Do you know the dirty four-letter word…
…which makes the angel investing world cringe…
If you’re not taking the risks of angel investing seriously or don’t understand how it impacts the investment…
You can kiss your money goodbye.
It’s those very risks that bring many startups to a breaking point.
When they break, it takes investor’s money down with them.
CB Insights (a business research firm) looked at 101 failed startups.
They discovered it’s not usually one factor that causes a startup to fail, but a combination of a few.
Top 5 Reasons Startups Fail
- Lack of Market Need
- Running Out of Money
- Team Related Issues
- Price / Cost Related Issues
You can’t eliminate all risks when investing in early-stage startups––it comes with the territory.
The key is to identify them early on and determine if the startup is capable of pivoting where necessary, patching holes, making changes where needed.
To better understand the types of risks that exist, how to spot them, and what you can do to manage their impact…
Angel investing is a risky business.
Hands down, investing in early-stage companies is one of the riskiest investments out there.
But as angel investors, we need risk. We thrive in it. This may seem counter-intuitive, but eliminating risk means eliminating reward.
Angel investors are swimming in a sea of risk — so there’s no use trying to stay dry.
The trick is knowing what areas to look at, having a solid foundation of knowledge, and pre-screened deals to consider.
By focusing on trouble-areas first, you can save valuable time during due diligence. The more comfortable you are with risk, the better an angel investor you will be.
Risk Is a Good Thing
Markets reward risk-takers — plain and simple.
You don’t get big rewards without taking big risks. Startup investments have the highest returns of any asset class precisely because they are so risky.
With any investment, you should never obsess over eliminating all of the risks — that’s impossible. A better strategy is to work through unnecessary risks and know when a problem is too large and just walk away.
There are so many unknowns when you invest in an early-stage company that you could go crazy trying to work through every nuance.
Professional angel investors know how to maintain a balance. By scanning over essential information and identifying major risks, an angel can find good deals and avoid spending too much time speculating.
But hey, riskier deals often have a lower valuation. This means you can get big chunks of the company for very little money. Even the riskiest of deals can be viable once you know what you’re doing.
How to Identify Angel Investing Risks
Identifying risks is simpler than it sounds. One of the best ways to do this is to conduct some standard due diligence focusing on essential areas first.
Always start with big concerns. Look at the team, market, product, and exit strategy.
When listening to pitches or studying a startup’s profile page, always check what assumptions need to be made for the proposition to work. This is the WNTBB or “what needs to be believed”.
Take these assumptions into the real world and see if they stand up.
If you see a hole in the startup’s plan, you can ask the founders what they will do to patch it up. One or two issues don’t usually make or break a deal — good founders can solve problems or hire people to strengthen weak areas.
However, don’t waste your time trying to shove corks into the many holes of a sinking ship — be sensible and head for the lifeboats.
Types of Risks
There are many risk categories to keep an eye on.
Unfortunately, there isn’t a definite flowchart of what risks are more or less severe than others, it all comes down to the individual company.
Keeping that in mind, let’s take a look at some of the risk areas of a startup company.
Probably the biggest deal-breaker is regulatory risk. This comes down to legal problems the company could face in terms of its products and services.
If a startup needs FDA approval or SEC regulation you can expect complications. In many cases, these standards won’t be met and the company will go out of business — meaning your investment goes down the drain.
Also, startups that offer dangerous activities can cause liability issues.
Unless you have experience with these kinds of startups or are certain that the regulations will be rock-solid, the risk may outweigh the reward.
The first part of team risk comes down to integrity.
The founder’s sincerity and transparency should be obvious. Personally, a dishonest or misleading founder is all I need to see to pass on a deal.
We talk about the importance of a strong founder regularly with members of our Angel Investing Insider service –– you want to back a capable jockey!
Next, you have to question the intelligence, people skills, and experience of the founders and management team.
Founders need to be exceptional problem solvers and that takes some brains. They also need the communication skills to get ideas across, lead their team, and convince future rounds of investors to buy-in. Finally, they should have experience in the field that proves that this isn’t their first rodeo.
First-time entrepreneurs aren’t out of the question, but they are certainly riskier.
If your founder and their team don’t check these boxes you are taking on a risky venture indeed.
Market size is essential. Ask yourself — is this market big enough to support the founder’s vision for the company? Is it healthy enough that I can get the exit plan I desire? Have there been sizable exits by similar companies in the space?
Competition isn’t a bad thing. Over-saturated markets aren’t advantageous, but competition shows you that there is a demand for a similar business model.
In reality, underdeveloped or non-existent markets are far worse than stiff competition.
Despite the popular misconception, big-breakthrough unicorns seldom create their market.
There were search engines before Google and MP3 players before the iPod. Where are they now? Kaput, gone.
Many times, the first startup on the market spends all of its resources trying to develop the market and end up failing because of it.
You also need to read the deal-terms carefully — there are a few red flags to watch out for.
Consider this, there are risks to startups and there are risks to investors. You need to be aware of both.
For example, unreasonably high valuations can be good for startups but bad for investors.
Valuation is always something to worry about. Signing on a deal with an unrealistic valuation means you are paying more and getting less. That is one surefire way to make your returns disappear.
Also, if there is no lead investor or an under-experienced one, you can mark that down in the “BIG RISK” category. A lead investor is an essential part of the equation. They work on behalf of the investors, advise the company, and increase investor buy-in.
How to Mitigate These Risks
You can mitigate risk through due diligence — but only to an extent.
At a certain point, the analysis yields less and less actionable information, as facts turn into probabilities that turn into wild guesses.
Investors are better off making quick assessments, deciding if the deal is right or not, and moving on to the next opportunity. Your time is valuable, and no one startup should ever make or break your angel investing portfolio.
This brings me to my next point — portfolios.
Probably the best way to manage risk is by managing the meta-risk of all of the startup investments in your portfolio. A sound angel investing strategy ensures that no failure of a company causes the whole structure to come crashing down.
An excellent investment strategy is to have enough sound investments that one success can make up for multiple failures.
Here’s a hypothetical scenario as an example:
You make 10 startup investments, expect 4 of them to outright fail. That is the simple reality of startup investing.
Of the remaining 6 companies, you will break even on about 5.
Finally, 1 of the companies will be a big success.
But here’s the thing, that one success could yield returns so large that it pays for your losses, your time, and gives you a hefty serving of profit on top.
With a sound strategy and portfolio, you can eliminate much of the risk.
Angel Investing Communities
The last thing I would recommend, especially for newer angel investors, is to gain the benefits of an angel investing community.
Angel Investing Insider is a community of angel investors led by seasoned investors and entrepreneurs.
In addition to the foundational information you need to evaluate and understand angel investing, you also get access to consistent deal flow –– the lifeblood of startup investing.
Working with a network like this can greatly reduce risk while supplying you with the deals you need to start growing your roster of startups.