Investing in startups is a risky business. For every Facebook, there are hundreds of Friendsters that have fizzled into obscurity. Thus, before getting into the startup investing scene and becoming an angel investor yourself, it’s important to have a keen understanding of all the risks involved and how you can best mitigate them.
1. STARTUPS HAVE A HIGH FAILURE RATE
New startups have a 50% chance of making it through their first five years. There’s no real science for predicting which ones will survive as there are a lot of uncertainties involved in new businesses, but the top three causes for startup failure are: no market need, running out of cash flow, and not having the right team according to this study on the top 20 reasons startups fail.
Because of the high risk nature of startup investments, you should not invest more than you are comfortable to lose.
There is no sure way to eliminate this risk, however, you should conduct a thorough due diligence of the company, drilling into track records of the founding team, examining if the company can feasibly scale, and investigating the financials. If you have less experience to judge any of these aspects, you should invest with an experienced lead investor who is well versed in the industry of the startup you’re investing in and who can conduct a more thorough due diligence check. In addition, there are many strategies from leading angel investors on how to pick the right startups.
2. STARTUP INVESTMENTS ARE ILLIQUID
Startups may not have the capital to pay dividends until many years later from the time you have made your investment. Thus, the only time you are likely to cash in your investment is when a start-up exits: that is, when it is acquired by another company, or when it goes public. Thus, understanding a startup’s exit strategy is important.
3. STARTUP INVESTMENTS HAVE A LONG TERM HORIZON
Even if your startup investment does survive, it may take a while before you see any returns. A startup investment is by nature a long-term investment since it may take a while for a business to exit.
According to Crunchbase, acquired companies were an average of seven years old. On the other hand, it took around 8.25 years for a startup to IPO.
4. YOUR INVESTMENT WILL BE DILUTED OVER TIME
Each time a company raises funds, it gives up ownership in a company by issuing additional shares. Each time a company issues additional shares, existing investors’ proportional ownership will decrease. This is called dilution. Though your portion of equity may decrease over time, the value of your investment can still increase over time if the company’s valuation increases.