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New horizons: How to invest in a start-up

Savvy investors who've mastered stocks, bonds and real estate may want to try to cash in on the hot start-up market, but experts advise they do so only after careful consideration of its elevated, buyer-beware risks.

There are many ways to invest in promising fledgling companies: buying into a venture capital fund, snapping up shares of pre-IPO firms on the secondary market, purchasing stakes in local chains or mom-and-pop-shops or nabbing publicly traded shares of young companies across the tech, biotech, health-care or food industries, which have yet to establish themselves as solid financial performers over the long term.

Since the enactment of Regulation A last May, in which the Securities and Exchange Commission began allowing companies to sell equity stakes to non-accredited investors with more limited disclosure requirements — even via crowdfunding — just about anyone can play the start-up field. Nearly 80 companies have raised more than $21 million via online crowdfunding alone since then, according to wefunder.com.

Startup
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But before you hit the "invest" button, heed the following.

Assess your risk tolerance and knowledge of the industry. "If you aren't in the industry, you should run the venture past at least five executives who are, and [then] develop a competitive map of the landscape to identify your prospective investment fits in," said Adam Kirsch, a serial entrepreneur (Daily Beta Media, Yorango) and former start-up investor with 1010 Capital and BR Venture Fund.

Determine your risk tolerance, since your investment may be illiquid for a decade or even lost. To get used to this reality, Kirsch recommends making a few smaller investments first so you can get comfortable losing a little.

When we think of tech start-ups, for example, they are usually in a pre-revenue stage, which means it might be a while until they start making money, said Cheree Warrick, owner of the Virginia business consultancy The Profit Partner. When they do, it could be the "big one" and if they never do, it could be the loss of a lifetime. If this idea is hard to stomach, choose to work only with start-ups with revenues, she said.

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"No matter what, remember you're not in the driver's seat, nor should you be. The entrepreneur is," said Kirsch at Daily Beta Media and Yorango.

Consider a "debt" investment. If letting go of your funds for up to a decade is too risky for you, consider offering a start-up a loan instead.

"You can receive 10 [percent] to 15 percent interest on a small private loan to a start-up business that has been around less than two years," said Warrick at The Profit Partner. "Most banks … will not lend to a start-up until they have three years of financials.

"The entrepreneurs have great credit but may be 'unbankable,'" she added. "Private investment can be a great route for them and you."

You can do this through various online crowdfunding platforms, on which the companies set the terms, or have an attorney draft documents for you that include provisions for collections and guarantees.

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Know the company's 'tier.' The SEC recommends you know the tier under which the company is offering a stake. It is required to indicate it on an offering circular, or its primary disclosure document.

This document must be evaluated by state securities regulators as well as the SEC, but those entities don't validate the information in it. In fact, the financial statements in this document don't even have to be audited by a third-party accountant, according to the SEC website.

A company can raise up to $20 million in 12 months under Tier 1 and $50 million under Tier 2. Under Tier 1, companies have little reporting obligations after the initial offering documents, and investors have no limitations on their investments.

Tier 2 firms have ongoing reporting requirements, and non-accredited investors cannot invest more than 10 percent of their household annual income or net worth, excluding the value of their primary residence. (An accredited investor must earn an income of $200,000 or $300,000 with a spouse in the two consecutive prior years or has a net worth of more than $1 million, excluding the value their primary residence.)

"These are high-risk investments. Don't invest a meaningful amount of your net worth. These are discretionary funds you want to think about putting to work." -Mike Norman, co-founder of WeFunder.com

Enlist professionals for due diligence. Individuals, even at a local level, should hire an attorney with securities expertise to iron out legal details and verify the startup's contracts, and that leases and obligations are valid and in place, said Gregory Sichenzia, founding partner of securities law firm Sichenzia Ross Friedman Ference in New York. This attorney should also draft your deal documents. That's because legal mistakes and oversight are more common than one might think.

"These are mom-and-pop operations … focused on the big ideas and not really on the details," Sichenzia said. "They're not making sure that corporate records are in order."

Because of this, you'll also want to look carefully at valuation. "It's arbitrary," Sichenzia said, adding that valuation are "made up" by management teams. "What is it that you're buying, and at what value?"

Kirsch at Daily Beta Media and Yorango also recommends chatting with current and potential customers to get their feel of the company, and understanding all of the industry's components.

Invest in companies and management you believe in. Since it is ultimately up to the company's founders to make it successful, investors should closely examine the management's focus on sales and revenue goals, operations and their personal commitments to their brand, said The Profit Partner's Warrick.

If a company is small and local, you may have an advantage of personally knowing the management, but don't make the mistake of trusting them too much, said Sichenzia at Sichenzia Ross Friedman Ference.

"Those are the worst offenders … the guys you know … because you're not going to ask [important questions] if you're golf friends," he said.

You should also invest in an industry or brand you would gladly endorse anyway. "Pure [return on investment] is not the majority reason investors are looking at these securities," said Mike Norman, co-founder WeFunder.com, which has raised over $13 million for companies in 47 offerings. "It's also an opportunity to buy into a company that I really believe in."

That said, the goal is to make your money back, plus some — as long as you can afford it. "These are high-risk investments," Norman said. "Don't invest a meaningful amount of your net worth.

"These are discretionary funds you want to think about putting to work."

— By Kayleigh Kulp, special to CNBC.com