How To Invest In A Start-Up

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Investing in start-ups, or early stage businesses, is no longer the preserve of high-net-worth individuals, thanks to the boom in crowdfunding over the last decade. 

Equity crowdfunding has become a mainstream source of finance in the UK, growing from less than eight fundraisings in 2011 to nearly 600 in 2021, according to start-up research specialist Beauhurst. 

Investors have been attracted by the potential for substantial returns, with crowdfunding investors in Scottish craft brewery BrewDog receiving a 2,765% return on their equity investment. 

However, there’s also a high risk of losses for investors, given that nearly 50% of start-ups fail within the first three years, according to data from the Office for National Statistics (ONS).

In addition to delivering returns for investors, start-ups also contribute to the wider economy. 

Alex Davies, chief executive and founder of investment advisory firm Wealth Club, comments that start-ups “grow three times faster than the traditional economy” and have been “responsible for 10% of job growth worldwide since 2017.”

Here’s what you need to know about investing in a start-up, including the different options on offer and what to consider before deciding to invest.

How can you invest in a start-up?

There are three main options for investors looking to invest in a start-up business:

  • Crowdfunding: this raises small amounts of money from a large number of individuals, often via social media or crowdfunding websites.
  • Venture capital fund: a form of private equity where a venture capital firm pools together money from investors to invest in start-ups and small businesses.
  • Business angel: a private, usually high-net-worth, individual who invests directly in a start-up, either on their own or with others.

Let’s take a closer look at crowdfunding and venture capital funds for potential start-up investors.

Crowdfunding

Crowdfunding is the third largest source of funding for start-ups in the UK, behind venture capital firms and business angels. Success stories for start-up crowdfunding include Monzo, Nutmeg, Freetrade and Revolut.

Crowdfunding platforms enable a large number of investors to participate in a funding round, with investors receiving a small equity stake in return for investing their money. 

Investors aim to exit or ‘cash out’ their investment if the company floats on the stock market, is acquired by another company or additional financing is raised.

1. What types of investments are available?

There are two main types of investments offered by crowdfunding platforms:

  • Equity: this is the simplest and most popular way to invest in a start-up. You commit to investing a fixed sum of money at a given valuation and, provided the company hits its funding target, you are given shares in the company. 
  • Convertibles: these are used when a company wants to access short-term funding, often ahead of a larger funding round. Investors purchase convertibles which are converted into shares at a discount at a later point, usually in the next funding round. They differ from equities as the valuation is not known at the point of investment.

Within equity fundraising, there’s two further options:

  • Primary round: investors purchase new shares issued by the company, which is the most common type of fund raising.
  • Secondary round: investors purchase existing shares from investors or employees of the company. 

Some platforms also offer ‘cohort campaigns’ which allow investors to become shareholders in a number of start-ups, managed by a campaign organiser. 

Another option is a ‘fund campaign’ where the crowdfunding platform runs an investment fund covering a number of start-ups, although these are rare.

2. How to decide whether to invest in a start-up

Legendary US investor Warren Buffett once commented: “The important thing is to know what you know and know what you don’t know.” 

Kirsty Grant, chief investment officer at crowdfunding platform Seedrs, believes investors should heed Mr Buffett’s advice when looking to invest in a start-up. She advises potential investors not to “invest in something you don’t understand and invest in companies you believe in.”

Matt Cooper, chief commercial officer at Crowdcube, also recommends that investors buy into “companies whose products they love, or whose missions they support. Many are existing customers who, in becoming shareholders, tend to spend more, refer more and churn less.”

Investors should carry out their own research when deciding whether to invest in a start-up, including:

  • What is the ‘added’ value of the product or service? Why will customers buy it, rather than alternatives?
  • If you are looking for a socially responsible investment, is the company aligned with your values?
  • What is the size of the market? Access to global, rather than local, markets may generate higher returns.
  • What are the barriers to entry? How easy is it for competitors to offer the same product or service?
  • What experience and expertise do the management team have, both in terms of the industry but also in running a company? 
  • Are the financial projections realistic, particularly cash flow forecasts? Will it need further funding to scale up? 

As investments in start-ups are high risk and ‘illiquid’ (hard to dispose of), you should consider consulting an independent financial adviser before making the decision to invest.

3. How do you invest using a crowdfunding platform?

Crowdfunding platforms offer a curated selection of start-up companies looking for investment and co-ordinate the fundraising. 

Crowdcube and Seedr are two of the largest crowdfunding platforms in the UK, each having raised well over £1 billion to date. Smaller UK-based platforms include CrowdBnk, Crowdfunder and ShareIn.

