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How Early Stage Investors Can Mitigate Risk In Startup Investments

Author: Arvind Agarwal, Founder & CEO - C4D Partners

Publication: Inc42

The year 2021 marked a point of inflexion for the Indian startup ecosystem. The country’s startup ecosystem is basking in the glory of its watershed moment, raising record-high investments, minting unicorns, and expanding exponentially. Euphoric investors are funding risky ventures, and many are investing in early-stage startup businesses, which puts them too close to the high end of the risk spectrum.

Many investors are ignoring the fact that 90% of startups fail within the first five years of inception in their pursuit of high returns and the chance to spot a unicorn. At this point, investors who invest in early-stage startups are experiencing the highest risk-return scenario. As a result, in addition to maximising their returns, investors should strive to minimise their risks. Which raises the question, how can early-stage startup investors de-risk their investment?

Adopt A Portfolio Approach

Unlike mature public companies, early-stage startups frequently lack a reliable product, a loyal customer base, and a substantial revenue stream. As a result, estimating their risks and returns is commonly based on assumptions rather than financials. Rather than evaluating an early-stage startup investment in isolation, investors should always take a comprehensive approach, viewing all of their investments objectively.

Diversification is an investment golden rule that always helps investors mitigate market risk. Investors should never lose sight of their principles, no matter how lucrative the idea appears to be, how persuasive the founders appear to be, or how groundbreaking the technology appears to be. Investors must use a portfolio approach to maintain their desired risk-return ratio.

Follow Financial Discipline

It is natural for young founders to overlook the financial aspects of the startup because other business concerns dilute their focus. Founders who lack financial discipline run out of money sooner than expected and are unable to raise subsequent rounds of funding. A startup that understands where its money is coming from and where it is going is more likely to meet its goals and advance to the next funding round.

Investors must thoroughly examine the startup business’s budgets, financial plans, and cashflows. They should use a monthly analysis approach rather than a quarterly financial evaluation during the early stages. Investors play a critical role in establishing financial discipline in startups and lowering the startup mortality rate.

Focus On Governance

During the first few months and years, early-stage startups frequently experience exponential growth. Founders often overlook business governance in favour of focusing on business operations and achieving milestones. Investors should be the ones to steer them in the right direction at this point, leveraging their business experience and acumen. Rather than regret their investment in an early-stage startup, investors should focus on restoring business governance. Additionally, investors should develop a strategy to determine how much regulation and management are required at each stage of growth.

Examine Exit Pathways

Nothing is more important than an exit decision for most investors. To exit the venture with high returns, however, an investor must time the exit carefully and always be on the lookout for exit routes. Many investors believe that as long as the startup is developing products and creating buzz, buyers will be plentiful, but this is not always the case.

Before investing in any early-stage startup, investors should consider the exit options available to them. Furthermore, investors should reduce their risks by identifying and engaging with potential buyers until they have successfully exited. Having access to a larger number of acquirers will give them an advantage, allowing them to earn a higher return.

Provide Non-Investment Support

Investors bring more than just money to the table. Most major investors provide critical non-investment assistance, such as access to their expertise, resources, and network. Early-stage startups frequently lack these critical elements, which are critical to the success of any business. Investors can provide critical ancillary services besides capital by sharing their wealth of industry experience, market resources, and network with the young founders. Instead of injecting more money into a risky venture, investors should provide non-investment support to de-risk their investments.

The Bottom Line

De-risking investments in early-stage startups can put even the most seasoned investors to the test. However, most investment fundamentals apply to early-stage startup investments as well. To assist young companies in succeeding, investors should always exercise caution, stay current on industry developments, and deploy capital wisely.

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