This article looks at the start-up scene locally and internationally and assess where one can place an investment within a successful start-up, whilst also gaining an understanding on the life of a start-up and its mission to overcome the ‘valley of death’.
In contrast to this, we thought we’d add our own section whereby we compare the differences in start-up investing against Stock market investing and the implications faced by the retail investor.
This article was made in collaboration with Adrian Galea, a representative of Malta’s leading start-up community page Malta Start-up Space.
How investors can get involved in early startups? (AG)
Before threading further, it is important to upfront define the different players in the market. Namely: retail investors, accredited inventors (aka business angels) and professional investors.
As far as I know, Malta does not have a specific law for accredited investors, so I defer to the UK model (my preferred version) which allows for self-certification and allows for new entrants to participate for as long as they form part of a recognised investor network or community.
When an investor invests in a start-up, that investor accepts the fact that the investment in a startup exposes them to a significant risk of losing all of the money or other property invested.
I opted to start at this very route because it highlights what is key about investing: RISK, and the identification and management thereof.
MORE THAN 90 OUT OF EVERY 100 STARTUPS WILL FAIL.
Why do people start-up anyway then? The answer is simple, founders believe they have an edge and just cannot find a means to scratch their itch other than going for it themselves. They may have tried to convince their CEO, their bank manager, or their industry association to take this on. But lacking validation or proof that it will succeed, it is up to entrepreneurs to take on the burden.
Due to uncertainty, access to finance will be inherently limited for startups, and this is where our investor personas come into play. Using a simplified framework, a typical startup needs Seed Finance to survive from the “valley of death” and Growth Finance to accelerate growth once core aspects of their business model become repeatable and scalable.
FINANCIAL INVESTORS IN STARTUPS
Friends and Family Rounds — this is when you are investing simply on the basis of your familiarity and social connection to the founder of the startup. Many times the degree of due diligence is negligible and never undertaken by professionals. Such investment carry the highest risk of complete failure.
WHY PARTICIPATE: if your friend or family member has a successful track record in business
WHY NOT: due to the strong familiarity with the founder, are you being objective and free from bias?
Equity Crowdfunding — nowadays such platforms are required to be licensed to operate or at least are subject to authority oversight. These platforms will place restrictions on the amount of investment made by a single person via the platform, usually below €10,000 per investor. Investment can take various forms: donation and reward based (available in Malta via ZAAR),loan and equity investing (not available in Malta, with Seedrs and Kickstarter being some of the most famous platforms).
The platform will conduct generic due diligence, mostly to ensure that the opportunity will not result in a fraud, but little effort is done on understanding its growth potential and value. Crowdfunders are not professional investors and have significant limitations on the resources and thoroughness implemented during the due diligence.
Note: many crowdfunding sites stop their relationship with the startup post investment, and therefore do not participate in the monitoring exercise required afterwards.
WHY PARTICIPATE: if the project is something needed in your community or provides you with a product that helps solve a problem for you, fills a gap in your life or is entertaining
WHY NOT: your investment is so minuscule that you have no influence on the outcome whatsoever
Angel Investor Networks — (in some countries a retail person will not be able to participate in an angel investment, so you must be accredited, however if there is active oversight by an investor network or other lead investors, the investment may be possible for a restricted amount).
Usually due diligence efforts are conducted by a lead angel investor or a committee of such, each having expertise in relevant aspects relative to the investment rationale. Example a qualified engineer is the lead investor on a robotics startup. Critically, such persons remain closely connected to the investment even after the investment is made, either as a board member or close advisor to the team, thereby maintaining a sense of oversight throughout the investment and in case of follow-on investment rounds. Many times these investments are organised as syndicates so that one representative is in charge of all matters for the benefit of the group of investors participating in a round.
(If you are interested, read more about this here)
Again, such lead investors may not be professional financial advisors and therefore the relationship is of a peer. The lead investor should act cautiously and not solicit the investment but simply limit their oversight and due diligence to a fact finding mission. Typically, an individual angel investor would invest between €20k-€50k on a deal, and the syndicate from the network can invest between €100–300k. In Malta, BAM is the only organised association I am aware of, although some HNWI do invest in one-off deals with their private networks.
Tip: the lead investor or association should not be earning a commission for soliciting investments as this may place them in a position of conflict, especially if undisclosed
WHY PARTICIPATE: if the deal leader is someone of great reputation and a strong track record of operating or investing in the field
WHY NOT: invest in what you know. If you cannot make an informed judgement on the deal, do not invest because of peer pressure.
Initial Coin Offerings [ICOs] — not my cup of tea, I have never participated in one and read a few white-papers that were terrifying from a governance and ownership rights perspective. My position is that ICOs are speculation [if one is being generous]. Make sure you know and trust the people behind the issue and you are participating very very cautiously.
