How to invest in startups as a private investor
Startups and venture capital (VC) have become an increasingly attractive asset class for private investors thanks to strong historical returns in recent years.
In 2022 global investment firm J.P. Morgan reported venture capital as being the best-performing asset class globally in terms of investor returns over the last 10 years, outperforming private equity, listed equities and property among others.
This heightened performance has forced an increase in the accessibility of VC in recent years. Where the asset class was once reserved exclusively for institutional investors, today - though still accounting for 15% of the average institutional investor’s portfolio - private investors can also explore the various routes for accessing startup investments.
Ultimately, investing in startups allows investors to buy shares at the early stages of the company's growth, and can be carried out via one of three overarching methods:
Direct investment - purchasing shares directly from the company, without any intermediaries
Co-investment - selecting opportunities from a range of companies alongside other investors, often via an online platform
Funds - submitting capital to a fund which invests into a portfolio of companies on the investor’s behalf
However, understanding how each of these routes operates in detail, alongside the strategies investors can employ to reduce risk, maximise returns and select opportunities when investing in startups can be crucial to an investor’s success.
Select a route
As previously mentioned, in the UK three core avenues exist for investors looking to invest in startups, under which various schemes, providers and opportunities fall.
Exploring each in greater can be an essential task for investors in identifying which pathway best suits their investment goals and personal circumstances.
Direct investments occur when an investor chooses to invest directly into an startup without the assistance of any intermediaries.
Due to a significant level of prior experience and/or capital that is required to structure this type of investment, direct investments commonly occur when a startup approaches a high-net-worth angel investor or informal angel investor network for investment.
Co-investment involves an additional party that groups and facilitates investment opportunities for investors to select from. This route will often take the form of online co-investment platforms (though can also include offline networks) that group together startup investment opportunities for investors to browse and select from at their will.
Where co-investment platforms can vary in their level of due diligence, sophisticated platforms will research, vet and select portfolio companies against a strict eligibility criteria before advertising them on their platform to best ensure growth potential.
Individual VC opportunities on co-investment platforms will often target between 5x - 20x money-on-money returns. Some platforms will also offer the option to benefit from tax efficient investment schemes with certain opportunities that can minimise the risk and maximise the potential returns associated with startup investments.
Venture capital funds (commonly recognised in the form of VCTs, EIS funds and SEIS funds), unlike the previous routes, do not involve purchasing shares in an individual startup.
Instead, an investor will pledge capital to a fund manager, who will pool investors’ capital to invest in an (often) predetermined portfolio of early stage companies. This portfolio's performance will then dictate the value of the investor’s shares.
Though funds can offer investors a less effort-intensive method for diversifying their portfolio, this spread of capital over a greater number of portfolio companies means funds tend to target less considerable returns than the previous two routes, with the regular fund fees often required also limiting an investment’s potential for growth.
Diversify your portfolio
Before deciding which startup investment route is best suited an individual’s goals, one consideration every private investor should take into account is their level of portfolio diversification.
Investing exclusively in particular markets, sectors or geographies can result in overexposure to unforeseen issues that may occur in one particular field, and potentially have detrimental impacts on a portfolio’s value.
Therefore, diversifying investments across a range of asset classes, regions and sectors is a common approach that most experienced investors will adopt to strengthen their portfolio against unforeseen macroeconomic impacts. Simply put, this is known as developing a portfolio diversification strategy.
Whilst various techniques for achieving this exist, one popular route is to incorporate a broader range of alternative investments into a portfolio, largely due to the space’s significantly broader scope of asset classes than the traditional investment space.
Whilst early stage investments have the potential to generate considerable investment growth, investing into small, unquoted businesses can also present a notable degree of risk.
Subsequently, developing a sophisticated risk mitigation strategy may be one task an investor may look to prioritise.
Though ensuring investors have an adequately diversified portfolio is one way to contribute to this, UK investors can also take advantage of a number of more direct methods for minimising risks, notably residing in the tax efficient investing space.
Two of the most popular schemes that fall into this category are the Enterprise Investment Scheme (EIS) and Seed Enterprise investment Scheme (SEIS). Introduced in 1994 and 2012 respectively, the schemes were introduced by the UK government to encourage private investment into early stage companies, and have since attracted a total of more than £27 billion.
Offering investors between 30% and 50% income tax relief on the value of their investment, capital gains tax exemption on the disposal of shares, inheritance tax exemption and additional CGT deferral and reinvestment reliefs, the generous tax incentives offered by the schemes have been integral to their popularity.
Ultimately minimising the downside risks and maximising the potential returns associated with investing in early stage companies, considering opportunities eligible for schemes such as the EIS or SEIS can prove beneficial for investors looking to mitigate the risks of their startup investments.
Whilst a range of tactics can be employed to enhance the potential success of a startup opportunity prior to investing, ultimately the growth of the investment will rely on the strengths of the company itself.
Subsequently, it is crucial that investors conduct adequate due diligence into portfolio companies and investment providers prior to parting with their capital.
Before exploring the more granular details of an opportunity, a trusted starting point for assessing a startup’s strengths on a broad level can be to consider the ‘5 Ms’:
Management Team - how experienced and entrepreneurial are the founders? Can the founders build a team capable of executing the growth strategy and creating shareholder value?
Model - business Model and revenue model. Does the startup have an innovative and disruptive business model? How does the company generate capital?
Market - opportunity, size, and overall market growth potential.
Money - how much capital does the business need and how will management deploy funds to create value?
Momentum - what has the company achieved to date? Does it have a strong pipeline of customers or any early commercial traction?
Whilst frameworks such as the 5 Ms can prove useful when initially assessing startup potential on a high level, for experienced private investors, employing more sophisticated due diligence strategies further down the line will likely be necessary.
Finding answers to key questions surrounding the business, management team, market proposition and exit plan - among other aspects - aided by resources such as investor due diligence checklists, can prove vital in assessing the viability and growth potential of a startup prior to investing.
Make a decision
Whichever route into startup investment you follow, thorough research into diversification techniques, risk-mitigating schemes and companies themselves will likely play a critical role in determining the potential success of your opportunity.
Whether it is by constructing a personalised VC portfolio across a range of sectors, taking advantage of the generous tax reliefs offered by the SEIS or investing via a reputable co-investment platform, selecting the most appropriate tools and techniques to suit your investment goals, level of experience and personal mission is essential.
In a UK venture capital market valued as the highest in Europe, ensuring investors understand as much as possible on what the space has to offer can breed lucrative results, and perhaps even pave the way for the next startup success story.
GCV Invest is a private investor network for experienced investors. We specialise in providing investors with access to carefully selected alternative investments including some of the UK's most compelling startup investment opportunities with the potential to deliver better returns than traditional investment products.
You can find out more about GCV Invest here.