The main risks of investing in venture capital
Loss of investment
One of the main risks of venture capital investment is the high probability of losing capital. Research suggests that around 90 per cent of startups fail due to factors such as the wrong business model, low demand, lack of funding or strong competition.
By investing at an early stage, investors hope to be compensated by the rapid growth of the company, which allows them to recover their funds with a significant return. In practice, there is every chance that the money will be lost. To avoid such situations, venture capitalists try to invest in numerous companies, so that a small proportion of successful ones will make up the losses of failed ventures.
Long-time horizons for income generation
Investors in startups are focused on growing the value of their investment, rather than generating returns in the traditional sense. The main reason for the long wait for income is the dependence on the exit strategy, which has several peculiarities:
- The long growth cycle of a startup. For an investor's stake to become significantly more valuable, a startup must go through several stages of development: from building and launching a product to scaling;
- Investors wait for the moment when the startup's value peaks and attract the next rounds of investment that increase the company's valuation;
- Exit depends on market conditions. During a recession or economic uncertainty, investors, and buyers are not ready to make deals. IPO may be delayed if the financial market is unstable;
- Risk of delays due to strategic mistakes or external factors. Investments can suffer from mistakes in choosing the right market niche, a weak team or slow implementation of the business model. Regulatory changes and competition also have an impact.
Risk of liquidity constraints for startups
This means that investors cannot easily sell their shares when they need a return on their investment. There are several reasons for this.
First, unlike shares in listed companies, startups are not traded on public markets. This makes it difficult to sell a stake at any time, as an interested buyer has to be found. In addition, many startups set rules for the sale of shares (pre-emptive rights), which further complicates their liquidity.
In addition, investors can only sell their shares during strategic and rare events such as a new round of financing, an IPO or an M&A transaction.
If a startup is in financial trouble, even finding a buyer for a stake can be difficult. The value of the company may plummet, significantly reducing the return to the investor.
Legal and operational risks of startups
Venture capital investments carry a high level of risk associated with the legal and operational aspects of startups. They can arise from the inexperience of the team, imperfect market conditions or external circumstances.
Legal risks:
- Many startups are established using simplified structures without consideration of legal nuances. This can lead to conflicts between founders and/or investors;
- Startups often work with patents, copyrights and trade secrets. If these assets are not properly protected, they can be exploited by competitors;
- Different markets have different requirements (e.g. GDPR in Europe or SEC in the US), which startups sometimes ignore. This can lead to fines or even the closure of the business.
Operational risks:
- Startups typically lack an experienced operational structure. This can lead to inefficient use of resources, delays, or errors in project execution. For example, a delay in bringing a product to market can significantly reduce competitiveness;
- Startups are frequently dependent on a few founders or specialists. If they leave the company, further development can be jeopardised. For example, if the CTO leaves, technical development may stop for months;
- If a startup defaults on commitments to partners or suppliers, this can affect its reputation and financial stability.
The wrong exit strategy
The exit strategy is key for venture capitalists because it is during an exit that they generate returns. A wrong exit strategy can lead to financial losses. Here are the main aspects of the problems associated with a failed exit:
- Bad timing. Exiting too early or too late can lead to a loss of value;
- A mismatch between buyer and business. If a business is sold to a buyer who cannot integrate the business effectively or has no strategic interest, this can harm the valuation;
- An ill-conceived IPO. An IPO involves complex preparation and high expectations. Failure to communicate with investors or a weak business model can depress the share price. WeWork, for example, attempted to go public in 2019, but had to call off the decision due to problems with its business model and critical evaluation by the market;
- Mergers or acquisitions can be blocked by antitrust or regulatory authorities. This not only delays the exit but can also reduce the valuation of the company.
Shining examples of startup failure
Theranos
Valued at $9 billion, the startup was supposed to bring to market a technology that could analyse blood from just a few drops. But the company had no working product and its success stories were lies. Its founder, Elizabeth Holmes, was found guilty on four counts: three of fraud and one of conspiracy. She was sentenced to 11 years and three months in prison.
