If you want to invest in a startup, tread carefully.
In May, Title III of the Jobs Act came into effect, making it possible for nearly anyone to try their hand at investing in startups. The legislation relaxed longstanding rules about who can and cannot invest in private companies. Previously, you needed to earn more than $200,000 a year or have a net worth above $1 million to be eligible to back most private companies. Now, anyone can, although the regulations do come with some limits: individuals with income below $100,000 can invest up to $2,000, or 5% of their annual income, while investors making between $100,000 and $200,000 may invest up to 10% of their annual income.
Exciting, right? These changes should serve as a boon to equity crowdfunding sites like AngelList. They will also open the door for donation-based crowdfunding platforms such as Indiegogo to enter the market as well. So what does this mean for first-time investors? How do you make smart decisions, keep your shirt, and make money?
Here are four things you must know.
1. While the rules are in place, the rest is still unwritten.
When you’re only investing a few thousand dollars, you’re probably not going to be leading transactions. Instead, you will be investing alongside other, larger investors who will be putting their reputations and credibility on the line. That follow-the-leader model has been prevalent on AngelList, where well known angel investors like Brad Feld, the Winklevoss Twins, and Barbara Corcoran, have formed syndicates that allow individuals to invest in companies they back. Such syndicates have invested over $160 million in approximately 400 startups to date. Although the SEC is overseeing the liberalization of crowdfunding, that doesn’t mean that there won’t be some spectacular failures and even some fraudsters, especially in the next few years. Put simply, mistakes will be made. Until the dust settles, you’ll be well served to sit on the sidelines for a bit and observe which crowdfunding sites attract the most credible companies and investors.
Related: How Chickpea Pasta Led One Part-Time Entrepreneur to Leave Wall Street
2. Don’t be a wildebeest.
If you’ve ever seen the migration of the wildebeest in the Serengeti, it serves as the ultimate lesson in followership. By the hundreds of thousands, wildebeest trail one another across the desert, packed together so closely that there is no space between the tail of one animal and the horns of the next. This behavior serves a very specific purposes: moving as a group makes it difficult for predators to hunt more than a few members at a time.
When it comes to investing, don’t be a wildebeest. Following blindly and hiding in the swarm cannot save you from making bad investments –– it only ensures that you will lose your money along with a bunch of other people. Just because you respect an investor or think a syndicate has a lot of promise doesn’t mean that you should follow someone else blindly. If you lose your money, they’re not going to send it back to you.
3. Remember that this isn’t ‘remote control’ investing
When you’re making investments, you are not simply going to go with the flow or accept things as they seem on the surface. You must do your own homework, understand why the company and the team are poised for success, and then only commit to ventures that pass these criteria. If you wanted to invest your money passively – i.e. follow the “set it and forget it” model, then stick to the stock market.
When you’re deciding whether to invest, make sure to conduct due diligence. This includes reaching out to other investors and to the company itself. Ask questions and don’t rest until you get the answers you’re looking for. If the company or the other investors ignore you before you even commit any capital, you can rest assured that they will ignore you once they have your money in hand. You can view the process of evaluating a company as a test run for a future relationship. It’s like dating — if you cannot get along when there is nothing on the line, what will happen later on when you’re in a committed relationship?
4. Only invest as much as you can afford to lose
Finally, never forget that early stage investments are risky in nature. You may lose everything or you may make a lot of money. In fact, you’ll probably do some of each within your portfolio. By keeping your investments to a prudent percentage of your net worth, you can create pathways to upside while making sure not to put all of your net worth into high risk ventures. In fact, according to the Angel Capital Association, the average angel investor in the United States allocates approximately 10% of their net worth to startups.
By taking calculated risks and treading cautiously, you can approach equity crowdfunding in a way that minimizes risk and aligns you with the most reputable companies and investors in the space. That doesn’t guarantee immediate success, but it does ensure that you can begin building a portfolio of early stage investments that can, over time, generate real upside while teaching you how to make smart angel investments. Just remember to think for yourself so that your successes, and your failures, will be your own.