Investing in startups is a risky business. The vast majority of new companies, products, and ideas simply don't succeed, so there's a real risk of losing your entire investment. But those that do can generate very high returns on investment.
Venture investors who start with founders, friends, and family (FF&F) funding are likely to end up with no results. Investing in venture capital funds diversifies some of the risk, but the harsh reality is that 80% or 90% of venture capital-funded companies never make it to the initial public offering (IPO) stage. is.
A rule of thumb is that for every 10 startups, 3-4 fail, 3-4 recover their original investment, and 1-2 succeed. Returns for companies that actually go public can reach thousands of percent, making early investors very wealthy indeed.
Startups go through many stages, and each stage offers different opportunities and risks to investors.
Important points
- Startups are in the idea stage and do not yet have a working product, customer base, or revenue stream.
- Many start with funding from the founders, friends, and family.
- Once the idea takes shape, founders may seek venture capital funding.
- Venture capitalists acquire stock in a company in exchange for an investment. It may or may not pay off in the end.
Startup stage 1
All startups start with an idea. At this first stage, founders do not yet have a viable product, customer base, or revenue stream. The Valley of Death Curve describes this period of time when a startup company has started operations but is not yet profitable. These new companies can raise capital by drawing on the founders' savings, taking out bank loans, or issuing stock.
When most people think about what it means to invest in a startup, the idea that comes to mind is that most people give away seed money in exchange for equity rights.
In the United States alone, 469,557 businesses were founded in the 12 months ending July 2023, according to the U.S. Census Bureau. This number is based on the number of applications for Employer Identification Numbers to the IRS.
Most of those businesses started with seed funding from founders, friends, and family (FF&F). The amounts are generally small, allowing the entrepreneur to prove that the idea has a high chance of success.
During the seed stage, the first employees are hired and a prototype may be developed to pitch the company's idea to potential customers and future investors. Invested funds can be used to perform market research and other tasks that help validate founders' proposals.
Startup stage 2
Once a new company begins operations and starts collecting some initial revenue, it progresses from a seed to a full-fledged startup.
At this point, the company's founders may pitch their idea to angel investors. Angel investors are typically individuals with accumulated wealth who specialize in investing in early-stage companies.
Angel investors are usually the first source of funding outside of FF&F money. Angel investments are typically modest in size. At the moment, the company's future is at its most risky stage.
Angel money may be used to support early marketing efforts and commercialize prototypes.
Startup stage 3
By this point, the founder should have developed a solid business plan that determines future business strategy and projections. Although the company has not yet made a net profit, it is gaining momentum and reinvesting its profits back into the company for growth.
This is where venture capital intervenes.
Venture capital is raised from individuals, private partnerships, or co-investment funds. Most companies are looking for an active role in a promising new company that has moved past the seed or angel stage. Venture capitalists often assume the role of advisors222222 and sit on the company's board of directors.
Additional rounds of venture capital may be sought as the company continues to burn through cash to achieve the exponential growth that venture capital investors expect.
Not an insider?
Unless you happen to be the founder, their family, or a close friend of the founder, you may not be able to join an exciting new startup from the beginning. And unless you're a wealthy accredited investor, you probably won't be able to participate as an angel investor.
Individuals can now participate to some extent in the venture capital stage by investing in private equity funds that specialize in venture capital financing, allowing them to indirectly invest in startups.
private equity fund
Private equity funds invest in a large number of promising start-up companies to diversify their risk exposure.
According to a report by the National Bureau of Economic Research, professional venture capitalists' investment portfolios have a success rate of just over 23%. Venture capitalists who have previously launched their own successful startups have the best success rate, at about 30%. Founders of failed startups fared even worse, at about 19%.
A typical venture deal takes 10 years or more to build up to exit. The ideal exit strategy is for a company to go public through an initial public offering (IPO), which can generate returns higher than expected by companies that take on these risks.
Other exit strategies are less lucrative and therefore less desirable for venture capitalists. This includes acquiring the startup by another company or continuing as a profitable but privately held business.
due diligence
The first step in conducting due diligence is to critically evaluate a startup's business plan and model for generating future profits and growth. The economics of an idea must be reflected in real-world returns.
Many new ideas are cutting edge and therefore run the risk of not being adopted by the market. Strong competitors and large barriers to entry are also important considerations. When generating new ideas, it is important to also consider legal, regulatory, and compliance issues.
Founder's role
Many angel and VC investors point out that the personality and motivation of the founder is just as important, if not more important, than the business idea itself.
Founders must have the skills, knowledge, and passion to get through growing pains and periods of disappointment. You should also be open to advice and constructive feedback from both internal and external sources. They need to be agile enough to respond quickly to unexpected economic events and technological changes.
Ask more questions
There are other questions to ask. For example, if a company's early launch is successful, is there a timing risk? That is, in five or even ten years, when the company is ready to do an IPO, the financial markets will welcome the concept. I wonder?
For that matter, is the company growing enough to pull off a successful IPO and provide investors with a solid return on investment?
Can I invest in a capital venture fund?
Capital venture funds are typically closed to all but the very wealthy individuals. Investors participate in the fund by becoming limited partners. Only accredited investors are allowed to participate in the partnership. This is a Securities and Exchange Commission (SEC) designation that indicates a person is wealthy and understands sophisticated financial transactions. Essentially, this acknowledges that the SEC has little regulatory authority over venture capital firms and that investors need to be well aware of what they are getting into.
Are there venture capital investment trusts?
There are mutual funds that invest in venture capital companies. In most cases, they may acquire a minority stake in venture capital in hopes of increasing overall returns.
There are also slightly less risky versions of venture capital focused mutual funds. This means the fund's focus is on small and medium-sized enterprises that offer innovative products and appear poised for rapid growth.
How do I become an angel investor?
Contrary to their reputation, angel investors are not necessarily rich and often make modest contributions to startups. There are many crowdfunding websites that bring together entrepreneurs and angel investors, such as SeedInvest and AngelList.
conclusion
Alphabet Inc., known as Google, is a storybook of successful startups seeded by founders, friends, and family and funded by venture capital.
The search giant launched as a startup in 1997 with $1 million in seed money from FF&F. In 1999, this fast-growing search company raised his $25 million venture capital funding and two VC firms each acquired about 10% of the company.
Google's IPO in August 2004 raised more than $1.2 billion for the company and nearly $500 million for original investors, with a return of nearly 1,700%.
This huge profit potential is a result of the extreme risk inherent in startups. Not only do most venture capital investments fail, but there are a number of unique risk factors that need to be addressed when considering new investments in startups.
