical, as is educating yourself on the entire world of startup investing.

If you’re game, there are things you should know about dipping your toe into the startup world. Here are some ideas on how to get started.

Who are you?

Lots of people may end up helping close friends and family members start their dream businesses, but if you’re looking to truly invest you should be what the Securities and Exchange Commission calls an “accredited investor.”

That’s someone with an income of $200,000 or higher ($300,000 for a married couple) for at least two years and with a reasonable expectation of that income continuing in the current year. Or, a person can become an accredited investor if they have a net worth of more than $1 million excluding the value of the primary residence.

The restriction is in place so that if (or more likely, when) one of your investments tanks, you’re not losing the money you’d need to survive, and also so you can handle the exceptionally long time frame—five, seven, 10 years or more—that these investments can take to provide a return.

For those who qualify to go the traditional startup investing route, you need to do some soul-searching about what kinds of opportunities you want to invest in and why. It’s not all about the dollars, say those who invest.

Carol Clark co-founded angel investing group X Squared Angels in Columbus focusing on women-owned companies. She reiterates that it’s wise to have reasons other than making huge returns. “I think people think they are going to make a huge amount of money, but that doesn’t happen very often,” says Clark, who became an investor after succeeding with her own startup, Mindleaders Inc., which she sold in 2007. “I personally invest because I like to see people get jobs they like and because I want to make the world a better place.”

Movies like the Social Network give people a glamorous impression of how much they can make investing in startups, says Lindsay Karas Stencel, a partner with Columbus venture capital firm NCT Ventures. “But it’s something like one in 27 is going to become a billion-dollar company, so if you only invest in one or 10, it’s ruh roh, spaghettio!” she says.

Comfort factor

Frankly, most people have multiple reasons to become a startup investor. That’s the case for Krishna Mannava, a Central Ohio surgeon who was looking to get more aggressive about his investing. He had some connections who were starting companies, and that kicked off his angel investing.

“I invested a lot based on relationships, starting with the founders of the companies and entrepreneurs,” Mannava says. Over the past five years, he’s invested because of connections he was comfortable with both in individual companies and funds. One of those companies was in a space he was familiar with— SmileMD, which is focused on delivering mobile dental anesthesia to pediatric patients. But other companies, like Hyperion Motors, an Orange County, Calif.-based fuel cell car maker, were completely new territory for Mannava, and he loves it that way. “Learning about these new fields is highly appealing,” Mannava says. “When you get to see the prototype, the clay model, it’s cool and fun. Those are things you never get out of investing in stocks.”

None of his investments have paid off yet, though some funds have started to pay dividends.

Mannava says Loud Capital is one of the groups with which he felt engaged. Loud is a relatively new local venture capital firm (founded in 2015) that jumps in at all stages of growth. The firm tends to be tech- and aerospace-focused, Hunegnaw says, but it also has been involved in helping jumpstart local favorites such as Hot Chicken Takeover. Loud likes to be involved in Central Ohio companies.

Managing expectations

So—if you’d like to be one of the daring, there are a number of ways to get started. But first, it behooves you to sit down, crunch numbers and consider priorities.

Obviously, numbers count. Hunegnaw advises that no more than 10 percent of your portfolio be in early-stage capital. Angel funds and individual angel investments used to seed the very beginnings of a company tend to be in the lower five figures. Venture capital funds, on the other hand, that power companies’ later growth stages are more typically six-figure investments.

Consider that you should probably be spreading the risk load around your startup portfolio even more than your traditional investments. Then, consider that in later stages of a company’s funding cycle, you may need to either invest more as the company expands or see your ownership share diluted. You should understand your rights in each deal.

In 2012, the SEC created another way for those in lower-income brackets to potentially get into the beginning stage investment: crowdfunding, which allows companies to raise funds through groups of microinvestments by lower-net-worth individuals. They invest in crowdfunds through SEC-approved portals and are limited in the amount they can invest each year by their net worth.

However, local VC investors caution that the likelihood of striking it rich in crowdfunded investments is, well, micro.

The amount of time you’re willing to put in also steers your investing.

Are you looking to be a silent investor, one who wants to spread investments around many companies with more institutional-type fund managers who understand the industry spaces more than you do? Then there are angel funds that might be a good fit for you. Stencel points to the proliferation of funds such as the Ohio Tech Angel Fund, the Queen City Angels in Cincinnati and the North Coast Angel Fund in Cleveland.

Clark says there are many opportunities to focus where your money goes, from funds pointed at education, social impact investing or green companies. “I’d say 80 percent of fund groups have a specialty, because you can only learn so much, and if you’re talking big money, you really want to do your best to have return on investment, so the more you know about the industry, the better off you should be.”

Cynthia Bent Findlay is a freelance writer.