Startup investing is an exciting way to potentially earn significant returns and support innovative companies. However, it also comes with a high degree of risk. In this blog post, we will discuss everything you need to know before you invest in startups. Including types of startup investments, how to evaluate startup investments, risks of startup investing, and how to get started.
Firstly, What is a Startup?
A startup is a company that is in the early stages of development. Startups are typically founded by entrepreneurs who are seeking to create and bring a new product or service to market. They are often characterized by their innovative and disruptive ideas, and operate with a high degree of uncertainty and risk.
Startups are different from traditional small businesses in that they typically have a focus on rapid growth and scaling. This is achieved through seeking high levels of funding from investors. With that in mind, it should be known that most new businesses fail in the first 3-5 years, which is typically when we consider investing in the startup.
Types of Startup Investments
There are four primary types of startup investments: angel investing, venture capital funds, venture capital trusts, and crowdfunding. Each has its advantages and disadvantages, and the choice of investment vehicle will depend on the investor’s goals, risk tolerance, and financial resources.
Angel Investing
This is typically reserved to high net worth individuals who open their doors to entrepreneurs. Angel investors tend to invest in start-ups at very early stages because a) they can and b) they really like the startup idea, hence the name, angel investor. There are angel investing groups such as Angel List that connect high net worth individuals with early-stage start-ups looking for funding.
Venture Capital Funds
VC is not as stringent as Angel Investing, but there will still be a minimum investment requirement of 5k+, depending on the size and quality of the VC fund. VC funds pool investors’ money and invest it in several startups to diversify the risk. Venture Capitalists tend to be ex-founders themselves and some funds choose to advise and support the companies in their portfolio to increase their chances of success. Of course, these funds carry handsome fees for their services, 1-2% annual management fees + carried interest. Carried interest, usually referred to as carry, is usually 20% of whatever the startup is sold for, so to be fair to the VC guys, they only get the bulk of their money when you get yours.
Venture Capital Trusts
There are also Venture Capital Trusts (VCTs), which are much more accessible to investors, with minimum investments starting from 1-1.5k. VCTs are listed on the stock exchange, and they tend to invest in private and public small businesses. You can invest in VCTs through most traditional stock brokers.
Crowdfunding
We’d argue that crowdfunding, as the name implies, is the most accessible to retail investors. This is because crowdfunding is all about platforms connecting thousands of small retail investors with regional and international start-ups looking for funding. There is no minimum for investing here and the investor is entirely responsible for the research and due diligence on each company they add to the portfolio.
Advantages of Start-Up Investing
There are clear advantages to investing in a new business with ambitions for growth in its infancy.
High Returns
Most startups do fail yes, but the ones that succeed tend to make up for all the losses and then some. Venture Capitalists and angel investors aim to achieve at least 50% on their portfolio of startups. This can indeed be achieved even after most of the companies go bust.
Tax Treatment
In the UK, startup investing comes with many tax advantages. From tax relief to tax exemptions, the benefits are plenty. The UK has the Enterprise Investment Scheme (EIS), Seed Enterprise Investment Scheme (SEIS), and Social Investment Tax Relief (SITR), all of which offer investors tax breaks and exemptions to incentivise such investments.
Risks of Startup Investing
Startup investing comes with great rewards as mentioned, but the risks are typically much higher than other asset classes.
- Lack of Liquidity: Start-ups are private companies and exiting an investment is not easy. Beyond secondary investment rounds, liquidating holdings is not an option until an exit is presented to investors.
- Total Loss: The risk of total loss is not only high, it is expected. Most start-ups fail and that includes most of the start-ups you will invest in.
- Limited Information: This is particularly pronounced for retail investors. There will be limited information available publicly to assess the start-up before investing.
- Dilution: It is very likely that the founders will raise more money in future before you can exit. This means that your ownership will be diluted with each funding round. This is unavoidable unfortunately, but we advise on this below.
How to Manage Risks
When evaluating startup investments, investors should consider the aforementioned risks. Let us dissect each risk.
Lack of Liquidity: Time Horizon
We mentioned this many times before, investors need to understand that some of their investments need a long time horizon. With start-ups, this time horizon could extend to 7 years or more. Sure, you can get lucky with a company that gets acquired 2-3 years after your investment. But you should expect to have your money tied up in start-ups for 7 to 10 years.
Total Loss: Diversification
It would be insane to invest in one or two startups only. 90% of startups fail so statistically you need at least 10 companies in your portfolio to end up with one winner. Of course, you don’t need to worry about diversification if you are invested in a VC fund or VCT. But for angel investing and investing via crowdfunding platforms, you should be looking at building a portfolio of 10+ companies.
Limited Information: Let the Professionals Do it
You do not have to perform the due diligence yourself on these start-ups. You can find a VC fund with low minimum investment (5k is the lowest we have seen at Cur8 Capital). On one hand, these funds are diversified and the managers perform proper due diligence and have full access to the books. On the other hand, minimum investment is at least a few grand and they will charge some handsome fees for their services.
Limited Information: Creative Due Diligence
If you end up screening startups on Seedrs or Crowdcube, because you want to invest smaller sums or to save on fund fees. Then you must know what to look for in terms of green and red flags. There are some frameworks for you to assess the company, but the most important considerations are discussed in the following section.
