Investing in startups is risky, but many investors look past the initial risks, hoping to see a massive windfall when the company makes it big.
You’ve probably read the stories of investors in tech giants like Facebook and Google and how they made millions because of their early backing. While stories like this are great to read, there are also considerable downsides to investing in startups.
Typically, high-net-worth individuals called angel investors provide financial backing for a startup in its early stages (with their own money). They can see massive returns on their investment in a few years or lose it all due to multiple unforeseen circumstances.
Let’s explore both sides of the issue so you can decide for yourself if you want to invest in startups.
The Rewards
First, let’s look at the bright side:
Big Payoffs
Investing in a startup can lead to massive payoffs. In most cases, startup investors get equity in return for their capital. They get a portion of ownership in the company.
If the company makes a profit, the investors make their money back. If the company soars past expectations and makes a big impact on its industry, investors can make millions, or sometimes even billions.
Facebook’s first external investor, Peter Thiel, is a great example. He invested $500,000 in the company in 2004. After Facebook’s IPO in 2012, Thiel cashed out for over a billion dollars.
Of course, not every investment will yield amazing results like this. Nonetheless, even a reasonably successful investment can bring in enough profit to make up for past failed investments.
Minimal Funding Required
Startups are generally a higher-risk investment, but they entail a lower risk when compared to acquiring an established business. This is ideal for beginner investors who don’t want to risk significant amounts of money.
In its early stages, a startup’s budget is generally lower, so the company wouldn’t require as large an investment as larger businesses. And smaller investments could also lead to good returns.
Larger investments have increased liability and responsibility, which could be too much for first-time investors.
Support Entrepreneurs and Create Jobs
By supporting startups and the entrepreneurs behind them, you can help boost the local economy and decrease unemployment rates. If you want moral or emotional rewards for your investment, startups are the place to go.
Seeing your investment help a struggling 2 or 3-person company grow into one that hires 20+ people can boost your confidence as an investor, and it’s an excellent addition to your investment portfolio.
Plenty of Investment Opportunities
The vast majority of businesses in most cities are startups or small to medium-sized businesses (SMBs). This means investors have a larger pool of possible investments. You can create a portfolio that’s as linear or diverse as you’d like.
These investments help you gain steady returns from multiple sources in the future. Startup investing is also better if you want equity or liquidity, as larger businesses often offer only shares to new investors.
In general, experts advise investing a small portion of your net worth into 10-15 different companies. So even if some fail and some succeed, you break even. If all fail, you still have enough to land on your feet.
Networking
Investing in startups allows you to meet founders, entrepreneurs, other investors, and members of that particular industry. Networking is crucial for any investor. A trusted network can lead you to lucrative future investments or warn you away from poor ones.
This support system can be a critical backbone for most investors, especially those just starting out. You can also enhance your support network and find other investors using free tools like an email finder.
Networking could also lead to attractive deals on future investments.
The Risks
If you’re about to jump into startup investment immediately, hold your horses! Consider the downsides first:
Unpredictable Future
The biggest risk of investing in a startup is that most startups can fail for various unpredictable reasons. There’s a high chance that you’d never make your money back.
CBInsights did a post-mortem analysis of 111 failed startups since 2018 and published this list of common reasons why startups failed in 2021:
Remember that the market for any new company, especially ones that are “trailblazers,” can change at any time, and your investment could amount to nothing.
Investors must always invest only what they’re ready to lose, especially when it comes to startups.
For the more risk-averse investor, there are investment opportunities that are somewhat more predictable. While the returns on more traditional investments, like stocks, might not be as dramatic, they can be considerably less risky. Learn more about building a solid return with stock trading by reading newsletters like the Capitalist Exploits Review.
Investments Being Locked in
In angel investing, your investment is locked in for years and years before you get a payout (if the company succeeds, that is). It could take 10+ years for the startup to go public or for the founders to decide to sell the business. You get your payout only when this happens. There is no guarantee that the startup will make it to this stage.
So, your startup investments need to be planned in advance, and you need to have tons of patience to see them through.
Fraud or Malpractice
If a startup business uses fraudulent practices and gets caught, you could lose your investment. The same applies to malpractice, misconduct, and generally poor workplace practices.
Startup investors need to be on the lookout for signs that indicate impending failure. This includes poor backing records despite the company’s “success stories” and constant user complaints on unregulated sites like social media channels. If other investors are pulling out or customers are unhappy, that company is likely going under.
Security Risks
A security is any financial item that holds value. This could be stock, real estate, or gold. Every security has a risk to it. Some investments like corporate bonds or preferred stocks are low-risk, meaning there’s a lower chance of losing your initial investment.
On the other hand, private company investments are high-risk. Many factors could negatively impact your security. Market fluctuation is a typical example. Mergers and acquisitions will also reduce the value of your investment.
Liquidity Risks
Liquidity is a term used to describe how easy it is to convert a security into actual money. For example, equity in a well-traded company like Google is easy to liquidate. You can easily trade it on the stock exchange.
However, equity in startups is harder to liquidate. So, if you’ve invested in a startup and it fails or looks like it’s about to, you can’t quickly sell your equity and recoup all or some of your investment.
Final Thoughts: Don’t Rush Your Investments
Investors are often successful entrepreneurs themselves. Given this, it might be tempting to jump into startup investing and try to make the most of your money. While we don’t discourage this, it’s vital that you do your research on startups and their industry before you invest in them. Without this research, there’s a high chance that your investment will be fruitless, and you will lose a significant amount of money with nothing to show for it.