Many startups got listed in recent months on the stock exchange. Some startups that got listed are – Zomato, CarsTrade, Nykaa, and Paytm. Many more plans to get listed in the coming months. The investors who invested in these companies in the initial stages have made mindboggling returns. For example, Info Edge, one of the initial investors in food delivery startup Zomato, made over 1000 times in 10 years.
Such gains are tempting many retail investors to start investing in startups. If you also plan to invest in startups, you must understand the complete picture before investing in them.
What is a startup investment?
When you invest in a startup, you are essentially buying a piece of the company with your money. You give them money in exchange for equity – a portion of ownership in the company and rights to its potential future profits.
Some disturbing facts
More than 90% of the startups fail. Startups backed by Venture Capitalists also fail – 25% to 30% of them. If any VC invests in 10 startups, three to four fail, another three to four break even, and only one or two make it big. Why are we discussing these numbers? The point is – even the investment firms with some of the best minds have a success rate of 10 to 20% when they invest in startups. How can a retail investor be sure of making returns in the startup?
How does one make returns in startups?
You must understand how you can make returns in startups. Mainly, there are only two exit options in the startup –
- you sell your initial stake to some other investors
- the company goes public, and you sell your stake in the open market
Pitfalls of investing in startups
Your principal is at risk – Above, we have discussed there are only two exit routes of an investor. If neither of these routes materializes, your entire capital is at risk. As mentioned above, more than 90% of the startups fail, in all these cases, and investors lose 100% of their investment. It is a very high-risk investment, and you should only invest in startups if you can bear the entire loss.
Liquidity risk – Startups are privately owned companies and do not trade on the stock market. It may be tough to sell securities you hold in them. In most cases, there is a restriction on the resale of stocks you have. You cannot even transfer them. Hence, the liquidity is almost nil with startup investment.
Long wait period – When you invest in listed companies or any other financial instrument, you can decide the investment horizon according to your requirement. For example, if your investment horizon is less, you can invest in large-cap companies. It means you have the flexibility of deciding the investment period. When you invest in startups, it is a long-term investment – the problem being you don’t know how long. In most cases, it takes a startup 8 to 10 years to get listed and generate returns for you.
Valuation risk – When you invest in listed stocks, the valuations are transparent – through the market-driven stock price. However, in the case of startups, the valuation is difficult to assess. Startups are not monitored by a central governing body. Hence, there is a risk of overpaying. If you are paying high initially, it will impact your final returns, if any.
Multiple unknown risks – You already know 90% of the startups fail. It is because of a number of risks. The biggest and most common risk is that a company fails to expand. The success formula for a startup is to grow exponentially. If it cannot, it is sure to fail – sooner than later. The other type of risks are
- revenue risk – it fails to increase its revenue and lower its losses
- funding risk – it runs out of cash and is not able to raise more funds
- Competition risk – A new player emerges with deeper pockets and get into a price war
We are not saying that investing in startups is not a good idea. However, with so many pitfalls, it is difficult for retail investors to get returns on investment. The risks are so high that you need to answer yourself – are you ready for a high-risk game? If you get one startup that gets listed, you can have multi-fold returns. However, getting that one startup is not so easy.
Most of us are not comfortable putting our capital at risk. When we read news about 1000x returns, our emotions drive our decision. Emotions are never good in investment, no matter what kind of investment you make.
What are alternatives?
The best alternative is the equity market – invest in direct equity. If you are comfortable taking risks, take risks in small and large-cap companies. There are many advantages when you invest in listed companies –
- These are regulated
- the results are declared every quarter so you can track growth
- you can exit as and when you want
To ensure you make returns from high-risk stocks, you should know how to pick them. If you are not sure which company to pick, you can take the help of Jarvis Invest. It selects stocks for you based on your risk profile and investment horizon. Download the app now.
