Investing in early-stage companies can be both exhilarating and perilous. Understanding the risks and the strategies to mitigate those risks is crucial. Entrepreneurs who are developing exciting new businesses need to ensure they qualify investors and make it absolutely clear that any investment is high-risk.
The earlier the venture, the greater the chance it will fail! But of course, the ones that do not fail become the grand slam home runs that we all dream of!
You should approach every investment assuming that failure is the most likely outcome and then invest in the ventures you are most confident can succeed. Let’s examine why some investors prefer early-stage companies over later-stage investments, as well as the advantages and disadvantages of early-stage investing, and provide some simple derisking strategies for investors to consider and for entrepreneurs to be mindful of.
Advantages of Early Stage Investments:
- High growth potential: Early-stage companies have the greatest capacity for rapid expansion and substantial returns. Unlike established businesses, startups are designed for exponential growth. They typically target large, addressable markets with innovative solutions, allowing for rapid scaling. This growth will translate to substantial financial returns for investors. While, along with insolvent turn-around candidates, they are the riskiest, a successful investment into an early-stage company can yield returns of 100x or even 1000x the initial investment. Such outsized returns are almost impossible with later-stage companies or public market investments, making early-stage ventures particularly attractive to risk-tolerant investors seeking high rewards. That said, public company returns are less risky, and you can always extract your investment should you need the capital in a hurry. In private companies, individual exits are uncommon.
- Exposure: Startups often operate at the forefront of technological advancement and market disruption. By investing early, individuals can participate in groundbreaking developments in cutting-edge fields like artificial intelligence, biotechnology, clean energy, or novel business models. This exposure offers potential financial benefits and provides investors with insights into emerging trends and technologies that could shape various industries. The knowledge they gain can be valuable for making informed decisions in other aspects of their investment portfolio or business ventures. In a sense, they are buying market research into other opportunities!
- Portfolio diversification: Oddly enough, early-stage investments can also balance traditional assets in a portfolio. While inherently risky on their own, venture investments will lower overall portfolio risk when combined with stocks, bonds, and other traditional assets due to their low correlation with public markets. A well-funded, pre-revenue, or early-stage startup isn’t affected by market fluctuations. These companies can pivot and contract easily enough when required. Often, startups that advance through troubled times are often the big winners in the long run, leading the charge through the next bull markets. Diversifying your portfolio via well-placed investments in industries that you believe will be part of the next wave will help smooth out returns over time and provide a hedge against market downturns. Looking forward, businesses addressing climate change, energy efficiency, mental health, and the application of AI to improve existing industry efficiencies all appear to be wise, future-looking options whose problems will continue to drive innovation, activity, and interest.
- Influence and involvement: Early investors have more opportunities to actively participate in the company’s growth. A smart entrepreneur is not just looking for capital, they are looking for advisors who are invested in the company’s success. This level of involvement allows investors to contribute their expertise, network, and resources to help shape the company’s direction and increase its chances of success. For many investors, particularly those with entrepreneurial or industry experience, this approach is a significant draw.
- Lower entry valuations: Early-stage companies will usually have lower valuations, allowing investors to acquire larger equity stakes for less capital. As these companies are often pre-revenue or early in their commercialization phase, their value is based on their potential rather than current financial performance. This presents an opportunity for investors to buy in at a lower price point. If the company succeeds and grows, the value of this equity stake will increase exponentially. As a further bonus, as an existing shareholder, you usually have the right to participate in later rounds. All too often, people lament that they can’t get in on a deal when they can see it’s successful. Participate early with a small investment, and then go in heavily when it is de-risked.
- Longer growth runway: Early-stage companies have more room for growth, offering investors a longer period of value appreciation. When investing at an early stage, companies are just beginning their growth. This means there’s a lot more upside as the company scales, releases products, and enters new markets. With each milestone, the company increases its valuation, and you can watch your investment grow over several funding rounds. In contrast, later-stage companies may have already captured a significant portion of their target market, limiting future growth potential.
- Personal satisfaction: Beyond financial returns, early-stage investing offers the opportunity to mentor founders, contribute to innovation, and potentially make a positive impact on society through the development of new technologies or services. Many investors find it personally rewarding to support entrepreneurs and play a role in building successful companies from the ground up. This aspect of venture investing can be particularly appealing to individuals who want to stay engaged with entrepreneurship and innovation without necessarily running their own companies.
- Access to future opportunities: By establishing themselves as valuable early-stage investors, individuals can build a reputation and network that leads to deal flow in other promising startups. When you’re known to be an active investor who enjoyed success, other investors introduce you to deals they are interested in so that you can help them validate the opportunity.
- Potential tax incentives: In some jurisdictions, there may be tax benefits or incentives for investing in early-stage or small businesses. For example, in BC, a government program allows investors to recover 30% of their investment, substantially derisking the project and helping to negate any debate on valuations. These programs can include tax credits, deductions, or favorable capital gains treatment. As another example, in the United States, investments in qualified small business stock can be eligible for exclusion from federal taxes on capital gains. While these tax benefits shouldn’t be the primary motivation for investing, they recduce risk, increase the benefits, and enhance the overall returns to make early-stage investing more attractive.
Disadvantages of Early Stage Investments:
- High failure rate: The stark reality is that many startups fail, often within the first few years. Studies suggest that up to 90% of startups that get funded do not succeed (and less than 3% ever get funded). This high failure rate is due to market conditions, competition, execution challenges, and often just simply ideas that did not gain traction. For investors, this means there is always a significant risk of losing part or all of their investment. It’s crucial for early-stage investors to be prepared for the possibility that their investments may not pan out and to structure their portfolios accordingly. Never invest more than you can afford to lose! No one expects to lose their money, but if 90% of startups fail, then 90% of the time, you will lose your investment!
- Illiquidity: Investments in early-stage companies are often locked up for extended periods, sometimes for several years. Unlike publicly traded stocks, there’s no readily available market to sell shares in private companies. Investors typically can’t exit their investment until a liquidity event occurs, such as an acquisition or an IPO. This lack of liquidity ties up capital for long periods and may pose challenges if an investor needs to access their funds. Just as you must never invest more than you can afford to lose, do not invest money you may need to access at any point. Investing in early-stage companies requires patience and the financial stability to withstand long periods without seeing returns.
- Limited information: Early-stage companies often have little track record or financial data, making it challenging to assess their potential. Traditional valuation methods do not apply, and projections can be speculative. This lack of information increases the difficulty of due diligence and can lead to investment decisions based more on the vision and team rather than hard data. To make informed decisions, investors must have a keen understanding of the market, technology, and team dynamics.
Simple Derisking Strategies for Investors (and entrepreneurs):
- Due diligence: Do your own, thorough, research of the company, market, and team is crucial before investing. Ask lots of questions about the business model, seek out independent perspective to assess the market opportunity, Google competitors and evaluate the competitive landscape, and scrutinize the founding team’s background and capabilities. Investors should also review legal and financial documents, understand the terms of the investment, and consider the startup’s growth strategy and potential exit scenarios.
- Diversification: Spreading your investments across multiple startups and sectors is a key strategy to mitigate risk. Given the high failure rate of startups, diversification will help ensure that the success of even one brilliant investment can offset the losses from all the others. Also, never invest more than you can afford to lose! As mentioned above; if 90% of startups fail, then you will lose your investment 90% of the time! Things often go sideways in startups, often through no fault of any one individual, but the result is still a loss of investment value. So, if you plan on it being risky and can afford to lose your investment, you are in the proper mindset to make your bets. No entrepreneur wants to lose your money, but no business is guaranteed success, no matter how good the opportunity appears at the outset! To diversify, consider smaller investments in a portfolio of companies across different industries and stages to balance risk and potential returns.
- Staged investing: Committing capital gradually based on milestone achievements rather than all at once can help manage risk. This approach, often called tranching, allows investors to provide initial funding and make additional investments as the company hits predetermined milestones. It provides protection against total loss if the company fails to progress and allows for a better assessment of its execution capabilities over time. However, this drip-feed funding model is a poor option for the entrepreneurs, as the ‘next payment’ is always at risk of delay, and the terms lock the company into a pre-determined path. Market developments may necessitate adjustments to the execution plan that are at odds with the agreements, and some investors have been known to take advantage of the situation to demand a larger share of the business. If, as the entrepreneur, you choose to go this route, then ensure your agreements are well structured, and there are penalties for an investor who misses milestones, not just you!
- Seek expertise: Consulting with or investing alongside experienced venture capitalists can provide valuable insights and potentially reduce risk. This could involve joining angel groups, participating in syndicates led by experienced investors, or co-investing with established venture capital firms. Leveraging the expertise and due diligence of seasoned investors can help navigate the complexities of early-stage investing and provide access to higher-quality deal flow.
- Focus on fundamentals: Prioritizing startups with solid business models and clear paths to market is crucial. While it’s important to consider the potential for disruptive innovation, investors should also evaluate the fundamental economics of the business. This includes assessing the unit economics, customer acquisition costs, lifetime value of customers, and the overall path to profitability. Strong fundamentals can provide some cushion against market volatility and increase the chances of long-term success.
Investors who focus on early-stage companies are generally attracted by the potential for outsized returns and the opportunity to be part of a company’s growth story from the beginning. Being an early investor in a company that has a successful exit is a badge of honor. Having an investment in a home-run exit can be life-changing! These investors value the chance to participate and influence the company’s direction and the excitement of working with innovative technologies or business models.
The lower entry valuations in early-stage companies allow investors to acquire larger stakes than they would otherwise be able to obtain. This can lead to substantial gains if the company succeeds. Additionally, the less crowded nature of early-stage investing can provide more opportunities for those with the right expertise and networks.
It’s crucial to note that early-stage investing comes with significantly higher risks compared to later-stage investments. While potentially offering lower returns, later-stage investments generally provide more stability, established track records, and clearer paths to profitability.
The choice between early and later-stage investing often depends on an investor’s risk tolerance, expertise, resources, and overall investment strategy. Successful early-stage investors typically have a high risk tolerance, deep industry knowledge, and the ability to add value beyond just capital.
By carefully weighing the pros and cons and implementing risk mitigation strategies, investors can navigate the complex world of early-stage venture investing more confidently. Whether opting for early or later-stage investments, thorough research and a well-thought-out strategy are key to success in venture capital.