WeWork
The coworking space startup grew at an astonishing rate. However, overspending, corporate governance issues, a failed IPO and scandals destroyed its valuation and its future. First, the company's valuation plummeted from $47 billion to $2.9 billion. Then WeWork's main investor, Softbank, took the company public through a merger with a SPAC. The company's capitalisation even exceeded $9 billion. But it all ended in a share price crash and bankruptcy.
Advantages of venture capital investment
High return potential
Venture capital investments have some of the highest returns among other investment opportunities. This is due to the potential for startups to grow and scale rapidly.
Startups often can become billion-dollar companies in a relatively short time, and as a result, investors can earn significantly higher returns compared to traditional assets such as stocks or bonds. Typically, venture capitalists hope to receive between 10 and 100 times their investment if the startup achieves market success.
Opportunity to participate in innovative project development
Venture capitalists actively support startups working in areas such as artificial intelligence, biotechnology, alternative energy sources, environmental technologies and many others. This allows them to be at the forefront of innovative change and create value in the marketplace.
For example, Tesla has become a leader in electric cars thanks to venture capital investment. Similarly, SpaceX became a leader in private space technology thanks to the support of investors who believed in the concept.
Investment portfolio diversification
Venture capital investments are an important element of portfolio diversification, reducing risk and allowing investors to preserve their capital even if one or more startups fail. Investing in a variety of companies in different industries allows you to generate returns, even if the chance of an individual company succeeding is low.
Venture capital is invested in startups with different business models and technologies, allowing a balanced portfolio. So even if some ventures do not make a profit or fail, others can make excellent returns and balance out the losses.
Examples of a startup's runaway success
In 2004, Peter Thiel invested $500,000 in a student social network that was one of the key episodes in Facebook's successful creation. The deal has made Thiel more than $1 billion.
In 2014, Facebook bought WhatsApp for $19 billion. At the time, Sequoia Capital owned 18% of the company, which was worth about $3bn, while initial investments were only $50 million.
How can emerging investors minimise risks?
Let's look at some approaches to minimising the risks of investing in startups.
Portfolio diversification
A portfolio can be diversified according to the following principles.
- By different sectors: fintech, healthcare, edtech, etc;
- By different stages of startup development. For example, pre-seed, seed and series A;
- Do not focus on one country or region.
Due Diligence
Due Diligence (DD) is the detailed examination of a company before an investment decision is made. This process typically includes:
- Validation of the business model. The value proposition, whether there is a unique technology or an unfair advantage, and the scalability of the product;
- Financial validation. Analysis of financial statements, cash flow and forecasts;
- Analysis of the team. The reputation of the founders, skills, and ability of the team to work together and deliver the vision;
- Analysis of the market, its size, trends, and competition;
- The state of the product and whether it solves the user's problem;
- Legal due diligence. Company registration, distribution of shares, liabilities, patents, etc.
Support from experienced investors or advisors
When you're starting, it's worth looking for opportunities to partner with experienced venture capitalists or find mentors in the field. One of the most effective approaches is to invest through an angel syndicate. These are usually led by experienced investors with wealth and expertise. Not only will they help you choose a company, but they will also have access to the best deals on the market.
A step-by-step plan for those new to venture capital investing
Step 1: Research the market
Before investing, it's important to understand how the venture capital market works.
- Learn about the different stages of funding (pre-seed, seed, Series A, etc.);
- Understand how returns on venture capital investments are generated;
- Analyse and identify high-potential industries;
- Read books, blogs, and interviews with venture capitalists;
- Join investment communities, platforms, clubs, or syndicates.
Step 2: Evaluate risks and rewards
- Only invest what you are prepared to lose;
- Diversify your portfolio. For example, invest in 10–20 startups to increase the chances of a successful exit;
- Determine if the startup is truly capable of generating returns of at least x10.
Step 3: Select startups to invest in
- Conduct due diligence on all startups you invest in;
- Use specialised platforms, hubs or local accelerators to research and find interesting deals. Networking can be more useful than expertise here;
- Join clubs or syndicates and work with more experienced investors.
Step 4: Monitor and manage the investment
- Stay in touch with the team;
- Communicate regularly with the founders and receive reports on the status of the business;
- Help the startup with your expertise, contacts, or advice;
- Keep track of KPIs (turnover, number of customers, product development);
- Define your exit strategy.
