If you’ve ever considered investing in startups, then you’ve likely heard or read that startup investments are risky. And with more than 50% of startups failing within the first four years, there’s no doubt that making an investment in a startup is a serious gamble. But what is it about startups that make them such a risky asset class when compared to stocks or bonds?
Primary Areas of Risk
There are a whole host of factors that can contribute to increased risk for startup investments. According to CB Insights, the top reason why startups fail is that there is “no market need” for the product or service. Other top causes include lack of cash, not having the right team, and competition, to name a few. Here is a quick breakdown of the primary risks investors should be aware of.
As with any business, having the right team matters – that includes personnel as well as outside guidance. The team may not have a vision that is scalable or could lack the expertise to execute on business strategy. For very small early-stage ventures, they may lack access to experienced advisors that can provide helpful guidance. If they do have access to professional guidance, some founding teams may not be responsive to their feedback, which is always a red flag.
Tips for Vetting Startup Founders and Leadership Teams
The market is a many-faced beast, and a number of variables can affect a company’s success on the market. There are a few different outside factors to consider here:
- Market demand: Market research aside, there is never a guarantee that there will be consumer demand for a company’s product or service
- Timing: From landing jobs to buying stocks, many successes can be attributed to being at the right place at the right time – the same idea applies to startups
- Market entry: Oftentimes there are high barriers businesses must scale to enter the market, which means a lot rides on the way a company strategizes their market entry
- Size: If there is a market, there is no guarantee that it’s large enough to meet investor expectations
- Competition: Competition for the company may already exist or could arise in the future, potentially affecting the company’s pricing and impacting their bottom line
Of course, for any business venture to succeed, it needs to have its internal ducks in a row, and that goes beyond management:
- Finances: Reaching profitability is no easy task, and if a startup is unable to reach profitability, they could require additional outside funding that they may or may not receive
- Technology: The company’s technology might not advance quickly enough, or even become viable at all
- Legal Challenges: The company could face many legal hurdles, including regulatory or even intellectual property challenges
Additional Outside Factors
In addition to market volatility, the company could be affected by environmental circumstances or political and economic factors, such as access to natural resources, changing tax policies, or government regulations.
What are the Most Important Things New Startup Investors Should Know?
We cannot stress enough that risk is inherent to any startup investment. However, savvy investors can take steps to mitigate risk by conducting thorough due diligence on an investment opportunity and working to diversify their investment portfolio as a whole across multiple asset classes.
Due diligence is essentially an audit of an investment opportunity and should happen before making any investment. The aim of due diligence is to confirm all facts surrounding the potential investment, or anything material to your decision to invest or not. This process should include an analysis of the total value of the company, their revenue, profits and margin trends, competition, the founding team, and more. Specific to startup investments, potential investors should also expect to see an exit strategy.
When aiming to manage risk, diversification is the name of the game. Historically, the average investor might not have the capital or access to opportunities to make the number of unique investments needed to mitigate risk across their portfolio as a whole. Because MicroVentures offers low investment minimums for crowdfunding opportunities, investors are now able to make many small investments across multiple opportunities, better spreading out risk across your startup portfolio. The amount of your portfolio that you allocate toward startup investments depends on your personal risk tolerance.
Mitigating Risk Through Portfolio Diversification
With any investment, whether it be in a traditional asset like a stock or bond or a startup investment, investors should thoroughly assess the risk involved with the type of investment, security, and business as a whole before making a decision. And as always, if an investment can’t afford to be lost entirely, it shouldn’t be made.