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Investing in Startups: What You Need to Know and Why You Should Consider It

Post on November 30, 2022 in Blog

If you’ve watched The Social Network, you may remember that billionaire Peter Thiel, a serial entrepreneur and successful venture capitalist, was one of the first outside investors in Facebook. Thiel invested $500,000 in 2004 for a 10.2% stake in Facebook.

When Facebook—since-rebranded as Meta—went public in 2012, Thiel owned 2.5% of the company. Had he not sold the majority of his shares shortly after the initial public offering (IPO), his stake would have been worth billions today. However, his move was hardly a blunder. He sold the majority of his stake for $400 million—800 times his initial investment.

What’s more? Because he made the investment using a self-directed Roth IRA, he’ll never pay taxes on those gains.

But more importantly, you can use this same strategy to invest in startups, and you don’t need a lot of money to get started. (As you’ll find out, Thiel accumulated one of the largest Roth IRAs ever off a single contribution totaling less than $2,000 combined with some very smart investments.)

Here, we’ll be talking about the reasons to invest in startups—plus how investing in startups using an IRA can be a super-savvy way to diversify your portfolio.

Key Takeaways

  • Early investments in startups, while risky, have the potential for oversized returns, add diversification to your portfolio, and can help foster innovation.
  • Companies are waiting longer to go public, making it harder for stock investors to get in on businesses during their early, hyper-growth years.
  • Investing in startups with a self-directed Roth IRA makes it possible to avoid paying any taxes on returns upon eligibility to take qualified distributions.

Why Invest in Startups?

Imagine investing in the next Facebook, Tesla, Uber, or Airbnb—startups that hit it out of the park and are today worth billions. While this may seem inaccessible to all but professional investors, more and more Main Street Americans are dabbling in startup investing, within more limited means.

If you’re able to spot potential and invest early, you could be part of similar startup success stories. Investing in startups is also a great opportunity for you to diversify your investment portfolio while affording you the satisfaction of having helped a business that you believe in.

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Peter Thiel sold the majority of his pre-IPO shares of Facebook for $400 million when now-Meta went public eight years later. Photo by Solen Feyissa on Unsplash.

Nonetheless, you should be aware of the risks before investing. No investment is a guarantee, particularly one in an early-stage company.

According to data from the Bureau of Labor Statistics, nearly 20% of new businesses fail within their first year. The same data demonstrates that almost 50% on average shutter within five years, and close to 70% don’t make it past the 10-year mark. In other words, never invest more than you can afford to lose.

So with so much risk involved, why invest in startups?

If you have the risk appetite, startup investments could be a valuable addition to your portfolio. Here are three reasons to consider investing in startups:

1. The Potential for Outsized Returns

Peter Thiel’s high-return investment in Facebook is just one example of any early investment that paid off. Plenty of other people and funds have made wildly successful investments in pre-IPO businesses.

Investing early comes with the benefit of owning a stake in a company at a low valuation—before its worth potentially skyrockets with continued success.

This is especially significant when you consider that companies are waiting longer to go public. According to The Economist, the average age of a company going public since 2001 is 11 years, compared to just eight years in the 1980s and 90s.

What does that mean for stock market investors? For starters, it’s harder to invest in up-and-coming businesses before their valuations climb, potentially quite dramatically.

Regulatory changes over the past decade have made great strides toward enabling Main Street Americans to invest in private offerings, like private equity and venture capital funds. Play it right, and your early investment in a high-potential startup could bring you multifold returns in years to come, often enough to compensate for failed bets.

2. The Opportunity to Change the World

Startups often take up BHAGs—big, hairy, audacious goals that attempt to tackle major issues impacting humanity and the planet. For example, Xilis, an American biotech company, is exploring artificial intelligence to generate a living model of a patient’s tumor to better determine the optimal treatment or drug to treat that particular cancer.

Startups are also creating futuristic technologies like flying cars, and even attempting to conquer space, the final frontier. Thousands of startups across sectors are trying to shape the world and improve quality of life.

Investing early in a startup you believe in or find fascinating lets you have a front row seat to a potentially world-changing idea and enables you to support and co-create a future you want to see.

3. Portfolio Diversification

Public markets can be extremely volatile, and it’s important to recognize that a variety of stocks does not constitute true portfolio diversification. You don’t need to look far to see this.

Today, as during other market sell-offs, public equities are, for the most part, down across the board. For example, stocks dropped by around 50% between October 2007 and March 2009, meaning that even if some stocks were winners, the losers likely would have brought down your entire stock portfolio.

