Early-stage investing can provide great opportunities for investors but it also involves heightened risks, extended timelines and in some cases increased volatility as a business finds its feet.
So why do sophisticated investors expose themselves to such possibilities? The answer is simple – for the prospect of enhanced capital gain over the medium to long term.
For each start-up, there are two potential outcomes: building the business to something that is scalable and profitable, or the loss of shareholder value. The problem for investors, therefore, lies in understanding how to calculate the risks involved in investing in such businesses and what measures can be taken to control or reduce those risks.
An investor should consider the variables that can help determine whether this business will be the next big thing, or another carcass in the start-up graveyard.
As a good starting point, an investor needs to understand the sector in question, not as an analyst but as an industry practitioner. Early-stage companies need more than just capital, they need guidance and hands-on support.
With that in mind, an experienced investor should have the necessary industry insight to unlock doors in the specific sector and, as a result, help drive growth. Without this guidance, many start-ups can fall at the first hurdle.
Another consideration for a serial investor or an investment fund is what sources of deal flow are available. This is important because, when placed alongside other factors such as share valuation, a quality deal-flow pipeline can have a significant effect on the performance of a given portfolio.
Even if deal flow and sector expertise are strong, one of the fundamental risks for any early-stage venture is access to future funding.
It is an oversimplification to ask how much do you need now and how much more investment is required to reach a profitable cash flow or exit. It is rare that a company will survive on a single funding round and rarer still that its growth will be optimised without additional capital injection.
An awareness of future funding must also extend to the company’s management, but there is a caveat. If senior management are spending too much time sourcing further funding and chasing new investors, it is unlikely that they are dedicating enough time and focus to growing the business.
Furthermore, even if they do find new investors, management then risks having their company spread thinly over a large number of shareholders, each with their own agenda and their own demands. As such, an investor must remember that a long-term as well as a short-term view is vital if they are to experience decent returns.
These challenges can be addressed by bringing together proprietary deal-flow sources – such as partnerships with leading universities – deep expertise and a flexible funding model incorporating third-party managed funds and direct, off-balance-sheet investment.