As a minimum, investors should take the following steps before considering investing in a start-up via a crowdfunding platform:

  • Choose your platform: you should check that the platform is authorised and regulated by the Financial Conduct Authority (FCA). It’s also worth checking fees, which may include an initial fee, annual fee and/or ‘success fee’ on profits made on the eventual sale of your shares.
  • Complete investor categorisation and verification procedures: there are different categories of investors under FCA regulations. If you do not qualify as a sophisticated, high-net-worth or ‘advised’ investor, you will be restricted from investing more than 10% of your assets (excluding your main property) into illiquid company shares.
  • Review the investment opportunities: the platforms list the start-ups currently looking for investment, together with the percentage of funds raised against their overall target. The start-ups provide comprehensive information about their business plan, and investors are able to ask questions and request additional information.
  • Check the due diligence: the level of due diligence carried out on start-ups varies by platform, but typically includes background checks on the company and directors, fact-checking of pitch information and a review of commercial contracts and litigation. 
  • Conduct your own research and seek financial advice (as mentioned earlier)
  • Review the shareholder protections: investors should check their rights as shareholders, including voting rights and rights on new share issues. Platforms may also offer protection to investors in the form of warranties against the provision of inaccurate information by the company.
  • Select your investment: you will be required to confirm the amount you’d like to invest, usually a minimum of £10, then review and sign the shareholder agreement (if you are happy with it).
  • Paying for the investment: depending on the platform, you can fund your account using a debit or credit card, or by bank transfer. If you fail to deposit your funds before the campaign closes, your investment will be cancelled.
  • Completion: once the campaign closes and all legal due diligence and investment documentation has been completed, investors will be sent an electronic share certificate.

Start-ups must reach their funding target within a specified timeframe, or money will be returned to investors. If a company exceeds their funding target, they can choose whether to accept ‘overfunding’ (on the same terms).

The crowdfunding platform provides regular updates after the fundraising to enable investors to monitor their investments. 

Venture capital funds

Venture capital is a form of private equity investment in start-ups and early stage companies that have strong growth potential but may have yet to make a profit (or even generate revenue). 

These funds buy minority stakes in start-ups and provide them with financial support and expertise.

Venture capital has been a particularly popular source of funding for technology companies, due to their potential for high growth and innovation. Companies initially backed by venture capital funding include Moonpig, Skyscanner, Google, Facebook and Amazon. 

Henry Whorwood, head of research and consultancy at Beauhurst, says: “Investing in private companies is a rarefied pursuit. Fewer than 250,000 people own shares directly in the UK’s high-growth private companies.” 

However, investing in venture capital funds provides an alternative way to invest in private company start-ups, while providing attractive returns. According to Wealth Club, private equity has outperformed global equity funds by nearly 9% over the last 25 years. 

That said, one of the barriers to investing in venture capital funds is the minimum investment amount, which is typically upwards of £10,000 but can be substantially higher. However, Mr Whorwood comments that this is changing as “platforms such as Further are making it easier to invest in venture capital funds with smaller tickets.”

How do you invest in a venture capital fund?

There are two main types of venture capital investment options available in the UK – funds and trusts:

Investing in EIS and SEIS funds

Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) funds invest in early-stage companies with between two and seven years’ trading history. 

As with mainstream funds, they pool together money from investors, but they differ as investors hold shares in the underlying companies, not in the fund itself. 

In addition, investors are only able to invest in these funds during the initial round of fundraising. 

Each fund is typically invested in around 5-10 start-ups, providing a diversified portfolio for investors. However, you have to meet the criteria for a sophisticated or high-net-worth investor to invest in these products. 

According to Wealth Club, two thirds of their EIS clients have investable assets of at least £900,000 (excluding house and pension) with the average client investing £37,000 in VCTs per year.

The funds specify their target rate of return during fundraising, which typically ranges from two to three times the initial investment over a five to eight year period (before tax relief). Some funds target a higher return of up to ten times, although these are the higher risk investments.

Investors usually pay an initial fee of between 2 – 5%, in addition to an annual fee of around 1 – 2% and a performance fee (which can be as high as 20% of profits made). Investors are dependent on the fund manager delivering on their exit strategy to return money to investors, and dividends are rarely paid.

According to Mr Davies, EIS success stories include investment platform interactive investor, flower delivery service Bloom & Wild and meal delivery service Gousto, which achieved between 18 and 27 times return for their EIS investors. Similarly, sales intelligence provider Cognism achieved a 43 times return for its SEIS investors. 

Investing in Venture Capital Trusts (VCTs)

The popularity of VCT funds has grown by over 50% in the last three years, with fundraising passing the £1 billion milestone for the first time in the last tax year, according to the Association of Investment Companies. 

VCTs are also a type of collective investment that pool money from investors to invest in start-ups. However, unlike EIS funds, investors hold shares in the VCT itself, not the underlying companies. The fund is usually invested in between 30 to 70 companies.

VCTs are listed on the stock exchange, meaning that investors can buy shares in the initial fund raising, or on the stock market once they’ve listed. Investors can buy and sell shares directly on their trading platform, although it may be difficult to find buyers for shares and, as a result, sales tend to be at a discount to the underlying net asset value. 

