Even though investing in a company might result in sizable returns, there are risks involved. There are no assurances that a start-up will succeed, and if it doesn't, investors could lose everything.

There are a number of important questions that investors should address before making an angel investment, joining a venture capital firm, or using a crowdfunding platform to invest in a start-up.

Important

So, your cousin or an ex-roommate from college has approached you to invest in their start-up business, which on paper actually seems promising.

Know the significant level of risk an early-stage (angel) investment entails before investing.

Make sure to conduct thorough research. You could need to have a more active position in the new company, depending on the investment.

Consider the anticipated timeline, return on investment, and method of final payment as well.

1How Much Engagement Is Required?

The type of investment directly affects the level of commitment that comes with funding a start-up. One would have little contact with the team running the start-up, for instance, if they invested in a start-up through a venture capital firm. On the other hand, an angel investor is considering a very different scenario.

When an investor makes an angel investment, they are given an equity position in the business, giving them the chance to make decisions alongside the start-up's management.

As opposed to an angel investor, a crowdfunding campaign investor for a start-up would likewise earn an equity portion but wouldn't have the same level of control.

Finally, when giving money to a business, it's critical to be clear about how much or how little engagement you'd like.

2How long will it take?

There are hundreds or even thousands of start-ups that take years to turn a profit for every overnight success story. Although investing is a long-term endeavour, it helps to have a rough sense of the time frame so that you may compare it to your own expectations.

While some investors might not mind waiting ten years for a return, others might prefer to see their money back in only five. It may be simpler to estimate the investment horizon by looking at the start-up's track record. The burn rate is one indicator of a company's potential.

Simply put, this represents the monthly expenditure of money. Even though a firm is still in its early stages, a particularly high burn rate could indicate that investors would have to wait longer to get paid.

3What is the anticipated return rate?

Angel and venture capital investments are frequently motivated by a desire to see entrepreneurs succeed, but there is also the potential for financial gain.

Investors who are interested in maximizing profits must evaluate the possible return on investment (ROI) connected with a specific business. Returns again depend on the kind of investment made.

It is customary for an angel investor to expect an annual return in the 30%–40% range. On the other hand, venture capitalists take on more risk, which results in a greater expected rate of return. Equity crowdfunding is a similarly risky investing method, and since it is still in its infancy, determining an average rate of return is challenging.

Be careful not to forget about any fees or costs related to the investment when forecasting returns. For instance, a venture capital investment can be subject to annual management fees. Investors must pay a fee to use crowdfunding sites' services. The more costs incurred by a certain investment, the more the profits are reduced.

4How Does Diversification Affect the Investment?

The baseline of any sound investing portfolio is diversification, and the main objective is to reduce risk without reducing profits. Investors should be aware of how a start-up investment may impact their overall asset mix and risk tolerance before making a decision. But it can be difficult to strike the right balance.

With stocks, it is simpler to spread the risk out because there are distinct divides across asset classes. Start-ups need to think differently because they are essentially hit-or-miss businesses.

Generally speaking, the likelihood of reaching target returns increases with the number of start-ups an investor invests in. Spreading investment funds too thin, though, might backfire if there isn't a standout performer.

5Does the exit plan make sense?

Any investment must have a clear exit strategy in place, but start-ups require it more than any other type of business. Investors should be aware of the exact time and procedure by which they can withdraw their initial investment and any associated profits.

An angel investor, for instance, would want to know when they would be able to sell their stock shares. Once more, this is why it's important to be aware of the time range involved in order to ensure that you can leave at a time that seems comfortable to you.

Conclusion

Although investing in start-ups is a great way for investors to diversify their holdings and support the success of entrepreneurs, it is not risk-free.

Even if a corporation has confident cash flow estimates, what seems excellent on paper might not hold true in practice. Investors cannot afford to skimp on conducting their due diligence when looking at start-up investments.