Investing in startups is often seen as an exciting way to build wealth, with the potential for rocket ship growth of individual businesses attracting money from traditional routes such as VC and institutional investors, but also increasingly from individual investors through platforms like Seedrs. But what are the risks involved?
All investments carry varying degrees of risk, and investing in early-stage and growth-focused businesses is no different. The main risk associated with investing in startups is that the business may simply fail, and investors won’t get their money back. Due to the potential for losses, this asset class is high risk.
This article will take you through some key concepts to understand when managing your risk, including:
- The Main Risks Associated With Startup Investments
- How Investors Can Mitigate Risk
- How Seedrs Works To Mitigate Risk On Behalf Of Investors
What Are The Main Risks When Investing In Startups?
There are three main types of risk when investing in early-stage and growth-focused businesses.
- Business Failure: The first is that the business may fail – or even that it may tick along without ever really succeeding or exiting – and you won’t get any of your money back.
- Illiquidity: Even if the business succeeds, your investment is likely to be illiquid. A successful investment will be locked in for a long time – often several years – while the business grows. This means that you are unlikely to be able to sell the shares, and you will likely not receive dividends
- Dilution: Finally, there is the risk of dilution. If the business raises more capital later on (which most successful startups need to do), the percentage of equity that you hold in it will decrease relative to what you originally had. You can read more about dilution in this blog post.
Read our Risk Warning for additional information about the risks associated with investing in early-stage and growth-focused businesses.
How Can Investors Mitigate Risk?
Whilst these investments are high risk and investors risk losing all the capital invested, there are a number of steps investors can take to mitigate their exposure to risk.
Investing Through A Nominee Structure
One of the most important features of Seedrs is our nominee structure, whereby we hold and manage the shares of startups on behalf of the underlying investors after an investment is completed.
To ensure our investors receive the professional-grade protections they deserve and entrepreneurs don’t end up with messy and hard-to-manage cap tables, we act as the nominee shareholder on behalf of investors on Seedrs.
In short, this means that:
Investors do not need to worry about administering their investments. We ensure that their investments are protected using both the statutory provisions afforded to shareholders as well as the professional, contractual protections that are in place under our subscription and shareholder agreements with each company.
The Importance Of Diversification
Diversification is a risk management technique by which investors invest their capital across a number of different asset classes, geographies and industry sectors in order to spread their risk exposure. Rather than making one big investment and putting “all their eggs in one basket”, an investor makes a number of smaller investments.
Diversification is a huge topic to cover, so for the purpose of this post we will look at diversifying within early-stage businesses, such as the ones listed on Seedrs.
With a diverse portfolio, an investor can lower the risk of losing capital and is more likely to yield a higher return overall on average.
To bring the concept of diversification to life, take this very basic example: an individual invests half of their investable capital in an ice cream company and half in an umbrella company. During the summer the ice cream company will be successful and return a profit, but since it isn’t raining, the umbrella company won’t do well. Conversely, during the winter the opposite will be true and the umbrella company will be profitable. In this scenario, the investor has diversified themselves against the effect of the weather on their portfolio.
As you can see from this example, the overall risk of a portfolio is reduced by investing in companies which are not perfectly correlated with each other, which means that they do not influence or depend on each other.
There are a few types of risk that affect a business’s success, but unsystematic risks are the most-easily mitigated through diversification. Early-stage businesses, in particular, are exposed to unsystematic risks, where most of the possibility of success or failure lies within the company and is not as dependent on the market as a whole. There are many types of unsystematic risk, but here are a few to be aware of:
- Execution risk: The business idea may be good, but does the team have the required skills and talent to reach their goals?
- Market timing risk: Is now the right time for the business? Are they too early or too late to market?
- Business model risk: Does the company have a clear business model which makes sense?
- Technology risk: Does the company rely on a technology which is still being developed?
In addition to considering the risks involved with the business itself, diversification also means looking at the type and number of companies. A diverse portfolio frequently considers these three diversification verticals:
- Sector/industry diversification: each sector and industry will move in its own way and have its own relationship with the overall business environment. Some sectors will come into vogue and others will fall out of favour, and this will affect how well the company will do.
