26/01/2021 – Tőkeportál’s own content

Investing in startups is a real challenge. Startups do not have a long track record of proving the profitability of their business model, their ability to grow and to realise a return on investment. The absence of a secondary market, with (far) future acquisitions or dividends, which are also quite rare, also makes investing in mature companies a higher risk.

At the same time, it is on the growth curve of startups that you can really make significant money and be part of the big adventure. More recently, however, the concepts of sustainability, the green factor and social impact have received considerable attention.

What is the significance of the upon mentioned information? Increasingly, investors are backing businesses that make our future better, perhaps at a lower expected return. In addition, many start-ups are putting the environment and social issues first. Their investors identify with their goals and expected impact, perhaps a notch more than with their financial plan.

Since most start-ups cannot rely on bank loans, they are moving into an alternative, non-banking, capital-raising path. This takes the form of corwd finance, angel investment and venture capital. In this article, we focus on the perspectives of crowd finance investors and retail investors. We also summarise advice that investors can use to increase the chances of success of their start-up investments.

We have been talking about start-ups since the advent of the internet, because they are primarily internet technology-based businesses that are capable of rapid growth and that raise external capital to ensure growth. The crisis of 2008 coincided with the development of web 2.0, which, with the emergence from the crisis, economic growth and globalisation, allowed start-ups to emerge en masse. There were also many failures; for a long time it was correct to say that one in dozens of start-ups, if really successful, would be a start-up.

That is why many professional investors have structured their portfolios so that if only one succeeds, it will cover the cost of the other failed investments. However, the growth in knowledge and experience has now brought about a significant improvement in failure rates, because both the founders and the investment knowledge have improved significantly, so that the rate has improved greatly, but it is still considered particularly risky to invest in start-ups for the simple reasons outlined above.

Obviously there is no 100% correct answer to this question, as different investors have different individual preferences. In this article, we review the benefits and risks of these investments and the “homework” that investors need to do before investing successfully. Let’s start with the key questions that everyone should consider when investing in start-ups.

What motivates the investor?

In general, 5 factors are commonly identified that determine investor decision making, particularly with regard to the benefits of investing in start-ups:

• The potential profit: with good design and product, a well-prepared team, a high-growth market, and lucky timing, startup investments can be highly profitable. Investing early, when the value of a company is still lower, gives investors the opportunity to buy a stake on favourable terms. After 5 to 8 years, when a more mature stage company buys all or part of the start-up, investors can realise significant returns. But not all investors are only interested in profits, so the following considerations are also important.
• Diversification: the broad asset class of startups allows them to explore different market sectors and investment alternatives. Investing in start-ups may be riskier, but the wide range and diversification allows you to reduce risk.
• Participation and impact: by investing, you contribute to the success of a business, you get to know a market segment better. It can be even more important and have an impact on our future. Our investment decision has an impact on our immediate environment. For example, by investing in the Solarbnb campaign that is running at the time of writing, you are helping the development of the renewable energy sector in Hungary.
• Sustainability: crowdfunding also allows us to invest in small businesses and start-ups with a vision and mission that are important to the public, that do not want to consume the future, but build it. Even those that institutional investors are reluctant to invest in because of the small size of their businesses and the slower or riskier investment process.

Start-ups are indeed high-growth businesses, but they are also high-risk investments. It is therefore always advisable to consider the risks that investors may face after investing in a start-up before investing.

The risk of bankruptcy is the biggest risk as it means losing your investment. Unlike other forms of investment (such as leveraged or debt-funded stock market positions), you cannot lose more than the amount invested in a start-up, but this is also a risk to be avoided

The risk of slower growth is the most likely risk. This is when the original business plan is not as successful as previously expected. The model is workable, it just doesn’t deliver dynamic growth. In this case, the start-up, which is otherwise better suited to a change in strategy, still has a chance to restructure.

The risk of mispricing is that subsequent, additional capital injections may have to accept a lower firm value, and thus devalue our investment. Although this can be guarded against by including founder’s compensation in the terms of the investment, it is not to the advantage of the founders. The start-up valuation shows the total value of the company calculated on the basis of the ownership stake offered for the requested investment in terms of HUF/EUR/USD. The valuation of start-ups is typically determined by market segment, maturity stage, results achieved and traction. Based on these factors, the market valuation of startups is often higher than the value of the assets in the business (valuation is discussed in a separate article).

