Investing money in a startup has the potential to yield significant returns, but it's not a risk-free enterprise. There are no guarantees that a fledgling company will take off, and if it fails, investors may walk away with nothing. Before diving into an angel investment, becoming a venture capitalist or investing in a start-up through a crowdfunding platform, there are several key questions investors must ask. (For more, see the tutorial: Investing for Safety and Income.)

1. What Level of Involvement is Required?

The level of involvement that goes along with investing in a start-up directly corresponds to the type of investment. For example, someone who invests in a startup through a venture capital firm, for instance, would have limited interaction with the team that runs the start-up. An angel investor, on the other hand, is looking at a very different scenario.

With angel investments, the investor is granted an equity stake in the company which means they have the opportunity to participate in decision-making, alongside the startup's leadership. By comparison, an investor who funds a startup's crowdfunding campaign would also receive an equity share but they wouldn't have the same scope of control as an angel investor. Ultimately, it's important to be clear on how much or how little involvement you'd like when handing money over to a startup. (For more on crowdfunding and startups, see: As Crowdfunding Matures, Investing in Startups Gets Easier.)

2. What's the Time Frame?

For every overnight success story, there are hundreds if not thousands of startups that take years to realize a profit. Investing is a long-term game, but it's important to have some idea of the timeline so you can compare it to your personal expectations. While some investors may be comfortable with waiting ten years to realize a return, others may want to get their money back within five years.

Evaluating the startup's track record can make it easier to approximate how long the investment horizon will be. One way to judge a company's potential is the burn rate. This is simply how much money is being spent each month. If a startup is still in its early stages but the burn rate is exceptionally high, that may be a sign that investors are going to be waiting longer to receive a payout. (To learn more about burn rate, see: Burn Rate Key Factor In Company's Sustainability.)

3. What's the Expected Rate of Return?

Angel and venture capital investments are often fueled by a desire to help entrepreneurs succeed, but the possibility of making money is also part of the appeal. Analyzing the potential return on investment (ROI) associated with a particular startup is a must for investors who are focused on maximizing earnings. Again, returns depend on the type of investment involved.

For an angel investor, it's typical to anticipate an annual return in the 30% to 40% range. Venture capitalists, on the other hand, assume a higher degree of risk which translates to a higher expected rate of return. Equity crowdfunding is an equally high-risk investment strategy and because it's still relatively new, pinning down an average rate of return is difficult.

When estimating returns, take care not to overlook any fees or costs associated with the investment. For example, there may be annual management fees related to a venture capital investment. Crowdfunding platforms also charge investors a fee to use their services. The higher the expense associated with a particular investment, the more returns are diminished. 

4. How Does the Investment Affect Diversification?

Diversification is the benchmark of any solid investment portfolio, and the number one goal is minimizing risk without curtailing returns. When considering a startup investment, investors must be aware of how it affects their overall asset mix and risk level. Finding the right balance, however, can be tricky.  

With stocks, there are clear divisions between asset classes that make it easier to spread the risk out. Startups require a different way of thinking because it's essentially a hit-or-miss proposition. As a general rule, the more startups an investor puts money into, the greater the odds of achieving target returns. At the same time, spreading investment dollars too thin can backfire if there isn't a winner in the pack.

5. Is There a Clear Exit Strategy?

Having a definite exit strategy in place is a requirement for any investment, but it's particularly important with startups. Investors should be clear on when and how they'll be able to withdraw their initial investment, along with any associated gains. For example, an angel investor would need to know at what point they'd be able to sell their equity shares. Again, this is why it's necessary to be aware of the time frame involved to make sure you're able to exit at a point you're comfortable with.

The Bottom Line

Investing in startups is an excellent opportunity for investors to expand their portfolio and contribute to an entrepreneur's success but investing in a startup is not foolproof. Even though a company may have strong cash flow projections, what looks good on paper may not translate to the real world. Taking the time to execute due diligence when researching a startup investment is something investors can't afford to skip.

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