What Are the Risks and Rewards of Investing Throughout the Startup Lifecycle?
Investing in startup companies is a risky business, but it can be very rewarding if and when the investments do pay off. The majority of new companies or products simply do not make it, so when you're going it alone the risk of losing your entire investment in a company is a very real possibility. The ones that do make it, however, can produce very high returns on investment.
Investing in startups, whether as an angel investor or even via equity crowdfunding platforms, is not for the faint of heart. In these situations, your money can easily be lost with little to show for it. Angels often have to sit and bear the stress of watching tens of thousands of pounds lost on company after company until they hopefully find a winner. However investing in venture capital funds diversifies some of the risks. Through a portfolio of lots of startups, that's done right, the losers will on average be more than offset by a few big winners. This is known as the “power law”, and though it means VC investors shouldn't expect to get lucky with a couple of 100x winners and call it quits there, they can expect on average a 3-10x multiple on their entire portfolio with much lower overall risk of loss to their portfolio compared to angel investing. At Old Street Ventures we take that one step further. Since even the best VCs can have a bad run, or generalist VCs can get caught by the most recent hype cycle (remember NFTs?!) we make sure to carefully allocate your investment across a number of specialist VCs in sectors with clear long-term potential. This protects our investors from those cycles, whilst at the same time maximising your chances of catching the future unicorns.
Startups go through a number of growth stages, and each one of them offers distinct opportunities and risks for investors. Let's take a look at these stages and summarise the balance of risk and reward at each stage.
Stage 1 of a Startup: Pre-Seed
Every startup begins with an idea. In this first phase, they do not yet have a working product, a customer base, or a revenue stream. These new companies can fund themselves by using founders' savings, obtaining bank loans, or selling equity (shares) to investors/friends & family in exchange for cash to fund their operations. Handing over seed money in return for an equity stake is what comes to mind for most people when thinking about what it means to invest in startups.
During the pre-seed phase, the first employees may be hired and prototypes developed to pitch the company's idea to potential customers or later investors. These sums are relatively small, up to around £500k, and allow an entrepreneur to prove that an idea has a good chance of succeeding. Investors get a relatively large cut of equity, up to about 25%, for their investment at this stage to reflect the higher level of risk. Though the chance of failure is really high, the potential payoff the equity provides is similarly very, very high if the startup succeeds. This usually is where the stories of 1000x return on investment come from.
Stage 2 of a Startup: Seed
Once a new company moves into operations and starts collecting initial revenues, it has progressed from ideation stage to a fully-fledged startup. At this point, company founders may pitch their idea to angel investors or some early-stage venture capital funds. An angel investor is usually a private individual with accumulated wealth who specialises in investing in early-stage companies.
Angel investors are typically the first source of funding outside of friends & family money. Angel investments are still relatively small in size, ranging from £500k to a couple million in total fundraising at this stage, but investors also have much to gain, because they will claim another 20-25% of the company's equity at this point, at a slightly higher valuation but still diluting existing investors. Investors at this stage will target about 100x return when evaluating an investment as a consequence of the risk they are taking on board and the expectation of their equity stake being diluted by future fundraising rounds.
Seed stage money is used to support initial marketing efforts and move prototypes into production, as well as make some select key hires who will enable the business to grow.
Stage 3 of a Startup: Growth/Scaling
By this point, the founders will have developed a solid business plan that dictates the business strategy and projections going forward. Although the company may not yet be earning any profits, it is gaining momentum in the market and reinvesting any revenues back into the company for growth. This is when venture capital really steps in.
Venture capital investors take an active role in promising new companies that have moved past the seed stage. Venture capitalists often take on advisor roles and find a seat on the board of directors for the company. The startup's valuation can grow a considerable amount through subsequent fundraising rounds (this is how unicorns are born), with VCs usually trying to maintain somewhere between 10-20% ownership of the startup at a minimum along the way.
For a simplified example, say a VC invests £10mn for 20% ownership of a startup. Let's say the startup raises once or twice more and is now worth a cool £1bn, while the VC's ownership stake was diluted down to 16% as more shares were created and given to newer investors and it didn't participate in the following rounds. That 16% is now worth £160mn, giving the VCs (and its investors) a 16x return on their investment, not too shabby eh? If it took the startup 5 years to grow to that size it was returning over 70% a year on average!
As startups mature the risk of failure begins to diminish and the valuation grows, so later investors can't expect the same returns. However, they are much closer in time to a potential exit. As such, some VCs specialise in later stage rounds where they can see quick returns on their investments for lower risk. Doubling your money every 2-3 years over and over again can add up quickly too!
So where does this leave you?
Unless you happen to be a founder, family member, or close friend of a founder, chances are you will not be able to get in at the very beginning of an exciting new startup. And unless you happen to be a wealthy, accredited investor, you will likely not be able to participate as an angel investor.
Until today, most investors could only take part in the startup lifecycle through crowdfunding platforms or pooling money with friends to syndicate (jointly invest) in a fundraising round. VCTs are an option available but come with large fees and their investment mandates are often driven by the corporations behind them. And private equity funds that specialise in venture capital funding for late stage companies may be interesting for those that can afford the investment and lockup periods before they can access their funds again, which allow for indirect investment in startups.
Old Street Ventures is working hard to provide all investors with a better alternative, giving everyone access to venture capital funds and the startups (and returns) they work hard to nurture.