‘Trust me, the projections are conservative. We are going to make millions together.’ I’m almost certain this is a line they teach in startup school. The projections are always conservative even when they look like a hockey stick. True unicorns (mythical creatures) are the ones that hit their growth projections.
Its important to contextualise the potential returns with the risks that are associated with them. Many startups fail to meet their projections, infact, many end up flatlining. It is often said that companies die slowly at first and then fall off the cliff. Startups are constantly treading along the edge of this cliff.
The rose may look perfect but gaze below the surface and you're sure to find a few thorns. You've got to carefully assess where you put your hands and not grab blindly. Understanding the myriad of risks associated with early-stage investment in startups is critical to achieving your goals as an angel investor.
Running the risk
Investments may, and frequently do, lose everything. There are no guarantees that it will achieve its business plan or that you’ll receive any of your money back. Investing in young unlisted companies carries all the risks associated with investing in the stock exchange, including political risk, currency risk, business risk and the like. In addition, angel investing has another layer of risks which include:
The team is a crucial determinant of the startup’s potential success. Technical skills and the interpersonal dynamics ought to be assessed before investing. This is the People Risk. Investors should ask questions like: Does the team have the necessary skill set to execute on the business plan? Are the members able to work as a team and committed? Furthermore, can I work with this group of entrepreneurs?
There's often misalignment in the market/customer’s perception of value and that of the founder. This discrepancy in product-market fit poses the Market Risk. One way this can be mitigated is through traction by way of paying customers. Its critical to assess the market’s willingness to pay for what a startup is offering.
Startup investments are illiquid and have a very long investment term. Even if all goes well, it will be several years before the company is able to facilitate an exit. This is known as Liquidity Risk. While there are techniques to mitigate this risk that will be discussed in follow on blogs, investors need to be aware that seed investments take 5 to 10 years to harvest.
Valuing a startup is more art than science. The number is always up for negotiation but setting it too high establishes a high hurdle rate for the next round of funding. This is known as Valuation Risk. A seed valuation is driven by the team in the main. Financials play a bigger part in the valuation from Series A onwards. Setting a high seed valuation means the startup will have to reach comparatively high revenue targets to justify an uptick in valuation for follow on funding.
Investments will hopefully mature and become scale-ups. At which time they will need follow on funding, which may not be readily available. Even if funds are available, follow-on-funders like VCs have strict mandates and your investee company may fall outside of this. It’s a Funding Risk that all angels assume. Angel investors should ideally identify a follow on funder before investing.
While angel investors have more control than they would investing in other asset classes like listed companies. Investors are reliant on founders for decision-making as they are typically minority shareholders. For this reason it’s important to maintain strategic alignment with management.
Last but not least, as we live in a fast-paced world with constant research and innovation, there is a Technology Risk associated with investing in a startup. This is the possibility of new solutions that are more innovative or more affordable having the potential to trump a startup’s offering.
According to Eric Ries, a startup is a human institution designed to deliver a new product or service under conditions of extreme uncertainty. Its this uncertainty that results in nine out of ten startups failing. Fortunately there are techniques to mitigate most of these risks. In this blog series we’ll be covering those we are comfortable with. The amount of resources available in the angel space continues to grow.
The startup space is a wasteland of potential that never materialised. Simply a good idea or product is never enough. With that said, when considering investing in a startup, one should question and critically assess all the important aspects of the startup: Is the solution outstanding? Is this an A team? Is the market in need of this solution?
The above mentioned are broader risks that an angel investor may have to confront. The list is not exhaustive and each deal may include a thorn unique to its rose. It is this high risk nature of Angel Investing that distinguishes it from other safer forms of investment.