Investing in startups: More fun than profit

  @Money April 5, 2013: 6:16 AM ET
entering startup

Investing in startups is exciting, but don't put in more than you can afford to lose.

(Money Magazine)

With Google clocking in at nearly 10 times its IPO price and sky-high valuations ascribed to Twitter and Pinterest, you might be asking, Can I get in on the next game changer?

The answer: Yes, but the odds of scoring a really big payoff are against you.

The risk: The majority of startups don't make it in the long run. "I get calls where someone may have inherited $50,000," says Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire. "I tell them, 'You're not going to find the next Google. Put it in a bank so you don't lose it all.' "

Risk aside, retail investors have limited options to get in early.

Venture capital funds invest in young companies that typically have a track record, but you need a net worth of at least a million dollars and must be able to put up $250,000. And while anyone can back an entrepreneur with a dream, "angel" funds, which diversify their holdings among startups, also restrict themselves to high-net-worthers.

Related: What's next for the Internet

Crowdfunding websites like Kickstarter allow individuals to put as little as $1 into a startup, but the ventures asking for money can't give you a stake now. That will change as a result of last year's JOBS Act, which will allow entrepreneurs to solicit small equity investments from the public. But the Securities and Exchange Commission has yet to set a date for when it will release rules for how crowdfunding sites will work.

Pot entrepreneur's startup takes root

Matt McCall, president of Penn Financial Group, recommends business development companies (BDCs), which buy equity or convertible debt in startups. You may receive interest payments or dividends, or get a future payoff via an initial public stock offering.

You can invest in a collection of BDCs via the UBS E-Tracs Wells Fargo BDC ETN (BDCS), a debt security similar to an exchange-traded fund. It generates returns based on the performance of an index of nearly 30 BDCs.

Related: Kickstarter's top projects

"This is one of the best options available for retail investors to get diversified exposure to startups," McCall says.

The caveats: The fund is new and volatile. It stumbled out of the gate in 2011 but rose 34% last year. "The average investor should limit exposure to 5%," says McCall. "Investors with less than a five-year time horizon should in most situations avoid BDCs."

Related: Cities where startups are thriving

You can also buy an ETF that tracks companies that have recently gone public, such as First Trust US IPO Index (FPX), but you're not getting true startup exposure. For example, GM, which sold new stock after its bankruptcy, is among FPX's top holdings.

Then there are publicly traded private equity firms. Take Hercules Technology (HTGC), which backs tech and health care ventures. Its five-year annualized return of 7.1% whips the S&P 500's 3.9%, but shares collapsed in the financial crisis. Remember: Pros spread their risk. For you, that means devoting no more than a little of your mad money to startups. To top of page

Hard game to win
A small percentage of startups make big money for investors.
How the young bloods do
Fall outright 40%
Pay off modestly 40%
Pay off big 20%
Source: National Venture Capital Association
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