portfolio management: What's the right number of startups to hold in a portfolio? (Hint: Kauffman Foundation research says at least 6)
taxes: You gotta pay Uncle Sam at some point, right?
With all this in mind, a startup investor has to juggle lots of things at once — but ultimately, it's all about the money.
How do I make money investing in startups?
As OurCrowd and other equity crowdfunding startups democratize early stage investing, we get asked a lot about how investors make money in startups.
Basically, there are 3 ways a startup investor can make money:
startup sells to another company: Large companies typically turn to startups to provide a shot of ingenuity with a side of technology for their existing businesses. So, at least in Israel, we see around 100 companies get bought every year by larger multinationals. For an investor in a startup, this is frequently the quickest way to make money on your original investment. When a startup gets bought out, an investor may receive cash or new stock (or a combination of the 2) from the acquiring company. So, how much an investor would see back on a merger or acquisition of this kind depends on his prorata share of the startup and the valuation the company was being acquired at.
startup goes public: This happens less frequently than startup M&A because the qualifications to publicly float stock are typically higher and only more mature startups fulfill them. Of course in a world of global stock markets, investors in Israeli startups may see their investments IPO on the Tel Aviv Stock Exchange (TASE), the London Stock Exchange (AIM), or in the U.S. on the New York Stock Exchange (NYSE) or NASDAQ.
startup gets big, pays dividends: Some companies decide not to get bought or IPO. Their founders have a vision of running large, standalone businesses. If they get there, they typically have lots of cash on their books and are generating more $$ every day. To repay investors, they can pay out part of their cash flow in the form of ongoing dividends or if the cash buildup on their balance sheet is large enough, they may decide to dividend out a chunk of that cash in a 1-time, special dividend. Conduit, a well-known Israeli internet technology company, decided to take this approach and paid back something like $300M to its investors.
sell a share to someone else: Investors in startups typically have the ability to sell their shares to another buyer for a profit…if they can find one. Unlike many stocks that trade on stock markets, most markets for selling shares in startups are really illiquid. Most likely, if you were to check Sharespost or SecondMarket, the 2 leading markets for shares in private companies, you won't find an active market in shares of a specific startup (unless it's super hot and big — like Facebook was before it IPO'd). When investors ask me, I tell them they have to feel comfortable owning shares in their startup for a long time.
There are some other less common ways early stage investors get paid back. Sometimes investor will use convertible loans (like OurCrowd did when it funded Israeli flight technology company for the Operating Room, Surgical Theater) to fund deals. These are loans that can convert into equity at a later date.
Regardless, investors should pay close attention to how a startup is valued, who owns the equity and importantly, who owns rights to determine whether a startup can be sold. Inexperienced angel investors aren't always aware of these types of terms that can have a big impact on future investment returns. Fortunately, at OurCrowd, we negotiate these rights for our investors from the start.