I am often asked about the risks of investing in a startup company. Entrepreneurs with a great business idea often approach friends and family to invest in the company. This phase of fundraising is often called a “Friends and Family Round.” This is typically before a “Seed Round,” which involves additional investment at a higher level. Next comes a “Series A Round,” which brings substantially more money into the company. The earlier the round, the greater the risk. However, often early investors are given a discount or a better deal because of that additional risk.
Example of raising money from investors in multiple rounds:
- Phase 1 – Friends and Family Round
- Phase 2 – Seed Round
- Phase 3 – Series A Round
- Phase 4 – Series B Round
- Phase 5 – Series C Round
- Phase 6 – Series D Round
At these early stages, the risks are high. There is virtually no marketplace for investors to sell off their investment and recoup some of their money. This means early investors often must wait until the next round to be bought out.
Investors know that the risks are plentiful. All sorts of problems could prevent the company from being successful. We all know the statistics: most startup companies fail.
If investors want to put money into a startup, my advice is to first look at the entrepreneur running the company. Can you trust the entrepreneur’s character? Can you trust the entrepreneur’s experience, demonstrating success in similar ventures previously? The best indication of future success is a track record of prior success in a similar venture.
After looking at the entrepreneur running the company, your next step will be to examine the business idea. Entire articles could be written about this, but the point is that the entrepreneur running the company is more important than the business idea. Often business ideas evolve over time: startups need to pivot to respond to market forces and new insights. It is the excellent skills and intelligence of the entrepreneur leading the company that brings success. Likewise, the best business ideas often result in failure because the company has the wrong leader.
In conclusion, if you are going to invest in a startup, understand the risk is high. The main way you can help avoid losses is by focusing your attention on the company leader. There is no replacement for excellent leadership. Everything else is secondary.