- By SeedInvest
- May 12, 2016
- 6 minute read
This guide sets out the risks that you need to consider when making an investment in a startup company on SeedInvest. Investing in startups is very risky, highly speculative, and investments should not be made by anyone who cannot afford to risk the entire investment.
You should carefully consider the risks associated with the type of investment, security, and business before making any investment decision.
Principal risk: Investing in start-ups will put the entire amount of your investment at risk. There are many situations in which the company may fail completely or you may not be able to sell the stock that you own in the company. In these situations, you may lose the entire amount of your investment. For investments in startups, total loss of capital is a highly likely outcome. Investing in startups involves a high level of risk and you should not invest any funds unless you are able to bear the entire loss of the investment.
Returns risk: The amount of return on investment, if any, is highly variable and not guaranteed. Some startups may be successful and generate significant returns, but many will not be successful and will only generate small returns, if any at all. Any returns that you may receive will be variable in amount, frequency, and timing. You should not invest any funds in which you require a regular, predictable and/or stable return.
Returns delay: Any returns may take several years to materialize. Most startups take five to seven years to generate any investment return, if any at all. It may also take many years before you will know if a startup investment will generate any return. You should not invest any funds in which you require a return within a certain timeframe.
Liquidity risk: It may be difficult to sell your securities. Startup investments are privately held companies and are not traded on a public stock exchange. Also, there is currently no readily available secondary market for private buyers to purchase your securities. Furthermore, there may be restrictions on the resale of the securities you purchase and your ability to transfer. You should not invest any funds in which you require the ability to withdraw, cash-out, or liquidate within a certain period of time.
Instrument risk: You may be investing in preferred equity, common equity, or convertible notes. These securities instruments all have different inherent risks caused by their structure. You should take the time to understand the nature of the securities instrument that you are investing in.
Dilution: Startup companies may need to raise additional capital in the future. When these new investors make their investment into the company they may receive newly issued securities. These new securities will dilute the percentage ownership that you have in the business.
Minority stake: As a smaller shareholder in the business you may have less voting rights or ability to influence the direction of the company than larger investors. In some cases, this may mean that your securities are treated less preferentially than larger security holders.
Valuation risk: Unlike publicly traded companies that are valued publicly through market-driven stock prices, the valuation of private companies, especially startups, is difficult to assess. The issuer will set the share price for your investment and you may risk overpaying for your investment. The price you pay for your investment may have a material impact on your eventual return, if any at all.
Failure risk: Investments in startups are speculative and these companies often fail. Unlike an investment in a mature business where there is a track record of revenue and income, the success of a startup often relies on the development of a new product or service that may or may not find a market. You should be able to afford and be prepared to lose your entire investment.
Revenue risk: The company is still in an early phase, and may be just beginning to implement its business plan. There can be no assurance that it will ever operate profitably. The likelihood of achieving profitability should be considered in light of the problems, expenses, difficulties, complications and delays usually encountered by companies in their early stages of development. The company may not be successful in attaining the objectives necessary for it to overcome these risks and uncertainties.
Funding risk: The company may require funds in excess of its existing cash resources to fund operating expenses, develop new products, expand its marketing capabilities, and finance general and administrative activities. Due to market conditions at the time the company needs additional funding, it is possible that the company will be unable to obtain additional funding when it needs it, or the terms of any available funding may be unfavorable. If the company is unable to obtain additional funding, it may not be able to repay debts when they are due or the new funding may excessively dilute existing investors. If the company is unable to obtain additional funding as and when needed, it could be forced to delay its development, marketing and expansion efforts and, if it continues to experience losses, potentially cease operations.
Disclosure risks: The company is at an early stage may only be able to provide limited information about its business plan and operations because it does not have fully developed operations or a long trading history. The company is also only obligated to provide limited information regarding its business and financial affairs to investors.
Personnel risks: An investment in a startup is also an investment in the management of the company. Being able to execute on the business plan is often an important factor in whether the business is viable and successful. You should be aware that a portion of your investment may fund the compensation of the company’s employees, including its management. You should carefully review any disclosure regarding the company’s use of proceeds. You should also carefully consider the experience and expertise of the management team.
Fraud risks: It is possible that certain people involved in the company may commit fraud or mislead investors. If fraud or misleading conduct occurs, then your total investment may be lost. You should carefully review any disclosures regarding the company’s management team and make your own assessment of the likelihood of any potential fraud.
Lack of professional guidance: Many successful startups partially attribute their early success to the guidance of professional investors (e.g., angel investors and venture capital firms). These investors often play an important role through their resources, contacts and experience in assisting startup companies in executing on their business plans. A startup company primarily financed by smaller investors may not have the benefit of such professional investors. You should consider the existing professional investors in the company and whether or not they or any other professional investors are participating in the current round.
Growth risk: For a startup to succeed, it will need to expand significantly. There can be no assurance that it will achieve this expansion. Expansion may place a significant strain on the company’s management, operational and financial resources. To manage growth, the company will be required to implement operational and financial systems, procedures and controls. It also will be required to expand its finance, administrative and operations staff. There can be no assurance that the company’s current and planned personnel, systems, procedures and controls will be adequate to support its future operations. The company’s failure to manage growth effectively could have a material adverse effect on its business, results of operations, and financial condition.
Competition risk: The startup may face competition from other companies, some of which might have received more funding than the startup has. One or more of the company’s competitors could offer services similar to those offered by the company at significantly lower prices, which would cause downward pressure on the prices the company would be able to charge for its services. If the company is not able to charge the prices it anticipates charging for its services, there may be a material adverse effect on the company’s results of operations and financial condition.
Market demand risk: While the company believes that there will be customer demand for its products, there is no assurance that there will be broad market acceptance of the company’s offerings. There also may not be broad market acceptance of the company’s offerings if its competitors offer products which are preferred by prospective customers. In such event, there may be a material adverse effect on the company’s results of operations and financial condition, and the company may not be able to achieve its goals.
Control risks: Because the company’s founders, directors and executive officers may be among the company’s largest stockholders, they can exert significant control over the company’s business and affairs and have actual or potential interests that may depart from yours. The company’s founders, directors and executive officers may own or control a significant percentage of the company. In addition to their board seats, such persons will have significant influence over corporate actions requiring stockholder approval, irrespective of how the company’s other stockholders, including you, may vote. Such persons’ ownership may also discourage a potential acquirer from making an offer to acquire the company, which in turn could reduce the company’s stock price or prevent you from realizing a premium on your investment.
This post was written by SeedInvest on May 12, 2016