How to Invest In a Start-up
How to Invest In a Start-up
Planning to invest in a start-up business? Take a minute to read this article as we uncover some of the key pointers to get you started on your successful start-up investment path. Unless, of course, you are already a seasoned investor, in which case, you might just enjoy the read and reminisce about your early angel investor days. Here we go.
The crowdfunding boom brought about a shift in high-net-worth investors' habits, pushing start-up investments towards the bottom of their priority list. And this can be said about the last ten years without any risk of error.
In the UK, for example, equity crowdfunding has gained so much traction in the past decade that it is now one of the mainstream sources of income. Surging from below eight fundraising ventures in 2011 to almost 600 in 2021, Beauhurst start-up research specialist shows.
Why does anyone invest in start-ups? Despite the risk, start-up investments have the potential to generate high returns in the long term. For example, crowdfunding investors in Scottish craft brewery BrewDog received a whooping 2,765% return on their investment.
However, this is not to suggest that all start-ups are alike or that all of them will generate the same returns. Considering that 50% of these ventures go belly up in the first three years, according to data collected by the Office for National Statistics (ONS), investors must carefully weigh their options and make wise investment decisions.
Let us not forget that start-ups are key pillars of the economy, they contribute to the national system not only by paying taxes but also by supplying innovative products and services that fill a gap in the market. This is what helps them “grow three times faster than the traditional economy” and have generated “10% of job growth worldwide since 2017”, according to Alex Davies, CEO and founder of investment advisory firm Wealth Club.
Here is what you need to know about investing in start-ups and how you could profit from it. Let's dive in!
Three clever ways to invest in start-ups
- Crowdfunding is the most popular source of funds for young businesses. It comes down to raising small amounts from a large number of investors, often through social media or dedicated crowdfunding platforms like Kickstarter, Patreon, Crowdfunder and others.
- Venture capital funding is yet another sought-after form of start-up investment. Unlike crowdfunding, venture capital investing is a form of equity funding whereby a venture capital firm creates a pool of funds collected from investors interested in start-up investing.
- Angel investing is a form of fuelling capital directly into a fledgling business widely used by high-net-worth individuals in exchange for 90% or more of the company's equity. We invite you to read our previous article on this topic, to get the lowdown on what it involves.
Let's take a closer look at crowdfunding and venture capital funding and their benefits for start-up investors.
The ins and outs of crowdfunding
There are two types of crowdfunding:
- Equity is the most convenient way to invest in a new business by committing to invest a fixed amount of capital at a specific valuation and, if the company reaches its funding target, as an investor, you receive a number of shares proportionate to your contribution.
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- Convertibles, on the other hand, are a form of short-term funding occurring before a more consistent funding round. Investors acquire convertible assets, which are converted into shares at a discounted rate at a later date, usually in the subsequent funding round. Convertibles differ from equity investments in that the valuation is unknown at the time of investing.
The ins and outs of venture capital investment
As a form of private equity investment, venture capital is an alternative way of investing in an early business with high growth potential but which has not yet generated any profit or revenue.
Typically, venture capitalists acquire minority stakes in start-up companies and provide them with further financial support and expert guidance. Companies like Amazon, Google, Skyscanner and Facebook are the result of venture capital funding.
Why should you consider venture capital funding? It provides higher returns than other forms of investment. According to data from Wealth Club, private equity investing has outraced global equity funds by 9% in over two decades.
One of the main blockages to venture capital funding is the minimum amount requirement which hovers above £10,000 (as a minimum).
If you're interested to invest in a venture capital fund in the UK, you have two options: funds and trusts. Read on as we unbox them below.
Fund investing: EIS & SEIS
Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS) invest in two to seven-year-old companies. Just like “traditional” funds, they pool capital from a group of investors, yet they differ in that investors own shares in the underlying companies not in the fund itself. Furthermore, with SEIS and EIS investors can only invest in these funds during the initial fundraising round.
Each fund pools together about 5-10 start-ups, offering investors excellent diversification. However, to qualify, you must meet the high-net-worth investor criteria to gain exposure to this type of investment.
Notably, the funds state their target return rate during the fundraising stage, which is between two to three times the initial investment over five to eight years before tax relief.
Investors pay an up to 5% initial fee on top of an annual fee ranging between 1 and 2% plus a performance fee (which in some cases can reach up to 20% of the profits made). With this type of investment, investors trust the fund manager to deliver on their fail-safe exit strategy and generate high returns. Dividends are very rarely paid.
Venture capital trusts (VCTs)
VCT funds have spiked in popularity by more than 50% over the last three years, with fundraising surpassing the £1 billion mark for the first time in the 2021-2022 tax year, data from the Association of Investment Companies.
VCTs are also collective investments; however, they differ from EIS in that with these funds, investors hold stakes in the fund itself not in the underlying companies. A VCT is generally invested in 30-70 companies, providing greater diversification.
VCTs are listed on the stock exchange, thus allowing investors to buy shares in the initial fundraising, or on the stock market once listed. Zoopla, Virgin Wines, Graze and Czoo are some prominent VCT-backed companies.
The initial fee for participating in a VCT is 5% plus a yearly management fee of 2%, give or take, on top of a performance fee of 20% of profits exceeding a 7% target annual return.
Unlike EIS funds, VCTs generate considerably higher returns, of which dividends represent a significant part. Over the past decade, the average VCT return has hit 117%, excluding tax relief, according to Alex Davies.
Now that you know what options you have, we'll let you analyse them carefully. If you need guidance or are looking for the next investment venture, FundMyPitch experts have a wealth of expertise in the field, not to mention, we're well-connected with investors and start-up founders with promising projects. Get in touch.