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Startup Investing: The Risks and Rewards

Angela Mae
Angela Mae
January 16th, 2023
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Startup investing is when an investor puts forth capital in a startup company and receives a certain amount of equity in return. When an investor does this, they’re essentially gaining partial ownership of the startup, as well as the right to a portion of the company’s (potential) future profits.

Investing in a startup can be highly rewarding, but it can also be risky. Successful startups can lead to real innovation and extraordinary financial gains, but they have a higher rate of failure than more established businesses.

Still, if you’re an investor with a higher-than-usual risk tolerance and the desire to diversify your portfolio, investing in a startup could be a good choice. Many different types of startup investing opportunities exist, including crowdfunding (ex. equity crowdfunding), angel investing, venture capital investment, and corporate investing.

Whether you’re looking for passive investments with passive income or more active ones, you’re bound to find an opportunity that matches your interests and can help you achieve financial independence.

Investing: Startups vs. Mature Company

Startups are new companies in the early stages of growth and operations that are working to release a service or product into the world. These companies are usually founded by either a small team or a lone entrepreneur.

Many startups have high initial costs and limited revenue, which is why they need investors to help get them off the ground. Nearly 400,000 small businesses are launched each year. As startups become more prominent, they also become a potentially lucrative opportunity for active investors.

Unlike startups, mature companies are more established in their industry and tend to be self-sufficient (capable of supporting themselves without outside investors). They’ve already gone through the early developmental stages and have already reached their customer segment with their service or product. They’re also usually better equipped at handling business-related challenges.

No matter how established it is, investing in any type of business comes with some level of risk and reward. If you’re debating between investing in a startup or mature company, here’s what you should know:

  • Selling Stocks: It can be tricky to sell shares in a startup, especially since not all startups let investors sell stocks before going public. With a mature company that’s already in the public market, investors can often sell stocks at any point.
  • Returns: Investing in a private, early-stage startup could be more lucrative for investors than investing in a publicly traded or mature company. However, startups are more volatile, so the returns can fluctuate wildly. If the startup fails to launch, the investor could lose their investment. Mature companies have a lower chance of failure, even if the market declines.
  • Timelines: Startups tend to be less structured and experience a lot of growth, whereas mature companies are more stable. When you invest in a startup, you may have to wait 5 to 7 years to see a return — if not longer. With a mature company, it typically takes a few weeks or months to see a return on investment.

Although startup investing can be high-risk, it can also be high-reward.

Take Chris Dixon, a successful American investor and general partner with venture capital company, Andreessen Horowitz. Prior to making his big exit from startup investing in 2012, Dixon had already made over 50 highly lucrative personal investments in startups like Pinterest, Kickstarter, and Stripe.

Since joining Andreessen Horowitz, Dixon has become one of the world’s most successful venture capitalists. In 2022, he was named “the world’s top crypto investor” by Fortune magazine. He also made Forbes’ Midas List of top venture investors.

Startup Investing: Different Ways to Invest

Ready to invest in a startup but not sure where to start? Here are the most common ways to invest, as well as the risk involved with each. You can choose one or more options, depending on your goals and risk tolerance.

Venture Capital Investing

Venture capital (VC) is a form of private equity investing investors give to startups and early-stage businesses with long-term growth potential. Many venture capitalists invest in companies that are ready to bring their product or service to the market but are lacking the necessary funds.

Usually, venture capital firms and individual investors diversify their investments in different startups to reduce overall risk. Since the company is typically past the ideation stage and is ready to roll-out its service or product, this type of investment may also be lower risk.

This is an active form of investing with a chance of high returns. But as with any startup, there is no guarantee that the venture will be successful.

Convertible Loan Agreement (CLA) Investing

A CLA is a short-term loan that can either be converted into equity shares (with interest) or repaid (also with interest) when it matures. This can be a more passive investment option for investors. For startups and other small businesses, a CLA is a fast source of funding that acts as a bridge between funding rounds.

CLA investing tends to be lower in risk and requires less documentation. Most CLAs come with a conversion discount of around 20%, which is applied to the company’s valuation. For investors, this could mean gaining more equity than with another type of investment since the discount could reduce the cost of each share.

Investing in a CLA tends to be high-risk, high-reward. If a startup is acquired before the loan’s maturity date, or if they don’t raise any additional equity funding, investors may not see the returns they anticipated.

Share Purchase Agreement (SPA)

A share purchase agreement, or stock purchase agreement, is a legal contract between the investor and company. These contracts typically have various provisions that can protect the investor.