How to Evaluate Startups
When looking at startups to invest in, there are a few key considerations to bear in mind. By no means will you guarantee a return by assessing these factors, but at least, you will increase your chances of success.
Founding Team
This is the most important one. You need to know you are largely investing in people here, people who will execute, pivot, hire, fire and pivot again till they make it work. So the experience, credentials and commitment of the founding team matters and it matters a lot. Make sure they know the industry they want to disrupt very well (by having at least one member with exposure to the industry), fully committed to the business (full-time founders only) and have complementary skill sets (is there a technical co-founder on the team?).
Total Addressable Market (TAM)
TAM is extremely important, and it will almost always be quoted, in bold, in the pitch deck. This figure quantifies the size of the opportunity, and is a proxy for the potential of growth of the company. This is why this number should be questioned, challenged and understood. Make sure the founder is clear on how he/she worked out the TAM and only invest in companies with a TAM of billions.
Customer Acquisition Cost (CAC)
Hopefully, the company has traded for a bit (i.e. they have a product and tried selling it) so they have a realistic estimate of the CAC. Be wary of founders who are quoting low CAC figures before selling anything. The only way you can calculate CAC is by spending on business development, marketing and bringing in paying customers.
Lifetime Value (LTV)
Lifetime value is another important metric that trading startups should know. Generally, a profitable operation can be achieved expected if the LTV is greater than the CAC. So ask questions about these numbers and stress test the CAC, because as startups grow, it may and will become more expensive to acquire customers. A great business would be one with potential to grow via network effects, word of mouth or referrals.
Valuation
To be honest, valuing an early stage business is just difficult, if even possible. The reason is that the future cashflows are so distant, it is difficult to predict, with accuracy, how much they would be and how fast they will grow. With that said, still keep an eye on the valuation, especially on crowdfunding platforms. It is in the interest of founders to inflate their valuations but you cannot really negotiate on these platforms. A good sense check is dividing 1 billion by the post-money valuation (assuming our startup became a unicorn), then divide again by 10 (ideally, we want our investment to at least 10x to counteract all the losers). The resulting number should be greater than 1, to account for dilution and total losses in the portfolio. We’d still recommend watching the insightful talk below by valuations expert Aswath Domodaran.
Execution
Most successful startups are successful because they executed very well. The idea is, surprisingly, not as important as the execution. This means that you should try the product before you invest. It does not have to be perfect at this stage, so don’t focus on the design of the app/packaging, but rather, how well does the product solve the problem. Good solutions may not always be good products, but good products are almost always good solutions.
How to Invest in Startups?
There are several ways for retail investors in the UK to invest in startups:
Crowdfunding Platforms: Crowdfunding platforms like Seedrs and Crowdcube allow investors to invest in startups in exchange for equity or other benefits. Retail investors can invest as little as £10 and get access to a wide range of startups across different industries.
Angel Syndicates: Angel syndicates are groups of angel investors who pool their money together to invest in startups. Retail investors can join angel syndicates and invest alongside experienced angel investors. Some popular angel syndicates in the UK include AngelList, SyndicateRoom, and The Angel CoFund. Some of these are, unfortunately, only open to accredited investors.
Venture Capital Trusts (VCTs): VCTs are investment funds that invest in small, unlisted companies. Retail investors can invest in VCTs and get tax relief on their investments. However, VCTs are generally riskier investments as they invest in early-stage companies.
SAFE & Convertible Notes
There are two main instruments founders use to raise money from investors, these are SAFEs and Convertible Notes. This will not be a complete guide without touching upon these important instruments.
SAFEs
SAFE is an acronym that stands for Simple Agreement for Future Equity. As the name implies, this agreement essentially grants the investor shares that will be issued after the funding round is closed. What then happens is that the company issues more shares for the new shareholders that are equal in value to the invested amount. This leads to the dilution of existing shareholders. See worked example below:
- Two founders, each with 50% of the company (50 shares each), are raising 1m using SAFEs and a 10m post-money valuation.
- The round is successful and they manage to raise the money from 10 investors on a crowdfunding platform, each investing 100k for simplicity.
- The founders then issue 10 new shares for the new investors, each share worth 100k.
- Now that the shares outstanding (total number of shares) is 110, the founders stake in the company is diluted to ~45.5% each (50 shares divided by the new total number of shares). The investors get 1 share each, representing 0.9% of the company.
- This will repeat when the founders raise money again, and all shareholders will get diluted once more.
Convertible Notes
Convertible notes are very different to SAFEs, as they are actually interest-bearing debt that will be converted to equity in the future. In this case, founders are raising a bit of money ahead of a big funding round. So they issue convertible notes that will carry interest and convert to equity when the big funding round closes. The valuation at which the notes will convert to equity is usually the final post-money valuation of the big funding round with a discount. The discount here is an incentive for investors to invest early in these notes, as they get more shares than the investors coming in later. The interest accrued on the investment is also paid in shares usually, although not necessarily.
Conclusion
We covered almost everything you need to know before you invest in startups. We established that startup investing can be an exciting way to potentially earn significant returns on investment and support innovative companies. However, it is crucial to do your research, understand the risks involved, and allocate your investments accordingly. Investors should conduct thorough due diligence and research to mitigate risks and maximize their potential returns.
