Nov. 11, 2013 — -- intro: With all the headlines about Twitter's successful IPO, you may have wondered just how early-stage startup companies get funded and whether it's something the average investor can get in on or even consider.
Today, new options other than traditional angel and venture capital outfits have become available including online venture capital and equity crowdfunding. But what is the difference between these and why should you care? The fact is that you may now, or very soon, be able to invest in some of these startups online.
Investing in early-stage companies involves substantial risks and many early-stage investments will be unsuccessful. However, the startup investments that do succeed can sometimes yield outstandingly high returns. Tech giants such as Google, Hewlett-Packard, Apple and Facebook all began as startups. Will tomorrow's tech poster child have been first made available to investors online long before its IPO? That is a question on much of the investing community's mind.
Because of the high risk, startup investment opportunities, by law, have only been open to "accredited investors" -- wealthy individuals with a minimum liquid net worth of at least $1 million -- excluding the value of their primary residence -- or an annual income of $200,000 (or $300,000 together with a spouse).
The Securities and Exchange Commission has been reviewing these laws and recently issued some guidelines on Title III of the JOBS Act to allow startups and small businesses to raise as much as $1 million a year from anyone, rather than the pool of wealthy investors who previously were eligible. This is what is referred to as "equity crowdfunding." The SEC guidelines are not final yet and are open for public comment until early 2014, when another SEC vote is required for this proposal to get fully implemented.
To be very clear: true "equity crowdfunding" is not presently legal or available to investors or startups. In addition, there are many industry watchers who have concluded that even once put into effect, the SEC rules will be so onerous that they will prevent all but the most desperate companies from engaging in equity crowdfunding, creating an adverse selection problem. It is unclear if mounting pressure from the tech community will change this, as the SEC must also contend with consumer protection groups and other interest groups and strike a potentially impossible balancing act with the rules.
Here's a breakdown of the three main types of funding available to startups:
quicklist:title: Angel and Venture Capital text:
Traditionally, angel investors typically first fund startups. They are affluent individuals providing initial "seed" capital. Often times these individuals are family, friends, and friends of friends who are investing more in the founding team and vision than an existing business. If the startup is doing well, and is open for further investment, venture capital firms often enter next. Both VC firms and angel investors typically try to add value beyond their capital, such as through introductions and strategic advice.
Venture capital firms typically invest after the seed round to provide larger amounts of growth capital in what is also referred to as "Series A round." Some VC firms will also invest at the seed stage, side-by-side with angel investors. They are likely to make additional investments if the company is growing rapidly. This is known as "doubling-down on the winners" and takes place through subsequent financings, termed simply Series B, Series C, Series D, etc.
Companies like Twitter, for example, raised a Series G before going public earlier this year. A venture capital firm makes money by owning equity in the companies it invests in, which usually have a novel technology. When a venture capitalist invests in a startup, the expectation is that the company is going to build at least a $1 billion business, very quickly. Hence, the "high-risk, high-return" premise, which also means you may get no return at all. Although shooting for such "home runs" or "unicorns" is the norm in the industry, there are some VCs who believe they do not need $1 billion exits to succeed, by altering their investing strategy.
Most VC funds have not performed especially well. Becoming an investor in a top-performing VC fund is typically very hard. The best performing VC funds are often closed to all but the inner circle of the managers of the fund, including individual insiders, and large pension, endowment, family office, and other funds. The phrase "wealth begets wealth" comes to mind.
In Photos: Meet Twitter's Biggest IPO Winners
quicklist:title: Online Venture Capital text:
In March 2013, online accredited investment was born, after the SEC acknowledged FundersClub as the first online venture capital platform. This model allows accredited investors to browse deals that are pre-vetted online. Before companies are listed, they are studied to determine if they are worthy of investment.
Beyond consolidating capital from a large number of people into a convenient format for startups, online venture capital platforms like FundersClub seek to loop together a network of influential, experienced, and affluent professionals to provide added value beyond capital such as introductions for new hires, customers, and partnerships.
The difference between a traditional venture capital firm, and an online venture platform like FundersClub, is that investors get more exposure to pre-vetted opportunities that, in the past, were only presented to a select group of wealthy insiders -- mostly based in Silicon Valley, Boston or New York -- often behind closed doors. Other online startup investment platforms for accredited investors have emerged in recent years, including AngelList, Microventures, WeFunder, and Circleup, although the quality of available startups and the amount of value provided varies by platform.
quicklist:title: Equity Crowdfundingtext:
Equity crowdfunding is different from traditional angel and venture capital investing. It has become popular these days in the news, and it probably has the potential to move the needle for small and medium businesses more than for high-growth, high-risk technology startups.
This is how it works: A company can raise money from the "crowd" by using an online platform. Entrepreneurs can use the Internet to reach thousands--sometimes millions--of potential funders that each contribute a small amount. People who invest in an opportunity (deal), do it in exchange for equity. This means that money is exchanged for a share of the business, project or venture.
The sector is not without its challenges. Companies that are listed on online crowdfunding platforms are responsible for determining whether they are ready for investment. In many cases, no one is assessing whether these companies are worthy of investment. If you don't have proper financial advice, you may face a higher risk of losing your investment. Industry pioneers are in discussion with regulators in an attempt to find a balance between protecting investors--many startup businesses flop early on--while allowing for the creativity and freedom needed to make ventures a success.
Read More: 8 Disappointing IPOs
Online investment tools will become more ubiquitous over time, and the laws may change. Whether you are an accredited investor or not, it is important that you know how the startup funding system works. By informing yourself about the risks and rewards of startup investing, you can make educated decisions about what opportunities you wish to participate in.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
Alex Mittal is CEO and co-founder of FundersClub, the world's first online venture capital platform. An alumni of Y Combinator, he is also an advisor to First Round Capital's Dorm Room Fund and a columnist for Inc.com. Prior to FundersClub, Alex was the founding CEO of Innova Dynamics, a VC-backed touchscreen hardware company; and the founding CTO of Crederity, a VC-backed identity and credential verification enterprise software company. He also blogs on startups and startup investing at www.mittal.vc.