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Featured Article

Navigating the Risks of Startup Investing

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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.

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 return potential 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.

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 comparably less money.

How to Identify Angel Investing Risks

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.

Regulatory Risk

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 and the investor’s risk tolerance.

Keeping that in mind, let's take a look at some of the risk areas of a startup company.

Regulatory Risk

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 and delays.

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.

Team Risk

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 Boardroom 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.

Market Risk

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.

Deal Risk

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.

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 single 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.

Angel Investing Communities

The last thing I would recommend, especially for newer angel investors, is to gain the benefits of an angel investing community.

The Boardroom is our private membership service where we show you the deals WE’RE investing in or about to invest in, why, and even what we negotiated with the founders.

We’re opening this service exclusively for Wefunder’s Investors – click here to learn more.

here’s no better way to learn than looking over the shoulder of experts in the space.

Other Resources

Startup Investing Key Terms
Our straightforward guide to the language of investing.

5 Fundamentals of Angel Investing
A quick must-read for every investor, old and new.

The Next Level of Investing Firepower

SEE the Deals we’re investing in, LEARN how we conduct our Due Diligence, and INVEST when we invest or take a pass!

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