When investing in a startup, investors must ask themselves a few key questions beforehand. What is the potential for this company to succeed? Is there a market for their product or service? What are the risks involved in this investment? How much money am I willing to lose if things don’t go as planned? These are just some of the questions investors should consider before investing in a startup.
Level of Involvement
When investing in a startup, your involvement depends on the investment type. EG, someone who invests in a startup through a venture capital firm, would have limited interaction with the startup’s team. However, an angel investor has a much more active role, as they are granted an equity stake in the company and have the opportunity to participate in decision-making alongside the startup’s leadership.
In contrast, an investor who funds a startup’s crowdfunding campaign would receive an equity share but wouldn’t have as much control as an angel investor. So it’s essential to be clear on how much or little involvement you want when handing over money to a startup.
Time Frame
It’s essential to have some idea of the timeline involved. Some investors may be comfortable waiting ten years for a return on their investment, while others may want to see a payout within five years. Evaluating the startup’s track record can help you evaluate how long the investment timeline will be. One way to gauge a company’s potential is by looking at its burn rate – how much cash is being spent each month. If a startup is still in the early stages but has an exceptionally high burn rate, that may indicate that investors will have to wait longer for a payout.
Return on Investment
VC and angel investments are often driven by a desire to help entrepreneurs succeed, but making money is also part of the appeal. Investors need to forecast the startup’s return on investment (ROI). Target ROI depends on the type of investment involved.
Angel investors typically expect a return in the 30% to 40% range. For venture capitalists, their expected rate of return is higher because of the increased risk associated with this investment. Equity crowdfunding is also a high-risk investment strategy; however, it is difficult to estimate the average return rate is still relatively new.
When estimating returns, investors should consider any fees or costs associated with the investment, such as annual management fees related to a VC investment or crowdfunding platforms charging investors for their services. The higher the associated expenses, the more returns are diminished.
Diversification
Regarding startups, investors should consider how the investment will affect their overall risk level. Diversifying your investments is key to minimizing risk while still achieving returns. However, it can be tricky with startups because they are a hit-or-miss proposition. You want to invest in multiple startups to have a better chance of hitting your target return, but if you spread your investment dollars too thin, you may not have any winners.
Exit Strategy
Having a solid exit strategy in place is a requirement for any investor. This means knowing when and how you’ll be able to withdraw your initial investment and any associated gains. For example, an angel investor would need to know at what point they’d be able to sell their equity shares. Knowing the time frame is important, so you’re comfortable with your chosen exit point.
Final Thoughts
Investing in startups can be an excellent opportunity for investors to expand their portfolios and help entrepreneurs succeed. However, investing in a startup is not without risk. Even if a company has substantial cash flow projections, what looks good on paper may not always reflect what happens in the real world. Investors need to do their due diligence when researching potential startup investments.