WHY PARTICIPATE: because you know exactly what you are doing and you have invested months of your time personally becoming informed about the space, technology and people behind it
WHY NOT: ermmm fraud! If you don’t have a track record in this space, ask yourself: why is this complete stranger asking for my money?
Venture Capital funds (very rare) — You may happen to be familiar with a venture capital partner and they may allow you to participate in the fund as a friend and family participant. Depending on the legal structure, such funds may not be legally allowed to take on retail investors, but there are limitations and exceptions.
Ensure this is a trusted person, with a good track record, plus all the necessary legal documentation and legal process is supported by a professional and reputable law firm or financial advisor.
VC firms conduct a professional due diligence, have a duty of care [i.e. legal responsibility] towards the investors in the funds (known as LPs) and have a vested interest in the success of the startups they invest in.
WHY PARTICIPATE: VCs are professional money managers, usually with a very big reputation of success behind them, either as serial entrepreneurs or investors. Many times, there is much public information about the partners. VC partners have unique access to the best and most exciting startup deals in their sector.
WHY NOT: you will have little to no influence on how your funds are deployed, so ensure you feel closely aligned to the investment thesis of the firm.
Financial Advisors/lawyers (very rare) — a financial advisor who may know your risk profile and who is a verified and trusted person to you may from time to time point you towards a startup investment opportunity.
WHY PARTICIPATE: Make sure this advisor has a previous track record with startup investments and understand what is in it for them, i.e. are they earning a commission and therefore have a conflict of interest?
WHY NOT: Financial advisors are usually familiar with corporate assets, like listed equities, funds, bonds etc… and usually do not understand entrepreneurship, technology and startups.
The market for a startup exists because of uncertainty (not risk). Risk can be calculated based on a known set of factors, uncertainty is lack of knowledge. If a business were risky, the management team of a corporation in that sector will evaluate the risk, and take an investment decision based on risk/reward analysis. The market for a startup exists because:
- The startup founder has an insight that is new or unique, usually particular to a niche set of circumstances (think how AirBnB first took on the festival travel market)
- New technology has emerged, but it remains unclear how this will impact the market (think blockchain in 2016)
- New cultural settings have emerged, think what Covid-19 has done for remote work or digital health for example.
If you are unconvinced that timing is key to startup success, watch this short video by IdeaLabs entitled: “The single biggest reason why startups succeed”
This uncertainty is a combination of tech, market, people, execution and macro risks just to name a few. The odds are truly stacked against any entrepreneurial venture.
The Approach To Investing In a Company Listed On a Stock-Exchange Vs a Start-up Company. (IH)
So just to start you off, when a company reaches a large enough size the Company has one of two options:
– 1. they become private; or
– 2. they go public.
We’re interested in point 2.
Assuming you’re a retail investor looking to open up a position in a Company (either a start-up or an organisation listed on the stock Market) here are some things that we think you should keep in mind, before getting started.
The Approach to investing in a Company that is listed on the Stock exchange is a lot more streamlined than taking on an approach to investing in a start-up Company.
Retail and professional investors have a variety of options in front of them when purchasing an investment in a listed Company, be it directly through an investment firm or directly through a mobile application. Technology has definitely enhanced the speed and convenience in which one places a buy or sell order on a listed Company.
When facing a start-up however, the logistics of placing a trade in exchange for a shareholding may be trickier due to the logistical complexities when compared to a company registered on the stock market. For example, not only do you need to find a suitable start-up but in many cases, you will need to see if the current shareholders want to sell their shares to you. And that my friend may be tricky.
In most cases, getting hold of shares in a quality start-up could be hard given that you’d probably need to form part of a close association of angle investors, or have close connections to the people running the start-up.
Every investment incurred carries a degree of risk, meaning that you could potentially lose money on any investment you make. However, one must keep in mind that every different investment carries a higher or lower degree of risk in it. This often is influenced by what stage the organisation is in its life cycle. For example;
Investing in an organisation that is still in the start-up phase of its life cycle can be classified as a high risk investment for several reasons. These ranging from the level of experience of the management within the Organisation, to the industry in which they are operating in. Remember around 90% of start up ideas never make it to the breakeven point, and therefore one must understand the risks of investing in a start-up.
However, with great risk may come great reward, meaning that if you successfully find yourselves invested in a start-up entity that eventually becomes successful, then you’re in for some pretty sizeable returns.
On the other hand, in order for an organisation to be listed on the stock exchange, the company in question must fulfil a list of requirements that are already set out by the Stock exchange, implying that companies registered are past the early establishment phases faced by start-ups.
This means that due the level of establishment of the Company, the risk of investment can be seen as lower when compared to the risk of investing in a start-up. However, in recent times more and more companies are entering the stock market that share similarities with start-up companies.