Portfolio companies can be privately owned, or quoted on the Alternative Investment Market of the London Stock Exchange. Companies backed by VCTs include Zoopla, Virgin Wines, Graze and Cazoo. 

Initial charges for VCTs are typically 5%, along with an annual management fee of around 2% and a performance-based fee (for example, 20% of profits above a 7% target annual return). 

In contrast to EIS funds, dividends form the majority of investor returns rather than growth in the value of the investments. 

According to Mr Davies, the average VCT has delivered a return of 117% over the last decade, excluding tax relief. However, they are recommended for more experienced investors due to the risk of losses. 

Tax benefits of investing in start-up schemes

The government offers generous tax reliefs to investors in venture capital schemes to encourage investment in start-ups. The reliefs vary by scheme but here’s an overview of the key reliefs available:

  • Minimum holding period: 3 years (SEIS and EIS), 5 years (VCT)
  • Income tax relief: 30% (EIS and VCT) and 50% (SEIS) of the amount invested in new shares
  • Income tax on dividends: charged on S(EIS) shares but not VCT shares (under certain conditions)
  • Capital gains tax on disposal: exempt for S(EIS) shares if held for three years and for VCT shares without a limit

These reliefs are subject to limits and conditions, which are specific to the individual circumstances of the investor. 

However, Mr Davies warns that the biggest threats “come from any changes in the tax reliefs available and /or eligibility criteria and we understand that the Treasury is considering its position on tax incentives of the three various schemes at the moment.” 

What are the benefits of investing in start-ups?

Investing in start-ups can give investors the satisfaction of helping a new business thrive, as well as providing financial rewards:

  • Growth potential: while investing in start-ups is much higher risk than the FTSE 100, there is also the potential for higher returns. According to Crowdcube, crowd investors made 19 times their initial stake when digital bank Revolut was valued at over £1 billion in its latest investment round. Similarly, the first investors in challenger bank Monzo have enjoyed a return of 15 times their initial investment in their latest funding round.
  • Value-based investing: Some investors want to support businesses that align with their personal values. Recent crowdfunded investments include sustainable house builder Verto Homes, energy storage provider Powervault and HealthUnlocked, which provides social networks for patient care. 
  • Belief in a new idea: start-up investing may appeal as you can see the potential opportunity for innovative ideas, whether it’s a craft beer, fitness-based food service or eco-friendly trainers.
  • Personal connections: many start-ups are supported by investment from their friends and family, who believe in their concept and ability to succeed.
  • A sense of fulfillment: some investors enjoy supporting entrepreneurs and watching their success first-hand. 

What are the issues with investing in start-ups?

Start-up investing is not for everyone, particularly investors who don’t want to risk losing their money:

  • High risk: according to the ONS, 10% of start-ups fail in the first year, and only 40% survive four years or more. Many investors in start-ups will lose some, or all, of their money and for every success story, there’s a failure. Spreading your investment over a number of start-ups, or investing in a venture capital fund, is one way of reducing this risk.
  • Length of investment: even if a start-up is successful, money invested in start-ups is likely to be tied up for at least five years, and possibly longer. 
  • Valuation: a start-up has to be valued for every equity fundraising. Valuing a start-up is very difficult, particularly if it has yet to generate a profit, or even significant revenue. The valuation expectations of the founders can be overly optimistic, particularly in terms of forecast earnings growth.
  • Dilution: every round of fundraising will dilute the existing shareholders’ stake in the company. In theory, raising additional finance should increase the value of the company, however, this is not always the case. Shareholders may be given some protection against dilution, including the right to participate in future fundraising.
  • Lack of income: other than VCTs, you are highly unlikely to receive an income, such as dividends, from investing in start-ups.
  • Ability to sell your investment: shares in start-ups are highly illiquid and investors are unlikely to have the opportunity to sell their shares unless the company is sold, floated or further funding is received. 

How much should you invest in start-ups?

Investing in start-ups is high risk with the likelihood of making losses on at least some of your investments. 

Mr Cooper comments that “Most businesses fail, so the idea behind early-stage investing is that a few long-term winners have the potential to make up for losses, and more.

“It is best to invest small-to-medium sized amounts in lots of businesses rather than hedging your bets with large amounts on just a few.” 

Investing in a venture capital fund may also reduce the risk of a start-up failing by providing a diversified portfolio of companies. However, Mr Davies advises that “EIS, SEIS and VCTs are only suitable for high-net-worth and/or sophisticated investors and should form a relatively small part of a balanced portfolio as they are high risk.” 

He also comments that, although still high risk, VCTs are “perhaps the least risky option and hence offer less generous tax benefits than the other options.”

As a rule of thumb, investments in start-ups should account for no more than 5% to 10% of an equity portfolio. Investors should also consider taking independent financial advice before investing, along with carrying out their own research.