The Risks and Rewards of Investing in Startups

Investing in startup companies is a risky business. The majority of new companies, products, and ideas simply do not make it, so the risk of losing one's entire investment is a real possibility. The ones that do make it, however, can produce very high returns on investment.

Investors in ventures that start out with founders, friends, and family (FF&F) money can easily end up with nothing to show for it. Investing in venture capital funds diversifies some of the risks but the harsh reality is that 80% or 90% of companies funded by venture capital will not make it to the initial public offering (IPO) stage.

One rule of thumb states that for every 10 startups, three or four fail, three or four return their original investment, and one or two succeed. For those that do go public, the returns can be in the thousands of percent, making early investors very wealthy indeed.

A startup goes through a number of stages, and each one of them offers distinct opportunities and risks for investors.

Stage 1 of a Startup

Every startup begins with an idea. In this first phase, the founders do not yet have a working product, a customer base, or a revenue stream. The death valley curve describes this period in the life of a startup in which it has begun operations but has not yet generated revenue. These new companies can fund themselves by using founders' savings, obtaining bank loans, or issuing equity shares.

Handing over seed money in return for an equity stake is what comes to mind for most people when thinking about what it means to invest in startups.

In the U.S. alone, 469,557 businesses were formed in the 12 months that ended in July 2023, according to the U.S. Census Bureau. That number is based on the number of applications to the IRS for Employer Identification Numbers.

Most of those businesses got off the ground with seed money from founders, friends, and family (FF&F). The sums are generally small and allow an entrepreneur to prove that an idea has a good chance of succeeding.

During the seed phase, the first employees may be hired and prototypes developed to pitch the company's idea to potential customers or later investors. The money invested can be used for performing market research and other tasks that help validate a founder's proposal.

Stage 2 of a Startup

Once a new company moves into operations and starts collecting some initial revenue, it has progressed from seed to bona fide startup.

At this point, company founders may pitch their ideas to angel investors. An angel investor is usually a private individual with some accumulated wealth who specializes in investing in early-stage companies.

Angel investors are typically the first source of funding outside of FF&F money. Angel investments are typically modest in size. At this point, the company's future prospects are at their riskiest stage.

Angel money may be used to support initial marketing efforts and move a prototype into production.

Stage 3 of a Startup

By this point, the founders should have developed a solid business plan that dictates the business strategy and projections going forward. Although the company is not yet earning any net profits, it is gaining momentum and reinvesting any revenues back into the company for growth.

This is when venture capital steps in.

Venture capital can come from an individual, a private partnership, or a pooled investment fund. Most demand an active role in promising new companies that have moved past the seed and angel stages. Venture capitalists often take on advisory222222 roles and sit on the board of directors for the company.

Additional rounds of venture capital may be sought as the company continues to burn through cash in order to achieve the exponential growth expected by venture capital investors.

If You're Not an Insider

Unless you happen to be a founder, a family member, or a close friend of a founder, chances are you will not be able to get in at the very beginning of an exciting new startup. And unless you are2 a wealthy, accredited investor, you will likely not be able to participate as an angel investor.

Today, private individuals can take part to some degree in the venture capital phase by investing in private equity funds that specialize in venture capital funding, allowing for indirect investment in startups.

Private Equity Funds

Private equity funds invest in a large number of promising startups in order to diversify their risk exposure.

Professional venture capitalists have a success rate of a bit over 23% of their investment portfolios, according to a report by the National Bureau of Economic Research. Venture capitalists who have previously launched their own successful startups do the best, at about a 30% success rate. The founders of unsuccessful startups do worse, at about 19%.

Typical venture deals are structured over 10 years until exit. The ideal exit strategy is for the company to go public via an initial public offering (IPO), which can generate the out-sized returns expected by those who take these risks.

Other exit strategies are less desirable to the venture capitalist because they're not as lucrative. They include a takeover of the startup by another company or its remaining a profitable but privately-held business.

Due Diligence

The first step in conducting due diligence is to critically evaluate the startup's business plan and its model for generating profits and growth in the future. The economics of the idea must translate into real-world returns.

Many new ideas are so cutting-edge that they risk not gaining market adoption. Strong competitors or major barriers to entry are also important considerations. Legal, regulatory, and compliance issues are also important to consider for brand-new ideas.

The Founder's Role

Many angel investors and VC investors indicate that the personality and drive of the company founders are as important or more important than the business idea itself.

Founders must have the skill, knowledge, and passion to carry them through periods of growing pains and discouragement. They also have to be open to advice and constructive feedback from inside and outside the firm. They must be agile enough to respond quickly to unexpected economic events or technological changes.

More Questions

There are other questions that must be asked. For example, if the company's early launch is successful, will there be timing risk? That is, will the financial markets welcome this concept five or 10 years down the road when the company is ready to launch an IPO?

For that matter, will the company have grown enough to launch a successful IPO and provide a solid return on investment for its investors?

The Bottom Line

Alphabet Inc., better known as Google, is a casebook example of a successful startup seeded by founders, friends, and families and then funded by venture capital.

The search giant launched as a startup in 1997 with $1 million in seed money from FF&F. In 1999, the rapidly growing search firm attracted $25 million in venture capital funding, with two VC firms acquiring about 10% each of the company.

In August 2004, Google's IPO raised over $1.2 billion for the company and almost half a billion dollars for those original investors, a return of almost 1,700%.

This big return potential is the result of the extreme level of risk inherent in new companies. Not only will most venture capital investments fail, but a whole host of unique risk factors must be addressed when considering a new investment in a startup.