Unless you happen to be a founder, family member, or close friend of a founder, chances are you will not be able to get in at the very beginning of an exciting new startup. And unless you happen to be a wealthy, accredited investor, you will likely not be able to participate as an angel investor.
Today, private individuals can take part to some degree in the venture capital phase by investing in private equity funds that specialize in venture capital funding, allowing for indirect investment in startups.
Private Equity Funds
Private equity funds invest in a large number of promising startups in order to diversify their risk exposure to any one company. According to recent research, the failure rate for a venture fund portfolio is 40% to 50% in a given year, and 90% of all companies invested in will not make it beyond the 10-year mark.
The notion that only one in 10 venture capital investments will succeed is industry expectation. The 10% of companies that do make it big can return many thousands of percent to investors.
Typical venture deals are structured over 10 years until exit. The ideal exit strategy is for the company to go public via an initial public offering (IPO), which can generate the out-sized returns expected from taking on such risk. Other exit strategies that are less desirable include being acquired by another company or remaining as a private, profitable venture.
The first step in conducting due diligence for a startup is to critically evaluate the business plan and the model for generating profits and growth in the future. The economics of the idea must translate into real-world returns.
Many new ideas are so cutting edge that they risk not gaining market adoption. Strong competitors or major barriers to entry are also important considerations. Legal, regulatory, and compliance issues are also important to consider for brand-new ideas.
The Founder’s Role
Many angel investors and VC investors indicate that the personality and drive of the company founders are just as, or even more important than the business idea itself.
Founders must have the skill, knowledge, and passion to carry them through periods of growing pains and discouragement. They also have to be open to advice and constructive feedback from inside and outside the firm. They must be agile and nimble enough to pivot the company’s direction given unexpected economic events or technological changes.
Other questions that must be asked are, if the company is successful, will there be timing risk? Will the financial markets be friendly to an IPO five or 10 years down the road? Is the company going to have grown enough to successfully IPO and provide a solid return on investment?
Big Risks, Big Rewards
A prime example of a successful startup story is Alphabet Inc., better known as Google. The search giant launched as a startup in 1997 with $1 million in seed money from FF&F. In 1999, the company was growing rapidly and attracted $25 million in venture capital funding, with two VC firms acquiring around 10% each of the company. In August 2004, Google’s IPO raised over $1.2 billion for the company and almost half a billion dollars for those original investors, a return of almost 1,700%.1
This big return potential is the result of the incredible amount of risk inherent in new companies. Not only will 90% of VC investments fail, but there is a whole host of unique risk factors that must be addressed when considering a new investment in a startup.