For example, the SPA may outline certain terms such as the number of shares available and their value. The contract may also specific what rights, if any, the investor has in the company’s decision-making process. Because of this, SPAs can be considered either an active or passive investment.

SPAs are often complicated, but they’re also safer for risk-adverse investors. They do require a higher amount of money to be invested, however.

Simple Agreement for Future Equity (SAFE)

A SAFE is a contract between a company and an investor that indicates that an investor will gain an unspecified amount of equity once the company reaches certain milestones. These contracts don’t specify the shares’ exact value at the time of investment — this gets determined at a later date, usually with consideration of the business’ valuation cap.

SAFEs tend to be safer for the business than the investor. In fact, if the company doesn’t make it to the next round of investing, the investor could receive no return on investment. Most SAFEs are more passive than active.

Crowdfunding

Crowdfunding involves raising capital through a large number of sources, often online, rather than one or two. As an investor, you could invest a small amount of cash and potentially see a much higher return. This helps reduce the overall risk since the amount invested, even if lost, isn’t high.

It can still take several years to see a return on investment and, even then, it could be small. Other risks associated with crowdfunding include the startup failing or fraud.

Still, if you’re looking for an active investment with minimal risk, crowdfunding could be a good option.

Angel Investing

An angel investor is someone with a high net worth who uses their own money to back a startup or aspiring business venture. They can invest nearly any amount (ex. $10,000, $100,000, $250,000, etc.).

Most angel investors are involved in the seed round of funding, the period in which an entrepreneur has an idea but hasn’t gotten it off the ground yet. This type of investment is risky since the business could easily fail before it ever gets truly launched. Done right, however, angel investors could see a ROI that’s several times higher than their original investment.

Corporate Investing

Corporate investing is when a well-established company uses venture capital to invest in a smaller business or startup they believe will succeed. These are fairly strategic and active investments that have minimal individual risk but could be high-reward.

Direct Investing

A direct investment, or foreign direct investment, is done by a company that wants to have a controlling interest in a small business. Rather than buying shares of the business’ stock, this involves providing capital funding in exchange for equity interest.

Foreign direct investing can be expensive, risky, or even non-viable for many investors. This is because foreign companies are often subject to things like political upheaval and a drop in foreign exchange rates. However, it could also contribute to the country’s economic growth and development.

Risk and Reward Equation: How to Manage It

To recap, here are the main rewards of startup investing:

  • Potentially high return on investment, especially compared to public investing
  • Portfolio diversification to include high-risk, high-reward assets
  • Ability to help companies with big ideas you believe in succeed
  • Investing early in a startup that eventually goes public could mean long-term profitability
  • Opportunity to connect with community members, entrepreneurs, and other investors in the industry
  • Many types of investment opportunities for all types of investors

And here are the biggest risks:

  • Startups are often volatile and have a high failure rate (around 90% of startups fail) compared to more stable options like government bonds or mature companies
  • Could take years to see a solid return on investment
  • May result in a total loss of capital (not ideal for more cautious investors)
  • May be difficult to sell securities since startups are privately held and not publicly traded (no secondary market)
  • Certain security instruments, such as preferred or common equity, have inherent risks
  • Smaller investors typically have few rights and can’t influence the business’ direction like major security holders

Before investing in a startup, conduct due diligence first. This means carefully evaluating the company to minimize risk and maximize reward or success. It involves asking questions about the business and any regulatory, legal, or compliance issues.

Here are some questions to ask:

  • What is the company’s business plan (and is it viable in the long-term)?
  • What are the financial predictions for the company’s future growth (ex. projected revenue)?
  • What’s the founder like and are they prepared to weather any challenges or growing pains? (A good founder should be agile and willing to change the company’s direction to ensure success)
  • Is there a timing risk in the market? How might the market be in five, 10, or even 15 years?
  • Does the company have any plans to go public with an IPO (initial public offering)? If so, what’s the return on investment looking like?

The rewards of successful startup investment can outweigh the risks. Take some time to evaluate any opportunities that come your way so you can make an informed decision and cut unnecessary losses.

Conclusion

Startup investing can be a great way to build passive income, diversify your portfolio, and get involved in an idea you believe in. Whether you choose more active (ex. venture capital) or passive investments (ex. CLAs, SAFEs), you have many options. Investing in new ventures can be risky, so be sure to do your research to try to minimize risk and maximize reward.

Even if you have an eye for solid investment opportunities, tracking private investments can be challenging. If you’re looking for some guidance or ways to save time while building wealth, Vyzer can help with both private and public company investments.