Should You Invest in Start-Ups?

Continuing with our discussion on alternative investments, should you consider investing in Start-Ups? ​​

Start-Up investing usually takes two forms:

• Angel Investing.
• Venture Capital (“VC”).

Distinguished by the stage of start-up investing, the parties involved, and the amount of capital.

Angel Investing is a very early-stage investing and involves one or more individual investors who take on a mentorship and financial role with an early-stage startup by providing seed capital, valuable guidance, and advice.

These angels are successful entrepreneurs and seasoned investors. They’ve been around the block and have accumulated valuable business skills that would be beneficial to startups.

Besides providing financial support, angels also provide other types of support including operations, marketing, brand awareness, accounting, and back-office support. Once a startup passes the seed stage, a VC firm steps in to accelerate growth.

Whereas angels typically invest in tens and hundreds of thousands of dollars, Venture Capital firms invest in millions and tens of millions of dollars – usually investing in rounds the further along the startup progresses.

VC firms are headed by fund managers who manage firms organized as partnerships (LPs and LLCs) that invest capital that is pooled from groups of high-net-worth accredited investors in startups.

The end game of VC firms and fund managers is to steer startups towards an exit plan involving an acquisition or going public to reap potentially massive returns on investment for themselves and their partners. Think of the VC firms that invested in Facebook, Twitter, Amazon, etc.

Investments by angels and VC firms always involve equity and almost always involve these investors retaining management and controlling voting rights. In other words, they run the show and have the final say in the business direction of the company.

Let’s evaluate startup investing based on the following criteria:

• Non-Correlation to Broader Markets.
• Lack of Volatility.
• Cash Flow.
• Appreciation.
• Above-Market Risk-Adjusted Returns.
• Security (i.e., backed by hard asset).

Non-Correlation to Broader Markets –

Startup investing is long-term. The equity held by angels and VC firms is restricted and typically non-transferable. This illiquidity shields investors from the volatility common in public markets.

Long lockup periods ensure startups are given a fighting chance to make it to the finish line of an IPO or acquisition.

Lack of Volatility –

The non-correlation of equity investments in startups to the broader markets is why these investments lack volatility.

Unlike Wall Street where herd mentality can result in rapid exits and entrances, the long lockup periods involved in startup investing prevent investors from acting on their impulses.

Cash Flow –

Cash flow in startup investing is non-existent and investors know this upfront. They’re willing to forego any current rewards for the chance at a big payoff down the road. They know cash is precious and vital to the growth of the startup.

Appreciation –

Startup investors are relying entirely on the potential appreciation of a startup from going public or being acquired to extract a return on their investment. Unfortunately, appreciation is not guaranteed.

Most startups fail without providing any return on investment to their investors. The reality is only 1 in 10 startups succeed. That’s a 90% failure rate. The 10% that do succeed can be highly lucrative but those figures prove that appreciation is not assured.

Above-Market Risk-Adjusted Returns –

Startups have the potential to offer investors way above-market returns but with a failure rate of 90%, this is often achieved at much higher levels of risk than market levels.

Security –

Startup investments are unsecured and in liquidation, equity holders take a back seat to debt holders.

Although startup investing can be highly lucrative, it is also risky and provides investors with no income or security.

Overall, startup investing has the potential to provide investors with significant returns on investment – much higher than any other alternative asset class – but this is often at the peril of losing their entire investments.