Investing in startup companies is a very risky business, but it can be very rewarding if and when the investments do pay off. The majority of new companies or products simply do not make it, so the risk of losing one’s entire investment is a real possibility. The ones that do make it, however, can produce very high returns on investment.
Investing in startups is not for the faint of heart. Founders, friends, and family (FF&F) money can easily be lost with little to show for it. Investing in venture capital funds diversifies some of the risks but also forces investors to face the harsh reality that 90% of companies funded will not make it to initial public offering (IPO).
For those that do go public, the returns can be in the thousands of percent, making early investors very wealthy indeed.
A startup goes through a number of stages, and each one of them offers distinct opportunities and risks for investors.
Startup companies are in the idea phase and do not yet have a working product, customer base, or revenue stream.
Around 90% of startup companies funded will not make it to initial public offering (IPO).
Investing in startup companies is a very risky business, but it can be very rewarding if the investments do pay off.
Stage 1 of a Startup
Every startup begins with an idea. In this first phase, they do not yet have a working product, a customer base, or a revenue stream. These new companies can fund themselves by using founders’ savings, obtaining bank loans, or issuing equity shares.
Handing over seed money in return for an equity stake is what comes to mind for most people when thinking about what it means to invest in startups.
It is estimated that, worldwide, more than a million new companies are formed each year. The first money obtained by these companies is usually that of founders, friends, and family (FF&F), known as seed money or seed capital.
These sums are generally small and allow an entrepreneur to prove that an idea has a good chance of succeeding. During the seed phase, the first employees may be hired and prototypes developed to pitch the company’s idea to potential customers or later investors.
The money invested is used for activities like performing market research.
Stage 2 of a Startup
Once a new company moves into operations and starts collecting initial revenues, it has progressed from seed to bona fide startup.
At this point, company founders may pitch their idea to angel investors. An angel investor is usually a private individual with some accumulated wealth who specializes in investing in early-stage companies.
Angel investors are typically the first source of funding outside of FF&F money. Angel investments are typically small in size, but angel investors also have much to gain, because at this point the company’s future prospects are the riskiest.
Angel money is used to support initial marketing efforts and move prototypes into production.
Stage 3 of a Startup
By this point, the founders will have developed a solid business plan that dictates the business strategy and projections going forward. Although the company is not yet earning any net profits, it is gaining momentum and reinvesting any revenues back into the company for growth.
This is when venture capital steps in.
Venture capital can refer to an individual, private partnership, or pooled investment fund that seeks to invest and take an active role in promising new companies that have moved past the seed and angel stages. Venture capitalists often take on advisor roles and find a seat on the board of directors for the company.
Venture capital may be sought in additional rounds as the company continues to burn through cash in order to achieve the exponential growth expected by VC investors.