Should you invest in startups? A look at both sides of the coin

Whiteboard reading Innovation

Source: Pixabay.com

Instagram. Uber. Pinterest. Airbnb. This is just a small excerpt from the miles-long list of startup companies that managed to transform a unique idea into a profitable venture.

But as startup markets near the point of oversaturation (developing countries included), is this type of investment still worth the many risks it entails?

In the last decade, startup funding quickly became a go-to investment strategy for many an investor due to the possibility of reaping high returns, as well as for what was at the time a novelty concept—to support never before seen products and services that would potentially solve many of the ills that modern society is currently facing.

But with about 100,000 startups launching each year in the UK alone, it can be frustrating to separate the true visionaries from the sly opportunists, especially considering that most startups would often require an upfront investment that will last them for the next 12-18 months.

Before diving deeper, though, let’s first clear the air on what a startup actually is.

What exactly is a startup?

 

A startup, or a startup company, is an enterprise that is established with the sole intent of creating a product or a service that solves a long-standing problem in practical, forward-thinking manner.

As a result, its business model often revolves around some innovative and untested idea that is designed to tap into a yet unexisting market niche.

Despite its name, a startup does not necessarily have to be freshly founded or operating within the confines of the technological sector.

However, what a startup enterprise must show in order to be considered as such is the promise of rapid future growth. And to secure that promise, budding entrepreneurs often resort to seeking out investment funds.

Now that we’ve defined what a startup is, let’s review the pros and cons of backing one.

A young entrepreneur writing on notebook

Source: Pixabay.com

Advantages of backing startups

 

The startup market tends to be less volatile

Many small private businesses in their early stages of development are not tied to any traditional market assets, such as stocks or bonds.

So, while putting a large portion of your investment funds in a startup company is inadvisable at best, allocating about 5% of your funds would allow you to diversify your portfolio in a less volatile market environment.

Your words have staying power

By getting ahead of the competition and proactively funding a startup enterprise, you will be granted a free pass to attend important management meetings, provide connections to influential people in the industry, and otherwise advise the founder(s) as the enterprise grows in size.

Being an early bird also means that you will be securing your position as the biggest stakeholder and won’t have to worry about other investors taking the reins over.

You help bolster innovation

Startup investors often pour money into topics they understand and ideas they deeply resonate with. By investing in startups you will have the opportunity to help budding pioneers realise their vision for the future and change the life of many for the better.

With a bit of luck, of course, you also stand the chance of multiplying your investment tenfold, or even twentyfold, in just a couple of years, once the company’s business ideas have come to fruition or if it is acquired by a leading competitor in its market niche.

Disadvantages of backing startups

 

Your investment may vanish into thin air

Unless you have gotten your hands on a vetted startup (a company offering investment protection schemes and one that is background-checked by regulatory authorities to ensure it’s protected from theft, technical issues, etc.), chances are that you are not very likely to break even on your investment, or see any returns whatsoever.

At this point, you are probably asking yourself: how often do new businesses fail? Well, according to a recent study, about 50% don’t even make it past their fourth year. And those businesses that do manage to hold onto their development cycle are probably not going to hand out dividends anytime soon, since any profits made are immediately spent on growth.

You invest in а highly illiquid asset

One of the pitfalls many startup investors end up falling into is thinking that they could easily sell their shares in the company when their value goes up. The harsh reality is that often times you will have no one to sell your stocks to, as no demand might still exist for the product or service that the small private business is attempting to pioneer.

As the years go by, you can also become the victim of shareholder dilution, which is when the stake in the business that you own greatly diminishes in size (and sometimes even cut in half) overnight as a result of the management deciding to float more shares on the market. This could be done in order to raise additional capital, for instance.

Your investment is likely overinflated

Many startups have the indecency of attaching a price tag to their startup ideas that far and above exceeds their actual market value. And many investors end up accepting these inflated terms in the fear of missing out on the next Facebook or Apple.

This is why it’s so important to take on a proactive role and persuade the founders to go over the actual performance numbers; otherwise you risk believing in unrealistic self-evaluations copied straight from the top performing startups in Silicon Valley.

The bottom line

 

As you have probably concluded by now, there is no magical startup investment “formula” that will help you dodge all risks involved and land the company you backed on the covers of famous business journals—such scenarios are reserved only for the realm of cinema.

As with long-term investments, the only way you can truly improve your chances for success is by trudging through heaps of research, investing early and under favourable market conditions, remember that past results or forecasts of a given startup do not guarantee similar performance in the future and, of course, have Lady Luck on your side.

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