Startup investing comes with a high-risk, yet high-potential-reward. Thus, it is important to understand all the risks related to startup investing.
Investing in startups comes with a lot of risks and there is no way of predicting with 100% certainty whether a startup you invest in will succeed to the point you will get your investment back, along with some interest. The reality is, most startups fail. Yet regardless, people still invest in startups. Why? Because with high-risk, there is a potential for high returns.
People who invest in startups are usually willing to take high-risks and potentially lose all their invested money in the hopes of hitting the jackpot with one startup. Therefore, think about your risk tolerance.
Unless you are willing to lose all the money you invest, you should not invest into startups.
There are different types of risk factors we have divided into three categories to consider before investing…
Loss of investment
The biggest risk to an investor is losing the investment completely. A lot of early stage businesses are at the risk of failing completely or barely surviving with no profits or growth. In such cases, it is highly likely that you might lose your investment completely.
Even if a company does become profitable, it is not a guarantee that you will get all of your initial investment back or get a return on that investment. The returns you could potentially receive might not cover the initial investment and be inconsistent in amount and frequency.
Loss of investment is related to general risks as well as business related risks. General risks can include geographical risks, political risks, legislative risk, and economic risk. Business risks include mainly market demand risk, industry risk, competition risk, growth risk, employee risk, fraud risk, and revenue risk. Keep in mind that the risks listed are only a few of many.
You can never predict with 100% accuracy that the startup you invest in will not fail to return your investment or generate profits. Only invest money you can afford to lose.
Illiquidity of the investment
Another risk you might face as an investor is the illiquidity of the investment. Even if the startup does become successful, it might take years until an exit happens and you see any of your money again.
It takes time and money to grow a profitable business and even once that’s reached, the investors might still not see any returns because the profits are going straight back into the business. Only once a company is mature enough to either start paying dividends to its investors or to have an exit, you will potentially see your money again.
On Funderbeam, investors can sell their shares on the trading platform, which enables their investment to become more liquid, so risk of illiquidity is slightly lower.
Regardless, due to the illiquidity risk, you should never invest money that you know you need to use after a certain period of time.
Risk of dilution
Startups usually have more than one funding round, meaning they are likely to raise more capital later on in the future. During those rounds, depending on the type of investment opportunity, new investors may get a share of the company’s equity. This dilutes the percentage of ownership for current investors because new shares are issued.
The new shares might have some advantages to the new investors like preferential rights to dividends or other matters. This could be a disadvantage to previous investors, who invested into the startup on different, less accommodating terms.
How to minimise the risks?
There are some things an investor can do to minimise the risks of investing in startups. First and foremost, you should try to understand the business you invest in as much as possible. It’s never a good idea to invest in something you don’t understand. Thorough research will help you avoid businesses who don’t seem solid enough and select the ones who look promising.
Another good idea is not to keep all your eggs in the same basket and instead have a diversification strategy. Many startup investors use the portfolio approach.
Instead of investing all the money in one startup, consider investing smaller amounts in many different ones.
This strategy increases the possibilities of success and reduces the risk.
How high is your risk tolerance?
Nothing can guarantee 100% that you will get a return on your investment and not lose all of it. Therefore, before you invest in a startup, think about how much risk you are willing to take. Are you willing to lose all the invested money if the startup fails? If not, there are a lot of less risky investment options out there to consider instead of startup investing.
Have a look at the questions below and see how comfortable you are with the risk you would be taking. If your answers are mostly ‘yes’, then startup investing is worth considering.
The Funderbeam Guide for New Investors
In case you missed the previous chapters in our series and want to know more, check them out here:
- Investing in Startups: 10 Checks Before Your First Deal
- 1) The Problem — Analysing Your First Investment
- 2) The Solution — Does It Solve The Problem And Can We Make Money Doing So?
- 3) The Market — Who Is Going to Buy The Solution?
- 4) The Competition — How Does the Startup Stand Out from the Crowd?
- 5) The Team — Who Are the People Behind the Scenes?
- 6) The Traction —Is the Startup Gaining Momentum?
- 7) The Use of Funds — What Will They Do With Your Money?
- 8) Exit Strategy — How Will You Get Your Money Back?
- More coming soon!
Funderbeam consists of three parts:
- Free data intelligence on investors and startups
- Tools for startups to raise funds and for investors to co-invest
- A marketplace for investors to buy and sell their investments
Our vision is to provide everyone in the world with equal opportunities, whether you are building a company, or looking to fund the next big thing. What if the next Silicon Valley is not a place, but a platform?
LEARN MORE ON FUNDERBEAM.COM, OR WATCH THE VIDEO BELOW: