Early stage startup investing is extremely risky. In all likelihood most, and potentially all, of an early stage investor’s investments will result in a complete loss of all of the investor’s principal.

Vator is committed to helping early-stage investors understand investing in startups and makes available a substantial library of content and lessons learned to investors. That being said it’s not feasible for Vator to provide a comprehensive curriculum on early stage investing to every investor.

There are a few risks we’d like to highlight about early stage investing. We think these are things every early stage investor needs to know.

First, to get an oriented as an early stage investor we think its helpful to provide a frame of reference, a mindset.

If we think of investing in mature, publicly traded, companies like backing a shipment of cargo on an airplane, with relatively clear manifest, route, and largely predictable arrival time. Then, investing in a startup should be thought of as backing an explorer about to set sail on an expedition to undiscovered lands, across dangerous seas. All the explorer can tell you is the general direction they plan to head and the rumors they’ve heard of the gold at the other end. Most of these explorers won’t find any gold, worse, many will die trying.

If you like the idea of backing low probability expeditions, then early stage investing is for you. If not, you really should put your money to work elsewhere.

Imperfect information

It’s essentially impossible to perform significant due diligence on startups. Further, because startups tend to be resource constrained they often cut corners on their legal expenses, contract negotiations, regulatory filings, licences, etc.. Further startups almost never follow many common business practices which would be expected from larger companies, like having financial and other forms of audits. The well publicized issues and lawsuits around Facebook’s pre-IPO ownership are an excellent example of the rather chaotic context of many startups.

Early stage investors should make a general assessment about the credibility the startup and perform their own due diligence, and understand that this is an imperfect business.

Vator Management LLC can not possibly perform deep due diligence on every startup, even the startups for which we create a fund. The work we do to understand companies should be seen as complementary to your personal due diligence. It’s almost a certainty that every investment Vator Management LLC makes will be in a company that didn’t disclose a material fact pre-investment.

It’s extremely difficult to get new companies off the ground

Startups are just really hard. There is no guarantee that a new, small, company will be able to attract talented employees, win customers, or find enough additional investment capital to stay alive. They will almost always take much longer than anyone originally thought to grow, and most won’t be able to overcome the challenges they encounter.

Your investment is essentially completely illiquid

If you invest in a public company and then decide you’d rather not be invested in that company, you can sell your position for a gain or loss in the public market and retrieve some or all of your invested capital. This is not the case with early stage companies. Once you make your investment it’s essentially impossible to get it out again (until the company is acquired, or goes public – and even in those cases you may not be able to get your entire investment out at one time).

There may occasionally be opportunities to liquidate some portion of an early stage investment prior to an IPO or acquisition, but the instances of these cases are so rare they should not be considered likely for planning purposes. Further, if you are investing through a fund (like Vator Funder or a venture capital fund) your options are further limited, as your not in direct control of the investment.

In short, once you make the investment consider it illiquid until the company is acquired or goes public.

Successful companies don’t always mean your investment will be successful

There are many examples of companies which eventually became successful, but from which the founders and early investors didn’t benefit from the gain.

How can that happen?

For the most part it happens because of the difficulty of getting companies off the ground and their need for new investment at unfavorable terms to existing investors. Terms like “down round” (a round at a valuation lower than the last round) and “recap” (a significant change to the capital structure of the company – typically in order to attract new investment) are used to describe these dynamics.

These challenges are exacerbated for early stage investors because they typically don’t have the follow on capital to participate in later rounds.

This is also a real challenge for investors investing through platforms like Vator Funder. If additional capital is required by the startup, Vator Funder may not be able to raise a new fund to invest in the future round.

So for early stage investors the subset of companies from which they will derive benefit is reduced further, to only those ones that didn’t undergo a substantial recapitalization.

The capitalization of many startups is highly dynamic and typically early investors suffer from changes over time (rights, preferences, etc.), so being early can mean you get a larger piece of the pie, but it comes with significant downstream risk.

Complex, and changing, regulatory environment

The securities industry is highly regulated, and the regulations themselves can often be a bit ambiguous. It’s important for early stage investors to have at least a basic understanding of the relevant securities regulations. One important area of regulation is around advertising investment opportunities to the general public. There is some discussion in the JOBS Act about easing the rules around General Solicitations (the technical term for promoting an investment opportunity to people you don’t know). However, for now it’s Vator’s opinion that these rules are still too new (and too complicated) to be relevant to startups, as such, we think, at this time, startups should not solicit the general public for investors. This is why Vator only makes investment opportunities available to members of the Vator community who are accredited investors.

This also has implications for the investor, you can’t communicate with the public that a startup is raising money. It’s important that everyone in the startup ecosystem only communicate with people they know about startups. You absolutely can not speak to the press, post on social media, or in any other way discuss the financing activities of a startup with the general public.

The other area of regulation that is relevant to Vator is around the government’s requirement to register as a broker/dealer in order to execute investment transactions. Vator is not registered as a broker/dealer. The SEC has a number of tests for whether or not the activities of an organization would require them to register as a broker/dealer. In our view, the key test is whether or not the organization is receiving compensation which is contingent on the trade of securities (essentially making the preponderance of their revenue on the transaction without any material stake in the outcome).

Vator is not in the “transaction” business. Our business model is more like a VC fund, in that the preponderance of our compensation is tied to the success of the investment in the form of carried interest, we’re in essentially the same economic boat as the investor. So in our view, and the view of our attorneys, we are not required to register as a broker/dealer. The SEC has issued a series of “No Action Letters” which broadly confirm this operating principle.

That said, this is a new regulatory area, and one that is in flux, so investors should understand that there is risk even in using funding platforms, like Vator Funder, as a means of investing in startups at all.

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