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How to invest in startups as a first time investor

The startup market, as viewed by a first time investor, can seem daunting. There are so many opportunities to choose from and numerous factors to consider before any funds change hands.

A widely-held belief about the riskiness of startups, meanwhile, prevails and can put off would-be investors.

But such risks are often overblown and can be mitigated with a thorough approach to any prospective investment.

Of course, like any investment, there are indeed risks - although the true failure/success ratio of startups is much disputed and the ratio itself is seen as irrelevant by some given the sheer range in quality that exists on the startup spectrum.

Backing early stage companies remains a highly attractive proposition for the savvy and astute cash-rich person.

In the UK, tax relief schemes draw many into startup investment, whilst the relatively low investment threshold for such incentives can be an added reason to take the bold step into angel investing, an area in which fortune really can favour the brave.

But as a first time investor in any stocks, you must initially understand exactly what the risks are - and establish your level of tolerance to any losses that may be incurred.

Read more: What do professional investors do to mitigate risk when investing in startups?

One of the key considerations for those eyeing up the startup path is to ensure you diversify your portfolio. This can help you to ride out any macro-economic waves which may affect sector-specific businesses over the length of your investment timeline.

Investing exclusively in particular markets, sectors or companies can result in an exposure to unforeseen issues occurring in one particular field. Investing across different asset classes, regions and sectors is therefore a common approach among seasoned investors and one newcomers should also follow when and where possible.

While there may be a sugar rush in chasing a speculative tip, the more sophisticated investor will ensure there is value to be had across a range of considered choices.

Warren Buffett, chairman and CEO of Berkshire Hathaway, is one of the most influential investors in history. His sage advice is:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Stellar stocks, with their perceived potential for high returns, say, for example in new medical breakthroughs or some hi-tech revolution, are very enticing - but you need to consider what the long-term future value of the company will be.

Plotting the future of a potentially high-growth startup may be far trickier than that of an established blue-chip, with some degree of guess work. This is when your in-depth research, looking at the startup from every angle, comes into play.

A trusted starting point is the so called ‘5Ms of startup investment’. This urges investors to analyse the startup opportunity through the prism of the management team, business model, market proposition, money and momentum.

While no ‘M-factor’ is more important than others, many feel your assessment of the management team is pivotal to the ultimate decision of whether to invest or not.

Some experienced business angels urge others to invest in brilliant people, not necessarily what is perceived to be a brilliant company.

Read more: investing in startups - the importance of a strong management team

Leading US startup investor and actor Ashton Kutcher, co-creator of venture fund A-Grade Investments, has invested in multiple tech companies. Among them is Airbnb, Spotify, Uber, Flexport, Oscar Health, Warby Parker, Nextdoor and Houzz.

His tried and tested methodology highlights a number of key metrics for any interested startup player.

One of his key pieces of advice is to ensure the investment target is a leading player in their chosen field.

This will involve determining their ability to demonstrate a deeper understanding of consumer behaviour, a historical insight into the market and the ability to provide the supporting data demonstrating that they possess a leading edge.

He believes that by doing this, potential investors can secure a level of confidence that their targeted investee has the domain expertise for whatever problem they’re trying to solve.

He also highlights the personal qualities of grit and determination; the capacity to persevere through really tough situations. He says this one is difficult to assess, and generally goes "by gut instinct on meeting the founder”.

Then there is the perceived level of ‘charisma’. He says:

“When I meet with a founder with true charisma, I usually come away feeling like I want to quit my job and go work for them. Because if I don’t get that sense…the best person for the job that they are hiring for isn’t going to have that feeling either.”

There are many benefits to investing in startups, which may reap returns far and away above a safer, more conservative market play.

But bear in mind that investing in startups and early-stage businesses involves risks, including lack of dividends and illiquidity, and is best done as part of a diversified portfolio.

The choice of potential startups in which to invest is continually increasing, with UK business startups growing rapidly.

Many new startups will set their eyes purely on growth over the first few years. As a result, there is likely to be a lack of liquidity in their stock in that time - with the prospect of a significant payout upon exit several years down the line.

The upside of the patience required as an investor can be startling. A payback of ten to twenty times the initial investment is a feasible target with the right investment, and whilst a higher risk/higher return strategy, a key consideration for a UK equity startup investor is the beneficial treatment they will receive from the domestic tax regime.

Venture capital schemes offer tax relief to individuals to encourage them to invest in unlisted companies and social enterprises. These schemes include the Enterprise Investment Scheme (EIS), the Seed Enterprise Investment Scheme (SEIS) and Social Investment Tax Relief (SITR).

Investors can also get involved with startups by buying shares in a Venture Capital Trust (VCT) - a company approved by HMRC which invests in, or lends money to, unlisted companies.

But whichever route into startup investment you choose, thorough research and careful analysis are advised before you invest in any opportunity. Due diligence is such a key element to any investment, and this doesn't differ with startup investing.

Yes, it can be tempting to back, on a hunch, what seems like a team who are about to set the world alight with their revolutionary idea, or to try and invest in what looks like the next Facebook or Google. But your research needs to take precedence. Your investments should be based on what it finds.

Understand your portfolio requirements, carry out your research and only invest when you feel as confident as you can. Taking this approach can't 100% guarantee returns, but whether you're a new or experienced startup investor, it can help to ensure you're investing in the right opportunity for you.

Driving Growth.
Creating Value.
Delivering Impact.

Backed by

Growth Capital Ventures (GCV) is backed by funds managed by Maven Capital Partners, one of the UK’s leading private equity and alternative asset managers.