Why Invest in Startups? Exploring the Pros and Cons

Investing in startups can be an exciting and potentially lucrative opportunity, but it also comes with significant risks. While some investors strike gold with early-stage companies that turn into industry giants, many startups fail, leading to total loss of investment. Before diving in, it's crucial to understand the potential rewards and drawbacks.

What are Startups?

The definition of startup might be different depending on who you ask. Pose the question to 10 different entrepreneurs and you might come away with 10 different answers from a venture capitalist, a retail investor, a business owner and many others. So, there must be some parameters that investors review when doing their due diligence of a startup.

But regardless of the specifics, most definitions of startup have two important factors:

• Company size
• Length of business history
• Aggressive growth plans

Startup companies haven’t been in business very long, usually topping out at five years. They also have only a handful of employees and get funding from either the founders, venture capital or angel investors. Additionally, startup companies usually aim for disruption, either by replacing a current enterprise (like Uber wants to do to taxis) or creating an entirely new market (like online dating companies).

Some startups design a product or forge a business plan in the hopes of getting bought out by a larger firm. Before becoming an Uber founder and CEO, Travis Kalanick developed a peer-to-peer file trading service called Red Swoosh, which he sold for $19 million to Akamai in 2007. Kalanick used his money from the Red Swoosh buyout to help get Uber off the ground.

Pros and Cons of Startup Investing

Before we discuss ways to buy in, you’ll want to consider the pros and cons of a startup program. Startup investments can be risky, but also extremely rewarding.

Pros of Investing in Startups

Here are the pros of investing in startups.

High Growth Potential

Startups have the potential for exponential growth, offering investors the chance to earn substantial returns. If you invest in the next big thing early on, the value of your shares could skyrocket as the company scales.

Equity Ownership

Unlike traditional stock investments, investing in startups often means owning a piece of the company. This can result in significant wealth creation if the business succeeds and goes public or gets acquired.

Portfolio Diversification

Adding startup investments to your portfolio can diversify your assets beyond traditional stocks and bonds. While high-risk, startups operate in various industries, some of which may be less correlated with public markets.

Early Market Access

Startup investors often get early exposure to emerging markets and innovative products before they become mainstream. This can provide a competitive advantage in identifying future trends.

Tax Benefits

In some countries, investing in startups can provide tax incentives, such as deductions, credits, or exemptions, particularly for supporting small businesses and innovation.

Personal Involvement and Influence

Unlike public stocks, where investors have little say, startup investors—especially angel investors—can contribute strategic advice, mentorship, and networking opportunities to help the business grow.

Cons of Investing in Startups

Now let's take a look at the cons.

High Risk of Failure

Most startups fail. According to industry data, about 90% of startups don’t make it past their early stages, meaning investors face a high likelihood of losing their money.

Illiquidity

Unlike publicly traded stocks, startup investments are not easily sold or traded. Your money may be tied up for years, sometimes indefinitely, before seeing any returns.

Dilution Risk

If a startup raises additional funding rounds, your ownership percentage may decrease unless you invest more money. This dilution can impact your overall return on investment.

Lack of Transparency and Data

Startups often lack the financial reporting and governance structures of publicly traded companies. This can make it difficult to assess risks accurately, increasing the potential for fraud or mismanagement.

Long Wait for Returns

Even successful startups take years to become profitable or reach an exit event (such as acquisition or IPO). Investors must be patient and prepared for a long-term commitment.

High Competition for Good Deals

The best startup opportunities often attract venture capital firms and experienced investors, making it challenging for retail investors to access high-quality deals.

Diversify Your Investments with Startups

Investing in startups can be a thrilling and potentially rewarding venture, but it is not for the faint of heart. It requires careful due diligence, patience, and a high tolerance for risk. If you’re considering startup investments, ensure that you only allocate money you can afford to lose and diversify your portfolio to mitigate risks.

Frequently Asked Questions