What to Consider When Investing in a Tech Start-Up

Author: Dennis Grady, Jr.

The technology industry has come a long way from the dot-com era of the mid-1990s to early 2000s. Since Silicon Valley’s rise to fame, research parks, technology centers, universities and incubators across the country have emulated its success — becoming breeding grounds for highly sophisticated start-ups and game-changing innovations across industries.

The potential for exponential returns makes technology starts-ups an attractive option for investors. But while these entities share some similarities with traditional small businesses, they also come with a unique set of circumstances. Long lead time to see profits (if they ever come), a life cycle flush with active fundraising, and special considerations for entity structure and the ultimate exit are just a few of the challenges to overcome.

Below is Tax Partner Dennis Grady’s interview with Taxonomics magazine discussing the issues investors should evaluate before taking the tech plunge.

Taxonomics: What are some of the significant differences between a traditional small business and a technology start-up?

Grady: From idea to launch to sale, they are two very different worlds. Before a tech start-up even secures funding to get off the ground, owners must have their eye on an exit event somewhere in the future. That changes much of the strategy and planning from the outset, starting with how the entity is structured. Then there is the funding. While a traditional small business often begins with either a loan, a grant or seed money from family or close friends, a technology start-up seeks funding from either angel investors or venture capital (VC) firms. Angels and VCs tend to take a much more active role in their investments. The funding source corresponds to the biggest difference — technology start-ups are expected to grow revenue at an accelerated rate, often at the expense of profitability. This growth is needed to support the company valuation and meet angel/VC expectations for a high return on their investment. To fuel this growth rate tech companies may go through multiple rounds of financing.

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