According to a study conducted by IBM & Oxford, about 90% of startups fail within the first five years since their inception. While there has been an exhaustive research published on the various reasons for the same and also countermeasures to avoid it, the fact still remains that, though returns if successful could be multifold, angel investment by far is one of the riskiest assets class to consider as an investment. It is due to this wide uncertainty associated with startups that makes it critical to understand the various risks that one is exposed to when he decides to take a leap of faith in this space.
These are all the risks that are associated with the nature of startups as an asset class. These could range from common risks such as principal risk (total loss of entire capital invested), returns risk or delay in returns, liquidity risk to even more serious such as political, business and funding risks.
Investing in start-ups can put the entire invested amount at risk in an event of shut down of operations or bankruptcy due to multiple reasons. Hence, startups are not an asset class where you park your savings or contingency fund but only those surpluses where you will be comfortable to absorb a total capital loss without any impact on your financial standing. Even when a startup is at the growing stage, there are still limited options to liquidate or find a secondary buyer for the holding as compared to public securities and hence, there could be a significant delay in securing the returns that an investor may have planned on this investment.
Dilution, Valuation & Reduced promoter stake risks
In order to sustain growth and to scale up, startups are in constant need to raise funds periodically as also generally outlined in their business plan. However, this also means that earlier one invests in startups; the more will he be diluted in the subsequent rounds. Hence, the eventual stake of an early angel investor at the time of exit may be significantly lesser than at the time of investing. This could not only decrease the overall voting rights but also lead to a loss in case the startup raises subsequent funds at a down round. Another risk of multiple funding rounds is that eventually the promoter’s stake, which is the main driver of the venture, may also be reduced to a significant minority, thus reducing their motivation to work for the growth of the startup.
Valuation in startups is a grey area and though there are several mathematical methods to work out the same, all of them are based on projections which have an inherent risk of not being realistic. Also, there are few comparables generally available for a competitive benchmarking of the same. Unlike publicly traded companies that are valued publicly through market-driven stock prices, the valuation of private companies, especially startups, is therefore difficult to assess.
Risks due to errors in judgment
A number of times, angel investments are made based on incorrect assumptions or without conducting an adequate research and study of the market in which the startup being evaluated is operating. This leads to errors in judgment while making an angel investment that therefore comes with an inherent risk to the investor. Sometimes, angel investments are made by tagging along with another investor in case he is a subject matter expertise without actually assessing the potential of the idea. This could, therefore, lead to challenges in case the reference investor ignores some of the key business aspects while taking a lead in investing. Hence, it is recommended to do a detailed analysis and due diligence of the startup opportunity before firming up a commitment to avoid any rude shocks later.
Angel investors sometimes also have impractical return expectations within a fixed timeline from their founders as a result of which they end up over-pressurizing them to perform or compel them to change the business strategy frequently which can lead to instability and lack of focus. Making an angel investment without a clear roadmap towards an exit is a major risk that angel investors can face in their portfolio.
A startup needs to have a globally scalable business model, in order to generate maximum value for its investors. However, as a startup grows it faces new challenges. Expansion may place a significant strain on the company’s management, operational and financial resources. To manage growth, the company will be required to implement additional operational and financial systems, procedures and controls and this may hamper the pace of growth.
An investment in a startup is primarily the investment in its management and their execution abilities. Hence, their prior experience and expertise are of paramount importance, which must be examined before making any angel investment. It is also critical to check if the team is fully committed to the venture and is not engaged in any other employment or consulting agreement which may consume the time and resources of any of the key management.
Irrespective of the space and sector, a startup will always have competitors for its offering and hence it is critical to creating entry barriers and compelling differentiators that safeguard its growth. Nevertheless, funding plays a key role in competition and well-funded players in the same space can prove to be a major risk for any startup due to their ability to tap opportunities, capture market and scale up at a fast pace. Competition may also trigger a price war in a sector that may further strain the margins of a startup.
The fundamental assumption of a startup idea is that there is a huge market for its product or offering and hence startups target a certain market share as they grow. However, this is no guarantee of success, and any unfortunate event or a change in consumer mindset and preferences can heavily impact startup’s prospects. In such an event, there may be a material adverse effect on the company’s results of operations and financial condition.
When a startup is in its early stage, it takes time to start monetizing and hence needs funding till the point to sustain expense and implement the business plan. The likelihood of achieving profitability should be considered in light of the problems, expenses, difficulties, complications, and delays usually encountered by the startup in their early stages of development. The startup may not be successful in attaining the objectives necessary for it to overcome these risks and uncertainties.
Post the bootstrapping stage, a startup requires the external funds for its operations till the business reaches a minimum threshold. Also, post breakeven, subsequent funding rounds ensure that the startup grows at a fast pace. Hence, access to capital and its timing are the most critical success factors in angel investment. The new funds are generally required to cover operational expenses, develop new products, expand its marketing capabilities, and finance general and administrative activities. If a startup is unable to raise subsequent funding rounds, then it could be forced by investors to delay its development, marketing and expansion efforts which eventually put brakes on the venture’s growth.
Future Competition and the Pace of Technological Change
One of the aspects that is usually ignored is that the angel investors generally assess the current competitive landscape while making an angel investment. However, it is equally critical to analyze how the competition will shape up in future and who will be his key competitors when the startup goes for the next round of financing or is looking to exit.
The changes in political, regulatory, tax-related or any such statutory policies can have an adverse impact on the startup.
Though, there are no guaranteed answers or solutions to address the risks linked to startup investment, some of the measures that could counter this risk should be conducting a detailed due diligence before investing, co-investing with an investor having a thorough knowledge of the space and has comprehensively studied the opportunity, investing in experience teams with a unique, capital efficient and globally scalable business models and picking a startup with a clear exit roadmap.
Posted By Mandar Gadkari, Global Head at CBA.