Apple started its operation in a residential garage owned by the parents of Steve Jobs. The first product of Toyota was an automatic loom used for weaving cloth and tapestry. Coca-Cola started as a producer of a nerve tonic beverage in a community pharmacy in Georgia.
Notable medium-sized and large-sized companies of today were once startups. The prospect of growth is undeniably one of the major advantages of investing in startups. However, the fact remains that most startups cease to exist after two to five years.
Understanding the Rewards and Risks of Investing in Startups
Advantages of Investing in Startups: Reasons Why You Should Invest in New and Emerging Companies
There are several funding options available for startup companies. Most do not start with an initial public offering. They instead sell shares to venture capitalists or angel investors, secure loans from banks or other credit institutions, issue other debt instruments such as bonds, or secure grants from government and non-government organizations.
Growth potential is the main advantage of investing in a particular startup. Remember that the biggest companies today were once small and fledgling businesses. Note that some of the advantages of investing in new businesses are similar to the advantages of investing in small-cap companies. The following are the specific advantages or benefits of startup investing:
• Different Investment Options: Startups can be flexible with their capital-raising activities. Interest investors can present themselves either as shareholders via venture capital or angel investment, as bondholders, or as creditors. Some startups can issue notes that can be converted into shares in the future.
• Substantial Ownership Potential: Most new businesses do not require a lot of funds while others may depend on funding from a few investors. This means that a particular investor has the potential to gain a substantial portion of ownership and even eventual control over a particular startup with minimal investment versus investing the same amount in mid-cap and large-cap companies.
• Prospect for Investment Growth: Another advantage of investing in startups is their potential for growth which translates to sizeable investment returns for their early investors. This is similar to the benefits of small-cap and growth stock investing. Note that investing $1000 in Apple shares in the 1980s would be worth more than $1.5 million today.
• Different Businesses to Choose From: There are thousands of startups created in the United States alone each year. New businesses are entering established and emerging markets and industries or sectors. Some are even creating new markets. The availability of different businesses with different business interests can provide investors with another means to diversify their investments.
• Returns from Buy-Out and Acquisitions: Early shareholders of a specific startup have the potential to realize their investments in a shorter period if its controlling shareholders offer stock repurchasing. Some startups can also be acquired by or merged with bigger companies due to their competitive potential.
Disadvantages of Investing in Startups: Reasons Why You Should Not Invest in New and Emerging Companies
Startup investing adheres to principles of risk-return tradeoff which state that investments with higher potential for returns come with higher potential risks. Investing in startups is a very risky decision that is ideal for ultra-aggressive investors. The following are the specific risks or drawbacks of investing in startups:
• High Failure Rate of Startups: Data from the U.S. Bureau of Labor and Statistics have revealed that 10 percent of startups fail within their first year and another 50 percent close down within five years. The high failure rate of startups means that investing in them has higher levels of uncertainties and risks.
• Unproven and Untested Model: One of the major reasons behind the high failure rate of startups is their business models. The management may not have enough experience to run a business or market a product. The product itself might be interesting but has no market potential. Some new businesses run out of funds in their initial years while others do not have a clear idea of how to generate both revenues and profits.
• Advantages of Larger Businesses: Newer and smaller companies have the potential to outcompete older and larger companies or disrupt specific markets. However, in most cases, most established businesses have key competitive advantages such as economies of scale and access to capital that would render startups unable to compete.
• Product and Market Consideration: Smaller companies have a narrower focus when it comes to product offerings and market reach. It is also important to note that some markets are either extremely competitive or already saturated by more established competitors. One of the risks of investing in a particular startup is that its business idea might not work due to the pressing challenging in its market.
• Other Notable Investment Risks: Another disadvantage of investing in startups is liquidity risks. Investors cannot readily take back their investments unlike in mid-cap and large-cap investing. Startups are also more sensitive to systematic risks due to market or economic downturns than larger businesses.
Pointers to Consider Before Investing in Startups
The advantages of investing in startups collectively suggest that doing so can be a rewarding endeavor. However, because of its disadvantages and risks, including the challenges that confront new and emerging businesses, startup investing is not for everyone.
Investors should be aware of their risk profile. Investing in startups is ideal for ultra-aggressive investors. Furthermore, the investment decision should be attuned to the greater financial goals and objectives of a particular individual.
Research is also important. To be specific, before funding a startup, it is critical to spend time learning and understanding its business model and all relevant strategies, the marketability of its idea or product, and the capabilities of its management team.