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How do sophisticated investors make money when investing in startups?
Although a relatively risky asset class, startup investment can deliver excellent returns.
Backing the right business at the right time, based on a fair valuation, can provide a major boost to the seasoned investor’s portfolio.
Startups are an illiquid investment, meaning the investor’s stake can’t swiftly be sold. But when the exit signs are flashing, the investor’s patience can really pay off. The returns available from a startup investment vary widely from business to business. According to the largest study into angel investment, the average return rate is 2.6 times the initial investment (or a 27 percent annual rate of return) with a 3.5-year path to exit.
The 2012 US study followed 539 angel investors and 1,130 exits, including closures, and was led by Willamette University’s Robert Wiltbank and Warren Boeker, of Washington University.
The proportion of startups that result in closure, and therefore a zero return to the investor, meanwhile, is much disputed. Research suggests that it may be a lot lower than popular startup rhetoric suggests, however.
An often-repeated statistic, which seems to have been in circulation since time immemorial, is that nine out of 10 of startups fail. Yet various papers, including a 2017 study by the Statistic Brain Research Institute, show that a more realistic proportion is likely to be around the 50 percent mark.
And even then, such research usually factors in every sector and aims to take into account all startups in a particular nation – in this case the US. The sophisticated investor, who may have years of business leadership experience, has a much greater chance of backing winners.
Their shrewdness in business, and in-depth knowledge of business models, markets and management teams, enables them to spot the startups destined to succeed and discount those showing signs of impending struggles. Often, to maximise their returns, startup investors will back upwards of 20 or 30 enterprises from a range of industries.
By adding these to their other investments, usually in stocks and property, they are able to create a well-balanced portfolio designed to consistently deliver returns.
Unlike stock market investments which can be bought and sold instantaneously, a stake in a startup is usually converted into cash once a liquidity event occurs.
Typically, these include the following five scenarios:
1. The startup is snapped up by another business
The rewards for investors willing to sit tight until the startup is sold can be great.
The tech sector is particularly abundant with reminders of the value of patience as a startup investor.
Last year, for example, the music and film recognition app Shazam was acquired by Apple for around US$400m, eight years on from its inception. Also in 2017, we saw Cisco’s US$3.7bn swoop for app management and analytics tool AppDynamics. The business was launched in 2008 and had been through five funding rounds, suggesting a number of happy startup investors following the deal.
Companies snapped up at an early stage in their development may involve a smaller margin of return and are often acquired to bring new innovation or technologies into an existing business.
The return on investment for the startup investor depends on the size of their stake and what valuation that was based upon. The original stake may have been diluted over time, as more investment was sought to aid the startup’s development. Experienced investors will have asked for transparency on this issue before they invested, however, and will have been prepared for this should they have decided not to follow on their investment in subsequent rounds.
2. The business goes public
In April this year, music streaming app Spotify’s initial public offering (IPO) valued the Swedish firm at US$26.6bn.
As with other public market debutants, the move was reportedly aimed at fuelling the company’s ongoing growth. For the startup investor, they are an opportunity to sell their stake and cash out.
Once on the market, share values will fluctuate and the investor must decide whether to exit at the earliest opportunity, sell only part of their stake, or hold on to it to see how the market plays out.
3. Dividend payments
Ongoing or one-off dividends are a common way for startup investors to make money. If the business is successfully trading, and the founders are not looking for an exit via sale or IPO, they may reward investors by paying out regularly or through a one-time special dividend.
4. The investor sells their stake to someone else
Although it can be difficult to find a buyer, it is feasible for startup investors to sell their share to another party. Increasingly, investors are using secondary transaction sites to buy and sell stakes in private businesses.
5. A management buyout
This option is largely reserved for investors who have remained involved throughout the company’s evolution from startup to SME, or even global empire. Perhaps they have stuck around for the favourable dividends, or the opportunity to shape the destiny of a product they are passionate about.
The next generation of management taking over the firm may offer fresh impetus to the business, or take it into new territories. Investors could decide it is their cue to exit, or may be more motivated to stay involved in a company with a renewed appetite for growth.
Making use of tax reliefs
Now as well as making money, investors can save it via the UK government’s various schemes, which support tax efficient investments. Among them is the Seed Enterprise Investment Scheme, which offers income and capital gains tax relief to investors backing qualifying early-stage firms.
Investors can benefit from 50 percent relief for income tax on the cost of shares, on a maximum annual investment of £100,000.
Another initiative is the Enterprise Investment Scheme, which rewards investors in small, high-risk firms in the UK.
Tax relief of 30 percent of the cost of the shares is set against the investor’s income tax liability for the tax year in which the investment was made.
Both schemes provided by the UK government to help mitigate risk in startup investment, they’re just two examples of the available schemes that can help reduce your level of risk, and ultimately help you to potentially make more money from your investment.
Investing in startups
With the world of startup investing considerably vast and varied, it’s never been as accessible as it is today.
And whilst returns aren’t guaranteed, as with any type of investment, if you complete your research, do your due diligence and feel confident the opportunity is right for your portfolio, being a startup investor can be exciting, interesting - and ultimately has the potential to be extremely rewarding.