What are The Risks of Investing in a Startup?

We often begin planning our investments as soon as we start our first job. The first few investment avenues we start with include the stock market, mutual funds, tenured deposits, gold, and debt instruments. However, as and when you accumulate a considerable amount of wealth, you can also think about investing in a startup. 

All investments carry varying degrees of risk, and investing in early-stage businesses is no different. Investing in startups can be exciting and potentially lucrative, but it's crucial to understand the risks involved. Why? Because of the comparatively greater degree of risk. The most recent startup failure rate (2024) stands at 90%. Out of these, 10% fail to establish themself in the first year, while 70% remain unsuccessful during two to five years of their launch. 

Such a nature of investment risk highlights the importance of knowing the potential pitfalls before committing your money. The primary risk with investing in startups is that the business may fail, but is this the only risk we should focus on and analyze? What are the other startup investment risks?

Startup Investment Risks:

There are multiple risks in startup investment, including the following-

1. Market Risks:

Market risk refers to the possibility that the startup's target market might be too small, competitive, or saturated to support its business model and value proposition. To identify this risk, you must conduct comprehensive market research and analysis. This involves studying various market aspects, such as its size, growth, trends, customer segments, pain points, needs, preferences, and willingness to pay. It also includes benchmarking the startup against its direct and indirect competitors to understand its strengths, weaknesses, opportunities, and threats. Lastly, you must validate the startup's product-market fit, which measures how well the startup's solution addresses a real and urgent problem for a large and reachable market.

2. Team risk:

Team risk is basically the possibility that a startup's founders and employees may lack the necessary skills, experience, vision, or chemistry to execute the company's strategy and goals successfully. To spot team risk, you must evaluate the team's composition, diversity, culture, and dynamics. Assess the founders' backgrounds, leadership styles, and commitment levels, and examine the startup's hiring, retention, and development practices to see if they align with its values and objectives.

3. Technology risks:

Technology risk refers to the chance of a startup's technology becoming unreliable, obsolete, incompatible, or infringing on patents or copyrights. Assessing technology risks requires scrutinizing the infrastructure, product performance, and innovation pipeline. For example, a startup developing advanced AI should have strong testing protocols to mitigate unreliable technology risks. To identify the tech risk, you need to review the startup's technology stack, architecture, and infrastructure to see how they support product development and delivery. You can also examine the startup's innovation pipeline, roadmap, and feedback loops to see how it adapts to changing customer needs and market conditions. Additionally, check the startup's intellectual property rights, protection, and enforcement to safeguard its competitive advantage.

4. Liquidity risk:

Liquidity means how easily you can turn a financial asset into cash without changing its value. Assets vary in liquidity; some are more liquid than others. When you invest in a startup, your money stays there for a while. You can't quickly withdraw your investment or sell assets (in this case, your stake in the startup) whenever you want.

5. Financial risks:

It is the possibility that a startup's financial performance will be poor, inconsistent, or unsustainable. To identify and mitigate financial risk, you can analyze the startup's financial statements, projections, and assumptions. It is important to examine its revenue model, cost structure, cash flow, and profitability before investing. You can also evaluate the startup's funding history, sources, and terms to understand their impact on valuation, dilution, and exit options. Additionally, investigate the startup's financial controls, governance, and compliance to prevent or mitigate fraud, errors, or legal issues. Plus, you can compare the startup's financial metrics and ratios with those of its peers and benchmarks to gauge its growth potential and risk-return profile.

6.Execution risk:

Execution risk is the chance that a startup's strategy, operations, or processes may be flawed or inefficient. To spot execution risk, understand the startup's vision, mission, and goals and how these guide its decisions. For this, you can observe the startup's operations, processes, and systems to see if they optimize resources, productivity, and quality. You can also measure the startup's performance, outcomes, and impact to ensure they align with key performance indicators and milestones.

7. Market fit risks:

This is different from market risk. The market risk focuses on the possibility of market saturation and growth, whereas market fit risk concerns whether the offered product aligns with the market demand and trend. Market fit risk is when a startup's solution doesn't match market demand, preferences, or trends. To identify this risk, you can monitor customer feedback, retention, and loyalty to see if the startup delivers value and satisfaction. Try tracking market share, penetration, and expansion to confirm the startup captures and grows its market opportunities.

8. Ownership dilution risk:

When startups raise more capital, dilution of ownership poses a risk for your stake in the company. This happens when the company issues more shares, impacting existing shareholders who don't purchase these new shares. This dilution reduces their proportionate ownership, affecting their voting rights, dividends, and overall stake value. New investors usually seek a bigger ownership share than the initial investors, further diluting the original investors' ownership and lowering their investment returns. So, if you are an initial investor, it is important to consider that the company’s growth can also dilute your stake.

9. Diversification risk:

Startup investments carry high risks, so diversifying your portfolio is crucial. However, building a varied portfolio of early-stage businesses is costly and difficult. So, if one startup fails, it can significantly impact your entire investment. As a shareholder, it's vital you align your chosen investment avenues with your overall financial goals and invest in startups accordingly. 

Despite the risks involved, startup investment is among the most rewarding endeavors. However, after completing the due diligence, analyzing the magnitude of every risk, shortlisting the companies, and finally investing in the business, it's time to monitor your investment and stay invested for the long term to reap maximum benefits. Keep engaging with the startup’s updates, strategy improvisations, and discussion forums to ensure you mitigate any possible risks that may arise during growth or expansion stages. Remember, no investment is risk-free, but due diligence and diversification can improve your chances of success in startup investing.

FAQs:

Q1. How much should I invest in a startup?

Ans. There is no standard amount of investment. It mainly depends on your financial goals, risk tolerance, and investment timeline. Some invest big in high-growth startups for quick returns, but this carries a high risk— either a big gain or a total loss. Some others invest as per the aimed investment horizon and risk profile. For example, investors with a higher risk appetite generally opt for long-term investments.

Q2. What are the different funding resources available for a startup?

Ans. The summon startup funding types include-

• Bootstrapping: Self-funding via personal savings, side jobs, or revenue.
• Angel investors: High-net-worth individuals seeking returns on startup investments.
• Friends and family: Investment or loans from close contacts.
• Venture capital: Professional investors backing high-growth startups.
• Crowdfunding: Internet-based funding from numerous contributors.

Q3. What is seed funding?

Ans. 'Seed funding' is crucial for startups in their early stages, from inception to market validation. It's the initial investment phase, supporting businesses with only a product idea.

Q4. What is investment risk?

Ans. Investment risk is the possibility of losing money as against the expected return. It shows investors' uncertainty about achieving expected returns and determines the extent of unexpected outcomes.