Nevertheless, asset classes that are weakly, or even negatively correlated with the public markets can reduce the risk of your overall portfolio significantly, making investing in innovation an attractive option. However, there are several factors to consider:
What type of investor is qualified to invest in a start-up company?
Investing in start-up companies comes with a significant level of risk (it is estimated that in the US, 75 percent of venture-backed companies never return the initial investment to investors ), you should have a level of net worth in order to accomplish two things:
1) As a general rule of thumb, do not let your total amount of investment into start-ups be more than 5-10% of your total net worth.
2) Make sure you can diversify. There is no golden rule here, but a number that is often mentioned is to invest in at least ten start-up companies. According to a study by the Kaufmann Foundation, out of every 10 start-up investments, just one or two provide 90% of a portfolio’s returns, meaning the other 8 or 9 will not succeed much in terms of growth in value. Diversification can be achieved through investing in start-ups in different economic sectors, stages of development, and geographical locations, for example. In other words, out of 100 investments in startups, the 10 successful ones should compensate for the 90 that fail. If one of the 10 develops into a unicorn, you hit the jackpot.
This means that you need a significant net worth to be able to invest in start-ups. If you cannot accomplish diversifications through direct investment, then you can consider investing through a venture capital fund, which automatically takes a fee in exchange for investing and managing a portfolio of investments. Adding to the risk is the fact that investments in start-ups are highly illiquid and until an IPO, there is no liquid secondary market for the shares you own.
What Stage are You Investing In?
The earlier in the development of a company one invests in, the higher the risk and hence the lower the investment amount for a specific percentage share of the company. By investing at an early stage of a company’s development, you will see in subsequent financing rounds such as a Series A or B, that if the company has been able to execute its strategy, there will be an increase in the value of your shares in the company.
The earlier one invests, the less meaningful the cash flow projections are. Of course, the cash burn and runway, which indicates the number of months that are left before the company runs out of cash, is important, however, the revenues are much more difficult to forecast, especially in the early stages as there is limited market feedback. Valuations, in the end, are generally based on expectations of the future, and that future, in the case of startups, is far more difficult to forecast than for mature companies with a long operating history in their markets.
When there is just an identification of a problem, a solution, a team to work with, and a business strategy, then the stage of development is typically referred to as pre-seed or seed. Most seed rounds are nowadays structured as convertible debt; hence the loan will be converted into equity with a discount to direct equity investors at subsequent financing rounds. Even though there are professional investors investing at this stage, or possibly investment through community funding websites, often at this stage the “fools, friends and family” step in in order to get the company going. If you provide financing and you are not a friend or family, do not take the term fool as a personal insult; this is merely to reflect that investing at this stage is very risky.
When you do your due diligence on a company, you want to look at everything that is relevant. However, the management team may arguably be the most important factor to consider. Is each member of the management team fully committed to the company? Will they be able to make the hours required? And how will they respond when the strategy needs to be adapted in face of market developments? Many startups will throughout the early stages make a pivot at some point. The pivot is based on learning, learning from market feedback, learning from experienced investors, and learning from peers.
Many investors will look at the management team to see if it has previous experience with start-ups. Of course, an experienced team will have gone through the stages before but can also not be as hungry for success as a team of first-time entrepreneurs. And of course, after all, there is a first time for every entrepreneur.
The valuation, like in every free market, is determined largely by supply and demand. If you are one of the few interested investors and the company is running out of cash, then you have a strong hand. If your competitors for investment are established venture capital firms and you can invest only a small amount, then you should be pleased if you are able to tag along at the valuation dictated to you.
However, to obtain an indication of a value, several methods can be applied. You can apply a multiple to total revenues or EBIT if the start-up company is indeed already profitable. One can also make an estimate of what it would cost to rebuild the company from nothing (“cost-to-duplicate”) and of course by discounting an estimate of future cash flows or terminal value (“VC-method”).
Tension Between Investors and Entrepreneurs
The relationship between investor and entrepreneur can be tense at times. The entrepreneur needs your money, but then typically prefers to be left alone. There is a lot of pressure for the entrepreneur to reach the milestones agreed with investors. The investor of course needs to have some indication that the money invested is spent towards reaching the milestones and not on overly expensive offices and lavish parties. Between investors, there can also be tensions with respect to the strategic course of the company, especially when times are tough. For example, when a company needs a new round of funding to survive, an investor is confronted with the difficult choice between letting the company go under and losing the investment or investing more.
The above is merely to provide a non-exhaustive overview of the issues that can come into play if you consider an investment in a start-up. At Blacktower we have in the past provided advice to clients on whether this type of investment is suitable for you as part of your portfolio, given your risk profile, risk appetite, and your financial goals. Please contact us in the Lisbon office for a free consultancy.
This communication is for informational purposes only and is not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice form a professional adviser before embarking on any financial planning activity.
Blacktower Financial Management: https://www.blacktowerfm.com/locations/portugal-algarve/
Tel: +351 289 355 685