How to diversify your portfolio by investing in startups
Property and blue-chip stocks may be considered relatively safe long-term investments.
Yet many savvy investors often also have a hankering for investments with a higher potential return – and ones which they can potentially influence via their business expertise.
Startups fit this bill and a cute investment in a high-growth, small company may reap returns far and away above a safer, more conservative market play.
But there is a need for caution; moving into this new arena can be challenging and comes with a financial health warning.
An abundance of options
However, the choice of potential startups in which to invest is seemingly endless, as UK business foundations hit record levels.
The latest available figures from Startup Britain’s Startup Tracker show a 10 per cent rise in startups between 2015 and 2016, with 658,000 new businesses being started in the latter year.
Of course, not all of these will be looking for private investor support, having secured funds from their own pockets, family, friends or the bank.
But many will, and the number of opportunities for potential startup investors is, therefore, vast – if maybe a little bewildering.
Thorough research is essential
One of the most important prerequisites for successful startup investing is ensuring you’ve done your homework thoroughly.
Commonly, investors refer to the ‘5Ms of startup investment’. These cover the essential checklist items that would-be investors should consider with any startup they are interested in. They include Management team, Business Model, Market, Money and Momentum.
Many other methods designed to minimise risk and maximise the likelihood of successful startup investing also exist, and most sophisticated investors will have developed their own through trial and error and years of experience.
Following the investor crowd
A fast-track route into startup investing, meanwhile, comes through crowdfunding and co-investment platforms.
No time-starved investor wants to spend hours on the internet, attending pitches or on the road in search of investment opportunities without making any actual worthwhile investments.
Crowdfunding through a reputable platform offers a guiding hand into startup investing, although pre-investment homework is still required.
The level of activity in UK crowdfunding businesses reached record levels in 2017.
Crowdcube, for example, achieved 120,000 investments - a 48 per cent increase from the previous year.
Last year, it hosted 33 funding rounds that raised over £1m pounds, which is in the bracket commonly offered by venture capitalists.
Co-investment generally, either through micro-investments or more sizeable sums, is a popular entry point to becoming a startup investor. Certainly, we have seen this on our own platform. While we work with seasoned startup investors, we also see growing numbers of sophisticated property and stock market investors using our co-investment opportunities to diversify into startups.
Diversity is key
If you do decide to add startups to your portfolio, you may wish to follow the sensible path of backing multiple companies in a range of industries. A diverse portfolio of startups protects against sector-specific downside risks.
Alternatively, investing capital and time into a select few firms could enable you to make a direct, positive impact on the success of those ventures.
Investors must decide whether they want to play an active role in steering the startups they back towards exit point, or simply want to remain in the shadows.
Glass half full
Clearly, investors must be mindful of the fact that many startups fail. In fact, some studies suggest that only around half of all startups will make it to their fifth birthday.
One piece of research, by Statistic Brain, plotted startup failure rate by industry in the US. After five years, it was around 50 per cent – and over 70 per cent after a decade.
But the usefulness of such studies to startup investors is questionable. To suggest the savvy startup investor only has a 50 per cent chance of success disregards their expertise and careful pre-investment analysis.
A more useful study would be to analyse what proportion of startups that pass the rigorous testing of a smart, would-be investor ultimately succeed. Their chance of success is undoubtedly higher than one in two.
In search of investment liquidity
Another important consideration is how long the path to an exit is likely to be – in reality, rather than what’s written in the business plan.
As an investor, the value of your equity in the company might not be realised for years, when the company is acquired or goes public (obviously on the assumption the startup reaches that stage).
Many startups take a long-term approach and avoid paying any dividends, with all profits being ploughed back into supporting growth.
It is also vitally important to be aware that there is unlikely to be a market for trading your share once you've invested. That means, even if your share soars in value, having to sit tight until the required exit is reached.
This may be a hard adjustment for a bourse veteran who’s used to buying and selling their way out of trouble and into profit.
Stocks or bonds have liquid markets, where shares can be bought and sold instantly, but being at the early stages of a company’s existence, startups are considered a relatively illiquid asset class.
A massive opportunity with startups
Yet the upsides of startup investing can be startling; putting your cash into a startup that is ultimately bought or even goes public could multiply your cash in just a few years.
Such instances could reap an angel investor 10 or 20 times what they initially invested.
The lucky few who get in early on a mighty unicorn – those elusive, US$1bn-plus giants – can expect even greater returns.
An early Instagram investor, for example, could have multiplied their investment hundreds of times over. One Silicon Valley venture capitalist firm reportedly saw its US$250,000 original investment soar to a potential US$78m following Instagram’s sale to Facebook.
In summary, investing a portion of your portfolio into rapidly-growing startups may help to achieve your financial goals – or even go far beyond them.
But bear in mind that investing in startups and early-stage businesses involves risks, including illiquidity, lack of dividends, loss of investment and dilution, and it should be done only as part of a diversified portfolio.
Ultimately, do your research well, and make sure the money you put aside is sufficient to make a decent return but not enough to inflict serious damage to your investment pot should the worse happen.
The opportunities are undoubtedly there to diversify your portfolio with startups, and the right approach could see you on the track to success.