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.
An investor must remember that a long-term as well as a short-term view is vital if they are to experience decent returnsIt 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.
What investors need to be looking for is a balanced portfolio in terms of the source of deals and sector exposure. Retaining focus on fundamentals is vital so revenue has to be a key metric with which to measure success in a portfolio of companies.
Investors must have a clear understanding of where the product or service will sit in the market, the route to that market, the right business model to deliver results and the milestones against which value inflections can be measured. This informs backers as to the capital needs and when those requirements will arise.
Alongside Seed Enterprise Investment Scheme and Enterprise Investment Scheme capital, there needs to be an awareness of available grant funding and the capacity to invest deeply in order to scale a business prior to disposal should circumstances dictate.
But simple cash funding for early-stage enterprise is not enough on its own. Businesses with disruptive technology and services aiming to tap into growing markets require informed investors and backing from a team with deep expertise in their target sectors.
Dovetailing a complete funding strategy with the requisite support and guidance to drive growth, while maintaining a strong source of deal flow, is the way in which early-stage investment risk can be mitigated.
There is no one single key to effective early-stage investment but having all the elements in place provides a combination with the potential to unlock successes.
Dr Mark Payton is chief executive of Mercia Technologies
KEY POINTS: Early-stage technology investing
Industry insight
In many cases, particularly when considering knowledge-intensive companies such as those spun out from universities, the founders may not have the requisite knowledge to build a business, be that from a marketing, accounting or recruiting standpoint. Nor might they be aware of the sector as a whole and what commercial opportunities exist there. So an investor needs to understand the sector in question.
Continuous deal flow
What deals are available? Does the search for start-ups extend beyond endless revolutions of London’s ‘Silicon Roundabout’? In other words, is the deal flow available sourced from trusted personal networks combined with venturing into new and fertile areas? Or does it mean following the herd? As an example, a current concern in London’s digital ecosystem is the large number of investors chasing a finite number of deals. This inevitably increases a company’s perceived worth and therefore reduces overall returns, should the business succeed.
Capital requirements
It is unlikely a company will need only one round of funding. As such, an investor must look carefully at whether follow-on capital will be provided, where it would come from, how it is accessed and what the total funding requirement of the business is likely to be.
To have both the requisite impact on early-stage enterprise and to generate a return on investment, early-stage capital must come with the ability to follow on over subsequent funding rounds as a business develops.
Source: Dr Mark Payton, Mercia Technologies
TAX RELIEF: What is a SEIS?
According to HM Revenue & Customs, a Seed Enterprise Investment Scheme (SEIS) is “designed to help small, early-stage companies raise equity finance by offering tax reliefs to individual investors who purchase new shares in those companies”.
It continues: “It complements the existing Enterprise Investment Scheme (EIS) which offers tax reliefs to investors in higher-risk small companies. SEIS is intended to recognise the particular difficulties which very early stage companies face in attracting investment, by offering tax relief at a higher rate.”
SEIS applies to shares issued on or after April 6, 2012.
HMRC notes on its website: “Income tax relief is available to individuals who subscribe for qualifying shares in a company which meets the SEIS requirements, and who have UK tax liability against which to set the relief.
“The shares must be held for a period of three years, from date of issue, for relief to be retained. If they are disposed of within that three-year period, or if any of the qualifying conditions cease to be met during that period, relief will be withdrawn or reduced.
“[Tax] relief is available at 50 per cent of the cost of the shares, on a maximum annual investment of £100,000.”
