10 Types Of Early Stage & Project Venture Investment Risk

Investor discontent definitely is noticeable, spurred by marked volatile capital and commodities markets on a global scale. And, it seems, with startups as well. The January 2016 edition of Vanity Fair article titled “Start-Up Investors Want Their Money Back as They Watch It Burn,” bluntly cited failed fintech startup Clinkle and the recent Bitcoin debacle for driving angel and VC investors to the point of raking back their cash and equity investments from risky ventures. While the unicorn club in general is on point with startups turning the entrepreneurial dream into reality into industry shift, investors need to give full attention to the inherent risks in investing in ventures that are in the infancy stage in both concept and in actual inception.

Investment in an early stage venture involves a high degree of risk. ‘Early stage ventures’ for our definition pertains but is not limited to startups, exploratory mining, and large scale real estate projects with no prior blueprint to copy or imitate. Prospective investors should carefully consider risks in evaluating investments and only those who can accept the risk of substantial loss should participate. No guarantee or representation can really hold water that any company or project will achieve investment objectives or that an investor will receive full return of capital. In evaluating whether to make an investment, especially in early stage companies and projects with stand-alone risks, potential investors need to strongly consider a wide range of risks and mitigating factors. Here are some of the more poignant risks for early stage ventures in the angel, VC, and private equity arena:

#1 Execution Risk

There is no track record of operating performance in ventures such as startups run by new founders, and in many projects with stand-alone risk. Investors will strongly need to gage the executive team’s expertise and ability to input initial capital. The executive team will need to show extensive industry, market and product knowledge to mitigate investor concerns.

#2 Return On Investment Risk

Many ventures operated by a team that initially demonstrates competence have still been unable to have longevity in business profitability. Passive investment in early stage companies and in stand-alone projects may lead to failure. Early stage ventures need constant monitoring and investors must consider active participation at the Board level to set company and/or project strategies.

#3 Profit Realization Risk

It is usually anticipated that current income from operations will be reinvested in a company or project to develop next generation products, facilitate business development, and increase sales revenue. Therefore, the return of capital and realization of gains will occur only when retained earning exceed the capital requirements of growing the early stage venture.

#4 Liquidity & Transfer Risk

If there is currently no public market for any of the venture’s equity securities or instruments, investment transfer risk from an offering arises. Any venture that is not registered under the Securities Act may not be resold or otherwise transferred unless subsequently registered and qualified under applicable state laws or unless exemptions from registration are available. Accordingly, investors may not easily be able to liquidate their investment in the venture. Private placements and securities offered hereby are intended for long-term investors who can accept quasi non-transferable risk. The possibility of total loss of investment in private placements exists, and prospective investors should not subscribe unless they can readily bear the consequences of such loss.

#5 Legal, Tax & Regulatory Risk

Legal, tax and regulatory changes could occur that affects the venture both individually and industry wide. There is no guarantee that unforeseen future government imposed regulations will not adversely impact the early stage or project venture’s profitability. Investors must do keen due diligence on the legal and tax structure of the venture and of industry regulations. It is not acceptable to enter into majority investment in such ventures without thorough background advice from external counsel pertinent to the industry.

#6 Financial Projection Risk

The early stage company or project’s financial projections in a private placement or any offering are simply projections that may not be based on any track record save industry standard. Future financial performance is based on assumptions of the executive team’s research. Such assumptions may be incomplete or inaccurate. Actual results achieved during the period covered may be expected to vary from financial projections and may be material and adverse. It is important to have all financial projections vetted by internal accounting and internal counsel.

#7 Pricing Model Risk

There is no assurance that the pricing model used to conduct market analysis for the venture was completely accurate, as it is very difficult to ascertain whether there is sufficient population of potential customers and/or revenue sources in a new venture, or in a project with stand-alone risk. Pricing and pricing models may need to be quickly modified on a learning-by-doing basis, which of course brings to question the aforementioned financial projection risks. Pricing risk could adversely affect the life and profitability of an early stage venture.

#8 Intellectual Property Risk

Many early stage companies in technology rely on having unique intellectual property through patents, which are usually granted post-funding. There is the likelihood that patents may not be granted, and thus that intellectual property may not be protected, or worse, be deemed moot.

#9 Supply Chain Risk

This is such an overlooked risk in all ventures, yet it is one of the most damaging risks to venture profitability. Any project’s success is highly dependent on maintaining vendor, distributor, contractor, and customer service relations from inception to last stage. Concentration risk within the supply chain may lead to an entire project shutdown if there is a conflict with a key distributor or if a key contractor goes out of business. Should supply chain relationships not continue as expected due to changes affecting distribution or manufacturing sources, the venture may not be able to enter into relationships in a timely manner to manage operation or project disruption.

#10 Management Control Risk

Senior management may own or control a significant number of the venture’s outstanding shares and/or other equity, and will continue to have significant ownership of voting securities after an offering. If the maximum aggregate amount is raised pursuant to a securities offering, senior management may continue to own a controlling interest of the venture’s outstanding common stock on a fully diluted basis. Thus, senior management will have the ability to effectively control the venture’s affairs, including the election of the board of directors. It is very important for major external shareholders to have an activist stance in both private and public ventures, and so encourage effective corporate governance from inception.

The risks above are highlighted pertaining to early stage and project ventures with heightened risk factors, and do not represent an exhaustive list that investors need to be aware of. With any type of investment vehicle, savvy investors need to be very cognizant of the risks involved and take an active approach in the shaping of early stage startups, ventures and projects. To entrepreneurs, these risks should be listed in all business plans, strategic plans, private placement memos (PPMs) and investment memorandums (IMs) as well as specific risks pertaining to the industry, market, product and service of the venture. Ensure all pertinent risks are documented especially for any future litigation purposes.

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Photo credit: Alexandra E. Rust via Visualhunt / CC BY