4 Risks Of Investing In Startups And IPOs

By David Bakke | September 18, 2012 AAA

Many investors want big returns on their money and so seek the vehicles that can deliver; but making big bucks usually translates to taking big risks. After all, if the risk wasn't there, everyone would be doing it. However, sometimes it can be easy to let dreams of double or even triple digit returns cloud your judgment and obscure the risk. Don't let this happen to you, especially when it comes to investing in startups and IPOs.



1. Don't Believe the Hype
A lot was expected from the Facebook IPO, but because of NASDAQ glitches and possible overvaluation, it was an abject failure. In fact, it fell from an initial $38 to $32 within the first few days, and even Mark Zuckerberg eventually sold off shares. The same goes for startups; don't believe the sales pitch unless you see hard data to back up projections and expectations. Whatever you invest in, make sure your own research matches the story the company tells you.



2. Don't Bet on Quick Profits
According to a recent study, the average IPO goes up 18% on the first day of trading, but generally underperforms when compared to stocks from smaller companies over the following three years. Sounds like a good recipe to get in and get out, right? Possibly, but that strategy relies on you getting in before the price shoots up, which could happen within the first few minutes of trading. A better strategy is to watch the IPO of a company you're interested in and invest when the hype dies down and the stock and overall market still look strong.



If you invest in a startup, expect to wait even longer to see a profit. The business might not even launch for a year or two. If your financing is considered to be "seed" money, it could take years after that point for it to be in the black. Understand that if you do invest in a startup, patience is not only a virtue it's a requirement.

SEE: When Selling Your Startup Makes Sense

3. Beware a Lack of Experience
A startup can be based on the greatest idea in the world, but if the team behind it doesn't have the experience or leadership to execute it, the chances of success are minimal. This logic applies to pretty much any investment, even mutual funds, and definitely IPOs. Examine the fundamentals of the company offering the IPO in addition to management's collective experience and successes. If they're anything less than solid, look elsewhere.



4. Remember, You Risk Losing It All
Research has shown that up to 90% of startups fail and that IPOs generally underperform their peers for the first three years. How do you beat these averages? Do your research and keep your cool. It can also help to remember that your recourse is limited if the investment goes south. For example, if a startup fails, investors are generally last in line in bankruptcy proceedings, and once you purchase shares in an IPO, the only way to recoup your investment is to sell those shares - even if they're only worth pennies on the dollar.

SEE: IPO Basics: Introduction

The Bottom Line
With big gains, comes big risk - there are no two ways about it. The more you pay attention to inherent risks and do your research, the less often you'll lose. However, it's not the end of the world if you buy into what turns out to be a losing proposition, so long as you didn't bet your shirt. In other words, limit your investment in any startup, IPO or other high-risk vehicle to what you can afford to lose. That way, a loss won't destroy your portfolio, and a gain will give you that much more with which to bet.

By David Bakke of MoneyCrashers.com

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