Pros and Cons of Investing in Startups
Every company has to start somewhere. Even the largest company was once a small business venture. Startups can be an attractive investment option due to high potential returns, but it’s important to carefully assess the risks.
With over 400,000 new businesses created in the U.S. each year, there are plenty of startups to invest in. However, a large percentage of these companies will not last more than a year or two. Investing in these small businesses carries a high risk, but could also lead to a huge return due to the high potential for growth.
Advantages
These are the advantages that motivate investors to choose startups:
1. More investment options. Larger, more established businesses only offer shares to investors. However, with startups, additional options exist, such as purchasing a convertible note that can be converted to shares later on.
2. Ways to lower your risks. You can, for instance, invest in a warrant, a contract that specifies how much you’ll invest at a set date provided that the startup meets a certain goal. If the startup isn’t a success, you won’t have to invest.
3. Most startups don’t require a lot of funds. This means you could get control of a significant portion of a small company with your investment and might even get to vote on the company’s board.
4. Wide availability. There are startups in many markets and industries. These small companies are a great way to diversify your investments across cap sizes and markets, including emerging markets.
5. Great potential for growth and profits. All it takes is an original idea and a solid execution for a startup to become successful. There could be a huge return on your investment if the startup you invested in performs well.
6. Buy-out potential. A lot of startups are bought by larger companies because they see the startup as a potential competitor or they want to use the technology created by the startup. If the small business you invest in is bought at a lucrative price, you should get a good return on your investment.
Disadvantages
Even with such growth potential, startups are considered high risk investments because a large percentage of small businesses don’t succeed.
Tying up a significant portion of your capital in startups puts all that money – and possibly your financial future – in danger, because there’s a high probability that you could lose it all. A wiser way to take advantage of startup investments is to allocate a reasonable portion of your portfolio to startups – whatever amount you could afford to lose if the company goes under.
Consider these downsides before investing in a startup:
1. It may be very difficult for the company to prosper. Some markets are extremely competitive or saturated and some business ideas simply don’t work.
• Take the time to carefully analyze the company you’re thinking about investing in to assess the chances of this startup.
2. The company owner could cause failure. The success of a startup partially depends on how hard the entrepreneur behind the idea is willing to work.
• To alleviate this risk, get to know the entrepreneur better. Find out the history of their past business ventures.
3. Unpredictable failure. Even the most promising startup can fail due to factors that cannot be predicted or controlled.
• Compensate for your risks by including safer investments in your portfolio.
Potentially high returns and the possibility to play an important role in the development of a revolutionary product or technology make startups an attractive option. However, these investments carry high risks and you shouldn’t count on getting a return because an idea looks promising on paper.
If you feel that startups are a good option for you, take the time to look for good business ventures and allocate a small percentage of your portfolio to this type of high-risk investment.