Investing in startups can help you diversify your portfolio. This strategy can pay off especially well if you are making high-risk, high-reward investments early on in your career, when you are young enough to accrue their financial benefits and more likely to sustain losses, if any.

That being said, anyone can benefit from investing in startups. It is, however, essential that you are well aware of the risks of investing in early-stage businesses and, as such, thoroughly understand the business you’re investing in.

Read more: Why Is It Important to Diversify Your Portfolio?

How to Invest in Startups

Unlike buying stocks or mutual funds, the process for how to invest in startups before IPO may seem a bit mysterious. And for years, it was. You pretty much had to ‘know someone’ or have a lot of money. Fortunately, that’s no longer the case.

Here are four ways you can invest in startups:

1. Venture Capital

Venture capital funds raise money from eligible individuals, called limited partners (LPs). VC funds research industry trends, evaluate companies that align with their sector focus, and finally make investment decisions after conducting due diligence.

Venture capital is a good match for companies that target sizable addressable markets and have the potential to scale quickly. Since venture capital funds invest time and effort in evaluating companies, investing in startups as an LP in a VC fund may be a good option for those looking to be relatively hands-off in the process.

You can even invest in venture capital using a self-directed IRA, like Peter Thiel did.

Alto has partnered with AngelList to provide accredited investors options to invest in rolling funds alongside experienced VCs, managed funds like the AngelList Access Funds, and individually through syndicates if you want to be more hands-on. The minimum buy-in is $1,000.

Read more: What Is an Accredited Investor and How Do I Become One?

2. Personal Angel Investing

If you have your eye on an early-stage startup that you want to invest in—and possess sufficient funds to do so—you could find a way to reach out to them through your personal network and express your interest in being an angel investor. Angels often play a mentorship and advisory role as well, beyond the funds they invest.

Depending on how much you invest and what experience you have to offer, startups may be open to bringing you on board as an angel if you have relevant professional expertise that would contribute to their growth and provide them with industry connections.

3. Angel Networks

If it’s hard to get good deal flow as a solo angel investor, you can consider joining angel investing networks. These are often organized around common interests, like alma mater. Stanford Angels and Entrepreneurs (SAE) is one such example of an alumni angel network.

Startups pitch to angel networks to access several investors under one roof and to raise a larger collective round through the individual contributions of many, without having to manage these individual investors themselves.

Often, angel networks will appoint a deal lead who will be the point of contact with the startup. Angel networks usually enjoy high-quality deal flow. You can consider investing through an angel network if you want to see a variety of interesting startups and also connect with other investors who share your interests.

4. Crowdfunding

Crowdfunding is one of the most accessible ways to invest in startups and is rapidly growing in popularity. In fact, the research firm Technavio estimates that the crowdfunding market will grow by $239.78 billion between 2021 and 2026.

Crowdfunding platforms like RepublicIgnite Social Impact, and InfraShares allow you to dabble in startup investing without committing large sums. In fact, you can invest a portion of your retirement funds in startups with as little as $100 using an Alto IRA.

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Global crowdfunding is expected to grow by $239.78 billion between 2021 and 2026. Photo by Timon Studler on Unsplash.

How to Use Your Retirement Dollars to Invest in Startups

Because Peter Thiel used a Roth IRA to invest in Facebook, he’ll never pay taxes on his investment. That is, as long as he waits until turning 59-½ to begin taking distributions. (Roth IRA holders must also hold their account for at least five years before taking distributions, which he obviously has.)

Still, you might be wondering: How did a billionaire use a Roth IRA? Aren’t there income limits to who can contribute to a Roth IRA?

There are, but there was a catch: Thiel used money already in his account from a previous wildly successful self-directed Roth investment. That investment was in then-startup PayPal, which he funded with a single IRA contribution of less than $2,000 made well before he exceeded the income limits. (He sold his PayPal shares for around $28.5 million after eBay acquired the payments company in 2002.)

Read more: What Is a Backdoor Roth IRA?

With Alto, you too can invest in alternative assets such as startups and other private investments that many conventional retirement accounts don’t provide access to. And you don’t need any special connections.

Investing in startups through a self-directed IRA can help you diversify your portfolio, as well as give you the opportunity to back paradigm-shifting ideas, all the while benefiting from significant long-term tax savings. Especially if you do so using a Roth IRA.

Explore our investment partners to discover your options for investing in startups and other alternative assets using your retirement dollars. You can even fund your Alto account with rollovers from an old 401(k), other IRA, or via a Roth conversion.