Return on investment, commonly known as ROI, is the ratio of a financial return or loss to the amount invested. The ratio is expressed relative to an investment where the increase or decrease in value is given as a percentage. Commonly, ROI is used to evaluate the profit or loss on a specific investment. 

How to calculate ROI

The most straightforward method for calculating ROI is to describe it as a percentage, gain or loss, of the initial capital amount. To figure out the ROI, the investor will subtract the "cost of the investment" from the "total gain on the investment" and divide that number by the "cost of investment." For example, if an investor puts $5,000 into a company and gets $10,000 back at the end of three years, the return on investment (ROI) is:

ROI: ($10,000 – $5,000) / $5,000 = 100%

How can investors make money from startups?

Historically, investing has been a solid strategy to earn additional income over the long run compared to leaving cash in a savings account. However, while investing in startups can be extremely rewarding, it is also relatively illiquid as you cannot sell your equity instantly as you would in a publicly listed company. So how exactly do you get your returns after investing in a startup? Here are four ways:

Secondary market

As a company grows and raises additional funding in multiple rounds, early investors, such as friends & family or angel investors, have an opportunity to exit. Typically, investors profit based on the proportion of equity they hold. So, for instance, an institutional investor may purchase shares from an angel investor if they wish to acquire more company stock than the startup is willing to sell. Buying from an existing investor is a secondary market transaction and usually depends on board approval.

Acquisition

Acquisitions are common in startup ecosystems as corporations seek expansion by acquiring smaller startups for their resources, employees and market knowledge. In such cases, investors receive either shares in the new company, cash, or a combination of both. A recent example was Stripe's $200m acquisition of Paystack.

Initial Public Offering (”IPO”)

A company's IPO is when its shares are made available to the general public for purchase through a public exchange. The road to an initial public offering is long, and few firms have attained this milestone. However, an IPO provides investors significant returns and liquidity once completed, as investors can now readily sell their equity to the general public.

Regular dividends:

Although rare & unlikely, there may come a stage when a startup achieves profitability or no longer requires investment or capital. The corporation's board of directors may then opt to institute a dividend payment schedule for the investors. This type of payout is typically predetermined between the investor and the company and is written into the terms of the agreement.

Understanding the link between risk and return is key to understanding why individuals make certain financial decisions.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Risks can come in various ways, and investors need to be compensated for taking on additional risks. For example, a U.S. Treasury bond is considered one of the safest investments and provides a lower return than a corporate bond. A corporation is much more likely to go bankrupt than the U.S. government. The default risk of investing in a corporate bond is higher therefore investors are offered a higher rate of return. High risk leads to high returns; similarly, low-risk investments lead to low returns.

A general rule of thumb is that most startups fail over 5 years. However, investing in the right startup could result in extraordinary returns. In comparison, a publicly listed company is less likely to fail, but buying shares in a publicly listed company with millions of stockholders is also less likely to make you wealthy.

Below are the earliest investors and their investment returns in the ride-sharing app, Uber at IPO

You may be able to achieve a balance between risk and return in your whole portfolio by investing along a spectrum of risk, from the safest to the more risky assets. By diversifying your portfolio in this manner, some of your investments have the potential to generate high returns, while others may help preserve your capital.