Which Benefits and Risks Come with Investing in Start-ups?
If and when the investments do pay off, investing in fledgling companies can be a very gratifying endeavour. The risk of losing one's entire investment is very serious because the majority of new businesses or products simply do not succeed. However, those who succeed might generate extremely substantial returns on investment.
It takes a strong person to invest in start-ups. Money from founders, friends, and family (FF&F) can be easily spent without yielding much in return. While investing in venture capital funds diversifies certain risks, it also forces investors to accept the sobering fact that 90% of funded companies will never go public (IPO).
When a company goes public, early investors can become extremely wealthy because the returns can be in the hundreds of percent range.
Every stage that a start-up goes through presents different opportunities and risks for investors.
Important notes
Start-up businesses are still in the concept stage and lack a functioning product, client base, or revenue source.
90% of new companies that receive funding will not eventually go public (IPO).
Investing in young firms is an extremely hazardous endeavour, but if the bets do pay off, it can be quite lucrative.
1Start-up's Initial Stage
Every start-up has an initial concept. They don't yet have a functioning product, a customer base, or a source of income in this initial phase. These new businesses can be funded by issuing equity shares, borrowing money from banks, or using the founders' personal savings.
When most people consider what it means to invest in companies, they typically picture giving seed money in exchange for an equity stake.
More than a million new enterprises are reportedly founded each year around the globe. These businesses typically receive their initial funding from founders, friends, and family (FF&F), also referred to as seed money or start-up capital.
These are often small sums that enable an entrepreneur to demonstrate that a concept has a good probability of being successful.
The first staff may be employed during the seed phase, and prototypes may be created to present the company's concept to potential clients or future investors.
The funds invested are put to use for things like conducting market research.
2Start-up's second stage
When a new business begins operations and generates its first revenues, it has progressed from seed to legitimate start-up status.
Entrepreneurs may now present their business proposals to angel investors. An angel investor is typically a wealthy private individual with prior experience investing in start-up businesses.
An angel investor is typically the initial funding source outside of FF&F funds. The size of angel investments is typically modest, but angel investors stand to benefit significantly because the company's future prospects are now the most uncertain.
Initial marketing initiatives are supported by angel funding, and prototypes are put into production.
3Start-up's third stage
By this time, the founders will have created a strong business plan that specifies the organization's future plans and strategies. Even though the business isn't yet making any net profits, it is growing and investing any profits back into the business to support expansion.
Venture capital steps in at this point.
A person, private partnership, or pooled investment fund that wants to invest in and play a significant role in promising new enterprises that have advanced through the seed and angel phases is referred to as a "venture capitalist." Venture investors frequently serve as the company's advisors and are given board seats.
As the company continues to deplete its financial reserves in order to attain the exponential growth anticipated by VC investors, further rounds of venture capital may be sought.
If You Don't Know Anyone
You probably won't be able to join in the very beginning of an exciting new start-up unless you are a founder, a member of their family, or a close friend. And it's possible that you won't be able to participate as an angel investor unless you're a wealthy accredited investor.
Investing in private equity funds that focus on venture capital funding today enables private investors to indirectly invest in businesses while participating to some extent in the venture capital phase.
Funds for private equity
To diversify their risk exposure to any one company, private equity funds invest in a wide number of prospective start-ups.
According to current study, 90% of all invested companies won't survive through the 10-year mark, and a venture fund portfolio's failure rate ranges from 40% to 50% in a given year.
Industry expectations state that only one in ten venture capital investments will be profitable. The 10% of businesses that succeed can give investors returns in the thousands of percent.
The typical framework for venture transactions is ten years until exit. The best exit route is for the business to IPO, or go public, which can produce the astronomical returns expected from taking on such a risk. Other less ideal exit methods include getting bought out by another business or continuing as a profitable, private operation.
Due Diligence
A start-up's business plan and model for future growth and profitability are both subject to a thorough evaluation as part of the due diligence process. The idea must yield real-world returns according to its economics.
A lot of fresh concepts run the danger of not being adopted by the market because they are so cutting edge. Other crucial factors to take into account are fierce competition or high entrance barriers. For fresh concepts, it's crucial to take legal, regulatory, and compliance considerations into account.
The Founder's Function
Numerous angel and venture capital investors claim that the company founders' motivation and character are just as crucial as—if not more so than—the actual business concept.
The ability to persevere through times of setbacks and disappointment requires that founders possess the knowledge, passion, and talent necessary.
They must also be receptive to suggestions and helpful criticism from both inside and outside the company.
They must be flexible and nimble enough to shift the company's course in response to unforeseen technical or economic developments.
Greater Questions
If the business succeeds, are there any temporal risks that need to be considered? Will an IPO be welcomed by the financial markets in five or ten years? Will the business have developed sufficiently to carry out a successful IPO and deliver a respectable return on investment?
Big Rewards, Big Risks
Alphabet Inc., commonly known as Google, is a shining illustration of a successful start-up tale.
The search engine giant received $1 million in early funding from FF&F in 1997 to establish itself as a start-up. The business, which was expanding quickly, acquired $25 million in venture capital funding in 1999, with two VC companies acquiring roughly 10% of the business each.
In August 2004, Google raised over $1.2 billion through its initial public offering (IPO), giving its investors an almost 1,700% return.
In a nutshell,
The enormous level of risk that new businesses entail leads to this high return potential. In addition to the fact that 90% of venture capital investments fail, there are other special risk considerations that must be taken into account when thinking about a fresh investment in a business.
