While investing in venture does give investors the potential for high returns, that comes in exchange for a high level of risk. Our perception of the venture market is colored by the success stories, but for every Facebook or Google, there are countless companies that never made it past a seed round.
Risk of Loss/Failure
For any number of reasons, the vast majority of startups fail, and in the majority of those cases, any investment into them will go to 0. Investors need to approach this asset class with the mindset that most of their investments will never see any positive returns or even the return of their initial investment. Even in companies where a “good” outcome is reached, the stack of preferences and rights given to later-stage investors can make the founder, employee and early investor shares worthless. No matter how much due diligence an investor performs, there will always be a high rate of failure, and an element of luck. For that reason alone, investors should only commit an amount of money that they can afford to lose.
Because investors generally can only exit an investment when a company IPOs or is acquired, there is a very low level of liquidity available in most venture investments. As such, investors should only commit funds that they will not need to access for a long period of time. Occasionally, with later-stage startups, there can be opportunities to sell shares on the secondary market, but that still usually only occurs multiple years after an initial investment.
There is also the risk that investors get in at overinflated valuations, as many of the financial projections and valuations are based on are educated guesswork at best. That, combined with potential dilution of shares through subsequent funding rounds, can turn what appears to be a successful investment into a successful company into a disappointment when they are eventually acquired or go to an IPO.
Venture can be a very lucrative asset class, but any investor needs to consider the risks before investing and before deciding how much of their portfolio to allocate to venture. And as with any type of investing, diversification can help limit overall risk.