In 2012, the government set the path for smaller investors to invest in small businesses. Most of the reception has been positive, it allows small business to have access to a new investor base and gives those investors the ability to choose whether these investments are worthwhile.
Unfortunately, it has taken a long time for the government to approve and implement the rules. That said, we are now starting to see some movement and it is increasingly becoming possible for companies to raise money directly from ordinary investors. (Learn more here)
Questions to contemplate:
How much do you really know about the business?
It takes a lot more than a good idea to make a profitable business. With most deals, you know a very limited amount about the underlying economics. While you may believe in the idea, you should not underestimate the uncertainty associated with the lack of information.
For it to be worth your while, the company has to grow A LOT
In most cases, these companies are raising hundreds of thousands, if not, millions of dollars. Venture capital firms that traditionally make these types of investments expect to get a 10X return. That is what you should expect when you put the chance of an investment going to zero on the table.
How liquid is this investment?
When you make these deals, you have essentially no control. The company might sell in a couple years, but it could also take 10 years. Even if you get the 10X return, if it takes 10 years to get your money back that will be less than 10% per year, is that really worth it?
Given these uncertainties, the following should be true for you:
You have a passion
Some simply enjoy the idea of investing in something they believe in and want to see come to life. They like following the company and it makes them feel part of a cause bigger than themselves. If this a passion of yours, that is definitely something that should factor into the decision.
Getting nothing back is OK
The general belief is that 1 in 10 of these companies will actually succeed. Assuming that is the case, the safe assumption is that you will never get your money back. For that reason, you cannot count on these returns to fund your future financial objectives. In assessing when you can retire or whether you can purchase a vacation home, you should assume these investments are worth $0.
You can still be diversified
Taking a significant portion of your savings and investing them in a startup is not investing, it is dreaming. These investments have two primary possible outcomes: You make money or you lose all your money. This is not something that can easily be modeled or relied upon for your future financial objectives. As the old saying goes, you should not put all your eggs in one basket. It applies here in spades.