"Nine out of 10 startups fail” is a well-worn statistic often repeated to discourage entrepreneurs and angel investors.
In fact, the true picture is brighter. A 2014 study by the insurer RSA gave startups a 44% chance of surviving until their fifth birthday.
The global investment firm Cambridge Associates, meanwhile, estimated that the startup failure rate never dipped below 60% between 2001 and 2010. Even in 2000 when the dotcom bubble burst, it remained well below the oft-quoted 90% figure at 79%, the study says.
The true odds on startup survival are clearly open to opinion, and heavily dependant on the types of businesses and sectors involved. However, there is undeniably an element of risk in investing in startups and SMEs.
So why do so many angel investors do it? What is it they see in the startup that persuades them to overlook the risks and invest their hard-earned funds?
The reasons are numerous, but there are 11 that constantly stand out.
1. A killer opportunity
Startups that spot an addressable market that can be exploited or disrupted, with lucrative results, have greater chances of securing investment.
Recognising such growth opportunities as an investor isn’t always easy, however, as the case of Amazon proves.
According to fortune.com, a US$5,000 stake in Amazon when the online retailer first listed in 1997 would have been worth $2.4m by 2017 - yet even the great Warren Buffet reportedly rejected the chance to invest, later admitting he regretted not recognising the opportunity and taking action.
Often the shrewdest angel investors are those who spot a winning market opportunity that others have overlooked.
2. An alluring management team
When the people driving the business are clearly going places, angels find the pull to invest hard to resist.
There is no watertight model for the perfect startup management team, but sought-after ingredients include chemistry (between each other and the business investor), in-depth understanding of the target market and sector, relevant experience, flexibility - in terms of being able to adjust approaches and learn from mistakes – and the right skills needed for the stage the business is at.
Whilst management functions required as the startup blossoms into a successful SME can be added later, integrity is a key factor - are the founders trustworthy? Are they giving the investor the full story about their aims, credibility and intentions?
3. The business is scalable
For a strong return on investment, sophisticated investors are looking for signs of major sales growth on minor incremental costs.
The true test of scalability is whether or not real customers in significant numbers will pay the full price for the product or service. Anything else is speculative and investors will rigorously question business plans to make their own assessment of how scalable the business is.
4. It’s built around a solid business model
The methodology of how the startup will fulfil the potential of its idea is critical. A realistic, workable approach to attracting and converting the customers needed to grow and succeed is a big tick for any investor.
5. Numbers look good
Having 'good numbers' doesn’t mean those tempting figures plucked from the air and which are reasonable only in the imagination of the ultra-optimistic entrepreneur.
‘Good’, to an investor, means evidence-based, realistic and robustly tested. If the calculations are attractive and feasible given the detailed research and data supporting them, investment may follow.
6. Wheels are already in motion
Evidence of a product making traction in its target market boosts business angel confidence, making them more likely to invest. Has anyone actually bought the product yet? Is anticipation of its launch building? Momentum is a powerful force for investors as it it's a great indication of customer confidence.
7. Timing is perfect
Some battle-hardened entrepreneurs believe there is never a bad time to start a business. Others are more pragmatic, and keenly follow trends and wider economic conditions before they make their move.
When a product arises that is perfectly in-tune with the backdrop conditions, and everything is in place to roll it out to the masses quickly, investors will emerge.
8. A chance to diversify
For many investors where the bulk of their portfolio is in stocks and shares, they can be left exposed to potential market volatility. Similarly, property-heavy investors are at the mercy of the fluctuations of the wider market and aspects outside of their control.
Although the economic backdrop can influence the success or failure of startups, they are generally much less exposed to shifting stock market dynamics and more tied into a specific sector and/or customer demographic.
Adding startups to a portfolio gives investors a more diverse mix of investments, something that's seen in both the asset type itself - an early-stage company - and within the asset itself, as investments into 10 startups could quite easily be in 10 completely different sectors.
9. The adrenalin rush
While some angel investors remain in the background as their investment grows in value, others want a piece of the action. Although tough, growing a startup is an adventure that many investors love being part of.
Compared to stock market investments, which angels can only buy and sell, startups give them an opportunity to actively influence the outcome of their investment. A seat on the board, next to entrepreneurs eager to listen and take advice, gives them a rewarding role helping to lead the company to the promised land.
It’s also a speculative game of high risks and rewards. Many angels, steeled by their experiences in business, are more than eager to bring their expertise to the table to play it.
10. Making a difference
Impact investing, backing projects that have a positive influence socially or environmentally, is growing rapidly around the world.
The US-based non-profit group Global Impact Investing Network recently reported that its members had impact investments worth US$228bn by the end of 2017, up from US$114bn the previous year. Since this only represents the GIIN’s 229-strong network of investors, the overall global impact investment figure is likely to be considerably larger.
Increasingly, business angels are looking to invest in ideas and innovations which challenge the world’s problems while also delivering a financial return.
11. The potential payback
Sophisticated investors usually invest in startups as part of a balanced portfolio. They take on board its risks, such as loss of capital, dilution of their share and illiquidity, primarily because of the potential returns.
David.S.Rose, the American serial entrepreneur and angel investment author who has backed over 100 startups, suggests serious angel investors with a stake in multiple startups should target an ROI of around 25% from their entire startup portfolio.
To offset the failure rate of startups, he believes individual opportunities should be approached with a 30% return on investment, on the basis of an exit within six years.
Should you invest in startups?
Making a decision as to whether you should invest in startups is one that needs to be made by understanding your financial needs, requirements and expectations. It's undeniably an attractive proposition - particularly when you consider many are eligible for the Enterprise Investment Scheme and the numerous tax reliefs available - but it's without doubt a higher risk/higher reward strategy.
Take your time, do your research and accept advice - it's what successful business angel investors do.