Author: Lorenzo D'Amore
Investing in start-ups has always fascinated financial enthusiasts because of the possibility of contributing to the success of emerging companies and, above all, because of its potential profitability. Indeed, funding a startup can be a great way to diversify one's portfolio and potentially achieve excellent returns, but it is important to understand that there are some risks involved. Indeed, there is no guarantee of success as the company may not achieve its desired goals.
Therefore, it becomes essential for investors to fully understand which strategies to implement when investing in a start-up and, above all, to assess the risks and return prospects. The aim of this article is to offer a guide for those who are thinking of investing in innovative start-ups, trying to highlight strategies, opportunities and risks.
What do we mean by investing in start-ups?
A start-up is a young, often innovative enterprise that is seeking funding to grow. Investing, means giving money in exchange for a small percentage, but with an important trade-off: if the company manages to make a profit, your share increases in value, while if not, risk comes into play, as you could possibly lose the entirety of the investment made.
What types of funding can a start-up benefit from?
1) Risk capital, which in turn is divided into two types:
venture capital, which focuses on financing innovative start-ups and companies in the expansion phase.
private equity funds, which are investments in unlisted companies, often with a solid trajectory behind them, that need capital to relaunch themselves or pursue new growth strategies.
2) investments by business angels, informal investors who offer capital and knowledge to start-ups with good development prospects.
3) bank loans, i.e. a sum of money requested from credit institutions or finance companies to meet an expense for which they do not have sufficient financial resources
4) government grants, financial contributions provided by the government to support specific projects or to promote innovation and economic development.
5) crowdfunding, a collective and collaborative process that, starting from the bottom, with the involvement of many people, allows financing innovative start-ups
But investing in a start-up does not always generate revenue, indeed sometimes it translates into a real risk, causing the backer to lose money. Let us look at the most common types of risk in investing in a start-up.
Which are the risks?
Market risk due to the high probability of failure. It is estimated that around 70 per cent of start-ups fail to succeed, highlighting how important it is to carry out a thorough evaluation before funding a start-up.
Risk of illiquidity of investments: Shares in a startup are not so easily sold before the company is bought or listed. As a result, financiers may tie up their capital for long periods.
Dilution risk: this refers to the decrease of a shareholder's stake after a new investment in the start-up. Typically, when the start-up succeeds in attracting backers, it then issues new shares in such a way as to increase the total number of outstanding shares. These new shares will ‘dilute’ the percentage of existing shareholders, thus reducing their share of the total number of shares.
Management risk: due to an inadequate team or an unrealistic business plan
Technological risk: this refers to potential start-ups that invest in innovative technologies, but which, over time, are overtaken by technological progress, rapidly losing competitiveness.
Are there any strategies to mitigate risk and maximise profit?
1) Value-based pricing: price your product based primarily on the value customers perceive in it, rather than relying primarily on cost or competition. This allows you to set higher prices while maintaining customer loyalty.
2) Price skimming: this is a pricing strategy that initially sets a high price for a product or service and gradually lowers it over time. This approach targets early adopters who are willing to pay a premium price to be the first to own or use a new product. As soon as the product begins to be accepted on the market, the price is lowered in order to attract more price-sensitive consumers
3) Penetration pricing: this consists of setting an extremely low initial price in order to quickly gain market share. This approach aims to attract the most price-sensitive buyers and can work well when entering a competitive market with standardised products that are difficult to differentiate. The strategy is to use penetration pricing to gain share in order to move to value-based pricing over time.
4) Tiered pricing: Rather than a single price, tiered pricing involves offering two to five ‘good/better/best’ price levels associated with increasing levels of features and benefits. In this way, customers with different budgets and needs can be segmented rather than imposing one model for all.
5) Bundled pricing: Bundling means combining several products or services together as a package at a single price, offering customer value, comprehensiveness and convenience. Bundling works well when products complement each other and customers want the complete package.
Which are the key factors influencing the investors' decision?
1) Enter in a promising and growing market to gain significant market share.
2) Ensure a unique and differentiating value proposition (competitive advantage).
3) Have a competent and motivated founding team
4) Choose a solid and scalable business model
5) Possess a clear and well-defined market strategy
6) Aligned industry trends and opportunities
Conclusions
We have thus understood how investing in a start-up can generate revenue opportunities but also expose it to considerable financial risks. What is recommended is an informed approach based on a thorough analysis of the market, the team, the product and the business model. This is crucial in order to be able to mitigate risks and increase revenue opportunities. The investor must be able to balance the trade off between risks and rewards. Only in this way will he be able to succeed in the world of start-up investments, so as to make the best possible use of the possibilities of a market that is growing every day. An investor with excessive ambition and without a proper risk assessment may end up with significant losses. Excessive caution may prevent you from making the most of a potential opportunity. The secret therefore lies in weighing one's finances wisely, for an accurate, profitable and, above all, targeted investment strategy.
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