What should investors actually look for in an early-stage investment?

7 questions to consider alongside EIS and SEIS tax relief

For many private investors, EIS and SEIS can be an important part of the appeal of investing in early-stage businesses.

The tax advantages can make a significant difference to the overall risk and return profile of an investment, particularly when investing in businesses at an earlier stage of their growth.

But tax relief is only one part of the equation.

When assessing an early-stage investment opportunity, there are several other questions worth asking about the underlying business, the market, the management team and the potential return.

Having worked closely with private investors and early-stage businesses, these are seven areas I think are particularly important to consider.

1. Is there a genuine problem being solved?

A compelling investment opportunity usually starts with a simple question:

What problem does this business solve, and how painful is that problem for the customer?

It's easy to be impressed by a sophisticated product, a large addressable market or an exciting piece of technology. But none of those things matter if customers don't have a sufficiently strong reason to buy.

I'd want to understand who the customer is, what they're doing today, why the existing solution isn't good enough and why this particular company is positioned to solve the problem better.

A business solving a real, expensive problem for a clearly defined customer can be much more compelling than one targeting a huge market without a clear customer need.

2. Is there evidence that customers actually want it?

There's an important difference between a business having a good idea and having evidence that the market wants that idea. Depending on the stage of the company, that evidence could look very different.

For an early-stage business, it might be:

• Paying customers

• Repeat purchases

• Revenue growth

• Customer retention

• Signed contracts

• A growing pipeline

• Strategic partnerships

• Strong user engagement

The earlier the company, the less historical data there may be. That doesn't mean the opportunity is unattractive - it means investors need to look harder at the signals that do exist.

One of the questions I always come back to is:

What evidence do we have that this isn't just a good idea? 

3. Can the business scale?

Growth is not necessarily the same thing as scalability.

A company might be able to increase revenue, but if every additional pound of revenue requires a corresponding increase in people, infrastructure or costs, there may be limits to how efficiently it can grow.

I'd therefore want to understand the business model.

• How does the company make money?

• What are the gross margins?

• What happens to the economics as revenue grows?

• Does customer acquisition become more efficient over time?

• And importantly, what does this business look like at £10m of revenue rather than £1m?

You don't need every answer at the earliest stage. But you should be able to see a credible path.

4. Who is going to execute the plan?

At the early stage, you're not just investing in a product. You're investing in a team.

That doesn't mean the founders need to have built a successful company before. Some of the best businesses are built by first-time founders. But I want to understand why this team is particularly well placed to solve this particular problem.

• Do they understand the market?

• Do they have relevant experience?

• Can they attract the talent they need?

• Are they realistic about the challenges ahead?

• And perhaps most importantly, do they demonstrate the ability to adapt when things don't go according to plan?

Early-stage businesses rarely follow the original business plan perfectly. The quality of the people making the decisions can therefore be just as important as the original idea.

5. Does the valuation make sense?

This is one of the areas that can be overlooked when investors become excited about a company. A great business can still be a poor investment if you pay too much for it.

The question isn't simply:

“Is this a good company?”

It's:

“Is this a good company at this valuation?”

That means understanding how the valuation has been reached, what assumptions underpin it and what the business needs to achieve to justify it.

For early-stage businesses, traditional valuation metrics don't always tell the whole story. Investors may need to consider comparable transactions, market opportunity, traction, intellectual property, growth potential, the strength of the management team and the amount of capital required to reach the next stage.

The valuation should ultimately be considered alongside the potential return - not separately from it.

6. How much capital will the business need?

A fundraising round shouldn't be viewed in isolation. I'd want to understand what the company is trying to achieve with the capital being raised and how far that capital is expected to take it.

• Is the funding going towards product development?

• Hiring?

• Sales and marketing?

• International expansion?

• Working capital?

• And what milestones should the business reach before it needs to raise again?

This matters because future fundraising can mean dilution for existing shareholders.

A company that repeatedly needs substantial amounts of capital to keep growing can produce a very different investment outcome from one that becomes increasingly self-sufficient as it scales.

7. What does the downside look like?

Perhaps the most important question is one investors don't always want to ask:

What happens if we're wrong?

Early-stage investing is about managing uncertainty, not eliminating it. You won't know exactly how the company will perform. You won't know when an exit will happen. You can't guarantee that the market opportunity will develop as expected. But you can ask what could go wrong.

• What are the biggest risks?

• What assumptions does the investment case depend on?

• How much runway does the company have?

• What happens if revenue growth is slower than expected?

• Could competitors enter the market?

• Is there regulatory or technological risk?

Thinking about the downside doesn't make you pessimistic. It makes you a better investor.

Where EIS and SEIS fit into the decision

For many private investors, the availability of EIS or SEIS relief is an important consideration when assessing an early-stage investment.

And rightly so.

The tax advantages can materially change the overall risk and return profile of an investment. Depending on the investor's circumstances and the relevant conditions, EIS and SEIS can provide significant income tax relief, alongside other potential benefits such as capital gains tax and loss relief.

But I think the most useful way to look at the schemes is as part of the overall investment proposition, rather than in isolation.

The questions around the business still matter:

• Is there a genuine problem being solved?

• Is there evidence of customer demand?

• Is the team capable of executing the plan?

• Does the valuation provide an attractive entry point?

• What could drive significant upside?

• And what are the key risks?

EIS or SEIS can then form an important additional layer to that assessment.

For an investor, the attraction may ultimately come from the combination of the underlying growth opportunity and the potential tax advantages available through the scheme.

That's particularly relevant in early-stage investing, where the potential returns can be significant but so too can the risks.

The investment case is more than one number

I don't think there's a single metric that tells you whether an early-stage investment is right for you.

The strongest investment decisions tend to come from looking at the opportunity from several different angles: the business, the market, the team, the valuation, the potential return, the risks - and, where applicable, the tax-efficient structure.

For me, that's what makes early-stage investing interesting.

You're not trying to remove uncertainty. You're trying to understand it.

And ultimately, the question isn't simply whether a company is exciting, or whether an investment qualifies for EIS or SEIS.

It's whether the overall proposition makes sense for you as an investor, given the potential return, the risks you're taking and the role the investment plays within your wider portfolio.

This article is for general information only and does not constitute financial, tax or investment advice. EIS and SEIS investments are high risk and investors should undertake their own due diligence and consider their individual circumstances before investing. Tax treatment depends on individual circumstances and current legislation, which can change.