- Time diversification: the macro economy will affect all businesses to an extent. By investing in companies over a long period of time, an investor can smooth out some of the macroeconomic cycles that may increase any business’s risk. This also helps to diversify against changes in the funding climate (in other words, the ability of early-stage businesses to access capital).
- Geographic diversification: Investing across countries allows an investor to tap into different trends, knowledge bases and opportunities which can not only add significant value to their portfolio but can also diversify it to mitigate geographic risk.
Doing Your Own Investment Due Diligence
Research and due diligence are important to mitigating your risk as a startup investor. Investors should make an effort to review all information that’s accessible on the campaign page, Companies House for UK businesses, and in the media. Whilst the risk of the startup isn’t mitigated directly, investors can get a level of confidence in the business and the market in which it is operating to make an informed investment decision.
Investors can learn more about conducting thorough due diligence in our next guide, ‘How To Select Startups To Invest In’.
S/EIS Tax relief
Various governments have created tax efficiency schemes to encourage investment into early stage businesses. In the UK investors can take advantage of the SEIS and EIS tax relief schemes.
These schemes include Income Tax relief for initial investments into businesses, Capital Gains relief for profits, and Income Tax relief on losses. This means that investors can risk less capital for the same exposure to a business, reducing the risk profile of the invested capital into these investments.
Investors can learn more about tax relief in our S/EIS tax guide, ‘Tax And The Benefits Of Investing In Startups’.
How Seedrs Works To Mitigate The Risk Of Startup Investing
Seedrs’ mission is to provide all types of investors with the opportunity to invest in exciting early-stage and growth-stage businesses, often presenting opportunities that investors could not access elsewhere. In doing so, we believe it is right that investors understand both the risks of investing in this asset class and the extent of, and limits to, the protections they receive.
For a business to be given the go-ahead to raise on Seedrs there is a large amount of due diligence that happens up front. Although some businesses may find it a little easier to raise on some other platforms, if a founder chooses Seedrs, it demonstrates that they believe that they have nothing to hide from our enhanced scrutiny. That’s exactly why many investors are so interested in the steady stream of opportunities that are available on Seedrs.
We provide all types of investors with the opportunity to invest in exciting early-stage and growth businesses, structuring deals to ensure that when there are returns, everyone shares in the success – including investors and founders.
Seedrs Due Diligence
Seedrs conducts a core due diligence process on all companies that raise primary funding rounds on Seedrs. However, we do not conduct an exhaustive legal or commercial due diligence process on all aspects of a business and we cannot provide personalised due diligence in line with an individual investor’s personal thesis or drivers for investing. We therefore encourage all investors to do their own due diligence, as they see fit and in line with their own risk assessment, before making their investment decision.
We have published our approach to due diligence so that investors can understand the breadth and limitations of the Seedrs due diligence process.
The Seedrs due diligence process covers five key areas:
- 1. Verification of the Campaign
- 2. General legal due diligence
- 3. Intellectual property
- 4. Share capital structure
- 5. Current financial position
Seedrs Nominee Services
Investors on Seedrs are able to invest in businesses through our innovative nominee structure, that we talked about above. The services that we deliver through the nominee structure enable us to act in our investors best interests, by enforcing shareholder rights and ensuring compliance by the company with its subscription agreements.
Our Portfolio Team
We have an impressive (and growing!) portfolio team at Seedrs. This team spends their time dealing with our portfolio of businesses and acting on behalf of our investors. This involves helping companies with exits, wind ups, and pre-emption rounds, enforcing and protecting shareholder rights, monitoring business performance, and chasing businesses to update investors consistently.
This section will have given you an overview of the risks associated with investing in early stage private businesses and as we’ve explored, the actions that both Seedrs and our investors take to help mitigate against these risks. We often explore the topic in more detail in our investor newsletters, where we share insights and case studies to help our investor community on their investment journeys.
You can sign up below to access these monthly emails, and continue to our next section, which helps investors understand “How To Select Startups To Invest In?”.