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What Are the Risks and Rewards of Startup Investing?

Posted by Erica Duignan Minnihan on May 7, 2016 4:00:00 PM



Do you like to take risk? Investing in Seed and Series A stage deal can be a beneficial addition to your portfolio not in spite of the high risk, but because of the high level of risk. If you have ever read Nassim Taleb’s book Black Swan, you know that adding some high-risk, high-return assets to a portfolio of liquid traditional public market assets can help enhance to overall risk-adjusted expected return of the portfolio.

There are many reasons to get involved in early stage investing. Let's go over some of the risks and rewards you should consider here:

REWARD >> Meet Cool People

One of the coolest advantages of early stage investing is the increased transparency that comes with getting in when the company is still small. You will likely have the chance to meet the founder and the team, and really get to know who and what you are investing in. And today’s startup founder might be tomorrow’s Steve Jobs.

RISK >> Binary Outcomes

Early stage ventures typically have a high rate of failure, and binary outcomes enhance the risk of loss. We describe them as binary outcomes because typically the company will either do really well and you will get a big return on your investment, or they will go out of business and you may not even get a return of capital. So in order to compensate for the total losses, the winner needs to pay off in a big way. This is why investors typically demand and expected 10x or greater return on investment. This means that if the company is expected to sell for $50 million in 5 years, you want to make sure the current post money valuation at which you invest is $5 million or less.

REWARD >> High Return Potential

Investors who take a portfolio approach and add a meaningful number of venture investments to complement their traditional, liquid, public market investors can do very well if they have low-cost access to high quality investment opportunities. For an investor who would like to allocate $250K to venture assets, a portfolio of 12 investments made over the course of a year may yield 4 total losers, 5 that return the capital, 2 that meet the 10x expected return and 1 that returns 50x over a 5 year period.  This reasonable performance, with only a 25% of the companies meeting the original projected return, still provides a 6x cash on cash return on the entire portfolio. Which would be a solid return over a 5-10 year investment life.

RISK >> Diversification is the Key

However, if you only invested in 2 or 3 companies, and they happened to be one of the 3 that were total loser, or the 6 that just returned capital, you wouldn’t have done so well. And diversification is key to making sure that 25% of high performers end up in your portfolio. The risks are there, but they can be managed, with the right approach and a partner like 1000 Angels to help guide you through the investment process and make sure you have access to investment opportunities that are well-positioned for success.

REWARD >> Tax Incentives

Another advantage includes the preferential tax treatment that comes with investments made in “qualified small businesses”. These are companies with less than $50 million in assets both before and after the investment. Capital gains in “qualified small businesses” that are held for 5 years or longer are 100% tax exempt, up to the greater of $10 million or 10x your investment. That alone can save you up to $2 million in potential taxes assuming your investment is successful.

1000 Angels is a community of like-minded investors who are searching for the next big deal. We seek and source investment deals that have potential to reward you in the areas that were mentioned above.

Be sure to visit and activate a trial membership, risk free.




Topics: Venture Investing, Invest in Startups, Venture Investing Academy, Risks and Rewards