Lack of liquidity is the primary and in all cases real risk: although the shares of start-ups created through private equity are marketable, they have low liquidity in the absence of an organised secondary market. If the start-up is not bought by an investor, the marketability of the investment becomes difficult. This problem is addressed by the new ECSPR Regulation, which allows investors to transmit their intentions to buy or sell to the platform, thus facilitating secondary trading. (We wrote about the ECSPR Regulation in this article)

The first thing to do from an investor’s point of view is to check that the founders have done all the “homework”. For example, whether they have made available accurate financial and business plans, analysed competitors and defined the size of the target market, defined what problem the start-up’s product solves and a range of other information that may be key to the investment.

In crowdfunding, platforms set specific expectations for campaign managers on the quality of investment documentation, which can facilitate the analysis tasks for investors and ensure that additional information is available.

After checking with the funders, the investor should do his/her homework. They need to assess the start-up against various parameters to see how successful it is likely to be in the future. Here are five different factors that we believe should be considered when looking at the investment opportunity ahead.

• The experience, competence and drive of the team members is important, as it will carry the business through the difficult times. As an investor, it is essential to understand whether the team that makes up the start-up is capable of delivering the strategic goals of the business. A true startup is characterised by its ability to take its ideas through the fire and water
• Product and market: investors need to know the product or service. Invest in a business where you understand the market and can therefore assess the start-up’s competitiveness.
• Go to market, marketing and strategy: for start-ups, it is not enough to do a traditional analysis of revenues and expenses. It is not enough to develop a competitive business model: it has to be brought to market in a very short time, as long as the startup has the capital and the runway. The primary target group must be reached as easily as possible, and then the mass market must be conquered after the early customers. This will not be easier than the first step… So, in addition to the go-to-market strategy, you need to continuously develop the “customer journeys”, the customer experience, during which the company sells its product or service. In addition to a go-to-market strategy, patent and trademark registration can also protect a startup from being simply copied by a larger company with an innovative solution that is worth a lot to investors and startups.
• Legal risks. Even the most innovative startup is no exception. A start-up that is about to invest is screened, i.e. legally vetted by the investor or the crowdfunding platform to ensure that it is not, for example, engaging in illegal activities.
• Exit strategy, financial planning. This return can be verified by the financial plan. It is very important that the inputs to the financial plan are real, verified or realistically expected numbers. The return is realised by the investor either through dividends or through an exit. The former is more theoretical, since the start-up uses the income generated to further growth and does not pay out to its shareholders. For this reason, it is important to assess whether the start-up has realistic exit plans, whether it has an idea of which large companies that are also making acquisitions might be interested in acquiring it if it successfully implements its strategy, and whether it is realistic to go public.

In addition to the documents and information available, it is advisable to ask the startup founders about the business, about issues related to the operation of the business or even about its plans that are of concern to the investor. There is no wrong question, but an incorrect investor decision made in the absence of information is even more so. This is something every investor should avoid. Social funding platforms provide a forum section for investor questions. Questions asked here will be answered by campaigners on an ongoing basis. It is also worth attending investor meetings or participating in online spaces where the public can ask questions to campaigners.

After the investment, it is important to maintain a relationship based on mutual trust, which is beneficial for both the startup and the investor(s). A system of regular requests for information and cooperation, which does not overly exhaust the startup’s management, can be decisive even at the investment decision stage.

After understanding the benefits, risks and valuation, investment can in practice be achieved through several channels depending on the investor profile. There are angel investor organisations where you can get to know startups by joining, but typically here, investments of at least several million euros can be negotiated in a narrow circle.

Smaller amounts and even multiple ventures at once can be done easily through online platforms that provide crowdfunding. The platform provider pre-qualifies investment opportunities and makes them comparable. Crowdfunding is the easiest way for the average investor to invest in start-ups, as it provides simple and easy access to innovative start-ups that have already passed a quality check, depending on the crowdfunding platform. Investors can invest in various start-ups through the crowdfunding platform for amounts as low as a few thousand forints.

The average investment size on crowdfunding platforms was $96 in 2020.

This is more than 20% higher than in 2019.

Resources:

https://www.fundera.com/resources/crowdfunding-statistics

https://www.forbes.com/advisor/investing/invest-in-startups/

https://www.boardofinnovation.com/blog/startup-investment-guide-10-steps-to-assess-whether-a-venture-is-suitable-for-investment/