Many listed organisations are still in the early growth stage of their own lifecycle. When a Company is in its early stages, it is normal that the Company would be loss making, as most of its income would be reallocated into the organisation, spent on research and development, and sales and marketing to raise awareness of the Companies services and products.
In most cases, these Growth companies enter the Market at a competitive disadvantage when compared to the already established leaders, however, like start-ups many growth companies have a few tricks up their sleeves that make them competitive. This could be due to several reasons, such as generations they’re targeting, or perhaps the technology they have devised that makes carrying out certain tasks significantly more efficient and user friendly. Its your duty as an investor to carry out your due diligence to better understand what these companies are doing.
In a nutshell, if an investor craves a high risk appetite, then they can always check into growth companies that have a lot of room for growth, and are still in their early stages of their life cycle.
If on the other hand investors don’t carry that high risk threshold then, they could always opt for investing in a steady well established organisation. These are often referred to as ‘value stocks’. With these types of stocks, one should not expect to see the same returns that would be incurred on a growth stock. Simple reason being lower risk, lower reward.
The Beauty of Dollar Cost Averaging
The above chart represents the S&P500 over the past 90 years, one thing that can be easily noticed is that over the long-term, the market always trends upwards. The dips and peaks occur due to the irrationality of the market, but as such, the trend line tends to thread along the ‘fair value’ in the long-term.
When investing in a company registered on a stock exchange, an investor could ‘buy the dip’ and lower their average cost basis on their holdings. If a calculated risk is taken, then the investor could be acquiring shares in a quality company at a discounted price. On average a person investing in the SNP500 over the past 100 years would see an average annual compounded interest growth of 6%-8%.
In the case of a start-up, the true valuation of the company may be a bit vague and hard to determine, unless;
i) You’re supplied with all the relevant information required; and
ii) You’re really, really good at valuing a company.
Unfortunately, if you’re interested in extending your position in a start-up Company, the opportunity to purchase additional shares may come about infrequently as you’d be dependent on other shareholders to sell their shares at a reasonable price.
Information around the start-up.
Information surrounding a start-up may be hard to obtain. As investors, we always aim to make an informed decision. The more informed a decision is, the more we’re able to take on a calculated risk, thus increasing the likelihood of being financially rewarded.
Without vital information surrounding the organisation, it may be very hard for a retail investor to draw up a calculated and informed investment decision.
Organisations that are listed on a stock exchange are required by law to issue quarterly returns highlighting the financial position of the organisation through financial statements, complemented with management comments and an earnings call. Furthermore, well established companies listed on the stock market are frequently covered by financial journalists, meaning that retail investors have no short-fall of information.
Therefore, to further our point on risk above, we can state that since retail investors may be limited in resources to obtain the relevant information surrounding ‘hot start-up’ initiatives, it can be difficult for retail investors to draw up informed decisions, adding to the overall risk of investing in a start-up when compared to a registered Company on the stock exchange, BUT this is all dependent on the risk preferences of each individual investor.
Liquidity is a big convenience when investing in the stock market. If your stocks are underperforming and you wish to liquidate your position, it can be done the touch of a button, and within seconds/minutes you’ll have your cash back. This is due to the mass amount of buyers and sellers on the stock market.
On the other hand if you’re investing in a start-up, selling your shares may not be that simple. In most cases, you’re stuck with your investment for the long-run, for better or for worse.
In fact, the only ways you could liquidate your holdings are completely in the control of the company, and whether or not there are any buyers on the opposite side of the spectrum.
For example shares in a start-up will most likely be liquidated in the following ways:
– The Company buys back the shares, usually this would be at a premium;
– The Company lists the shares on the stock exchange; and
– The Company is acquired by another Organisation.
In addition to this, if you want to exit your shareholding, you’re going to need permission from the other shareholders, yep that’s right. All the other shareholders that carry voting rights can always disagree not to buy your shareholding leaving you stuck with the shares for the long — haul. Believe in what you invest in.
Therefore, if you’re investing in a start-up you should always maintain that long-term mindset, and be ready to bite the bullet.
To wrap it all up
Thinking of Adding a Start-up to your Investment Portfolio ?
Let’s be honest the idea of being invested in a start-up is a pretty cool idea, and can add some real diversity to your portfolio of investments. If you are in a position to invest in a start-up ensure that you understand exactly what you’re getting into before taking on the investment, and that you have enough information at your disposal to make a sound judgement to increase your chances of being financially rewarded!
If you’re interested in joining us on our journey, join our Facebook group: The Investment Hub — Malta
Any views or opinions presented in this article are personal and shouldn’t be taken/used as professional advice as we are not qualified financial advisors.
Any statistics mentioned have all been linked to their respective documents together with their ownership.
Lastly, we would like to note that this article has no tie to our professional jobs and was conducted in our free time.