Risks & Considerations

Private equity and startups have massive potential for success if the right investment is made, but are also fundamentally risky. There are a number of components to this risk, most of which have to do with the company one decides to invest in.

General High Risk Level

Startups and private companies are inherently risky investments. Many startups fail, and private companies may not perform as expected, potentially leading to the loss of the entire investment.

  • Failure Rates: Statistics show that a significant percentage of startups fail within the first few years of operation due to various factors such as market competition, operational challenges, and insufficient funding.
  • Performance Variability: Even if a company does not fail outright, it may not perform as expected. Market conditions, management decisions, and unforeseen events can all impact a company’s performance and, consequently, the return on investment.

Investors need to have a high tolerance for risk and be prepared for the possibility of losing their entire investment. This makes private equity and startup investments more suitable for those with a diversified portfolio who can afford the potential loss. To mitigate risks, investors often diversify their private equity investments across multiple companies and sectors. This can help balance out the impact of any single investment’s failure.

Illiquidity

Private equity investments are typically illiquid, meaning that capital is often tied up for several years. This lack of liquidity can be a drawback for some investors, depending in their financial situation. If you may need access to your funds on short notice, this might not be the investment class for you.

  • Nature of Investment: Private equity investments typically involve committing capital for an extended period, often ranging from 5 to 10 years or more. This long-term commitment is required because private equity funds invest in businesses with the intention of growing and eventually exiting through sales or public offerings, which takes time.
  • Challenges: Unlike publicly traded stocks, private equity investments cannot be easily sold or traded on an open market. This lack of liquidity can be problematic for investors who may need quick access to their funds due to unexpected financial needs or changes in personal circumstances.

Before dipping your toes into this type of investment, consider the following implications of investing in private equity and startups:

  • Financial Planning: Investors must be prepared to leave their money invested for the long haul and should ensure that they have sufficient liquid assets elsewhere in their portfolio to meet any short-term financial requirements.
  • Exit Strategies: Understanding the potential exit strategies and timelines of the investment can help investors gauge when they might expect to realize returns.

High Level of Due Diligence Required

All investments require due diligence, but due to the high-risk nature of investing in private equity and startups one should place an elevated level of care into the evaluation process. Assessing a company’s business model, management team, market potential, and financial health requires considerable expertise and effort. Thorough due diligence involves a detailed examination of the target company’s business model, management team, market potential, financial health, and competitive landscape. Because of the complex nature of these various components, it may be wise to lean on outside experts who can provide a detailed analysis of the investment’s viability, such as financial analysts, legal advisors, and industry experts.

High-quality due diligence can help investors make more informed decisions, increasing the likelihood of selecting successful investments. On the other hand, inadequate due diligence can lead to poor investment choices and significant financial losses. Although a comprehensive due diligence process can be time-consuming and costly, investors must be willing to invest the necessary resources to conduct a thorough evaluation before committing capital. At the end of the day, you want to make sure you are backing the right horse.

Regulatory Requirements

Regulatory bodies, such as the Securities and Exchange Commission (SEC) in the United States, impose restrictions on private equity investments to protect less experienced investors from high-risk investments. Typically, only accredited investors—those who meet certain income and net worth thresholds—are allowed to invest in these opportunities. Potential investors will have to ensure they meet these criteria before pursuing private equity opportunities. This will generally involve verifying income, net worth, and investment experience.

For startups, the requirements are not as black and white. Non-accredited investors can invest in startups under certain circumstances, but there are more restrictions in place. For instance, non-accredited investors can invest in startups through equity crowdfunding platforms like Kickstarter, Indiegogo, and SeedInvest. These platforms facilitate the investment process and provide access to a variety of early-stage companies. There are also SEC-registered crowdfunding portals, which came about through Regulation Crowdfunding. Regulation Crowdfunding was introduced by the JOBS Act (Jumpstart Our Business Startups Act) of 2012, and allows approved companies to sell their securities by crowdfunding. It introduced Regulation A+ offerings, which include:

  • Tiered Offerings: Regulation A+ allows companies to raise up to $50 million from the public, including non-accredited investors. It has two tiers: Tier 1 (up to $20 million) and Tier 2 (up to $50 million). For Tier 2 offerings, non-accredited investors can invest up to 10% of their annual income or net worth, whichever is greater. There are no investment limits for Tier 1 offerings.
  • Public Offerings: These offerings are similar to mini-IPOs and must be qualified by the SEC.

Private placements with exemptions are another way to invest in startups as a non-accredited investor. Rule 506 (b) of Regulation D allows a limited number (up to 35) of non-accredited investors to participate in private placements. However, these investors must have sufficient knowledge and experience in financial and business matters to evaluate the risks and merits of the investment. Companies must provide detailed information, similar to what is typically provided in a public offering, to ensure they understand the risks involved. Non-accredited investors in these offerings often need to demonstrate their financial sophistication and ability to bear the investment’s risks.

In addition to making sure they meet accreditation requirements, investors should stay informed about changes in the regulatory landscape, as new laws and regulations can impact their investments. This might include changes in tax laws, reporting requirements, or investment restrictions.

Recap

  1. Investing in private equity and startups can offer substantial returns, it also comes with significant risks and challenges.
  2. These types of investments are generally illiquid.
  3. A high level of due diligence is required to achieve potential success in this investment class.
  4. You must be an accredited investor to invest in private equity investments based on SEC regulations.
  5. Startup investments don’t always require accreditation, but there are limitations on the ways non-accredited investors can invest.
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