Early-stage investing in startups is perhaps one of the most exciting, albeit precarious, ventures that an investor can undertake. Getting involved with the next ‘big’ thing has an alluring appeal—it stirs the desire to support a company in its infancy and witness its growth into a market leader. However, this potential for success also carries a significant risk: the possibility of losing every penny you invest if the startup fails, as is often the case.
In the UK, the landscape for startups has grown significantly, especially in sectors such as technology, fintech, and health tech. While the potential returns can be monumental, investors need to be prepared for the high-risk, high-reward nature of early-stage investments.
In this article, we outline the characteristics of early-stage startups, why they are both risky and rewarding, and what UK investors need to consider before taking the plunge.
What are early-stage startups?
Definition
Early-stage startup companies are those in the initial phase of their life cycle. These companies usually generate little to no revenue or have just started earning their first income. Typically, they require a substantial amount of investment to expand and grow because they do not yet have a proven product-market fit. Early-stage startups often need significant resources to bring their product or service to market and establish themselves in their chosen industry.
Examples of Successful Startups
Many of today’s most successful companies, such as UK-based giants like Revolut and Deliveroo, were once early-stage startups. At the time, they needed large amounts of capital without any guarantee of success. Investors who had the vision to believe in these companies early on saw incredible returns as these firms disrupted their respective industries and became market leaders.
Why Early-Stage Startups Are An Attracting Animal To Investors
Despite the risks, early-stage startups attract investors because of their potential to grow exponentially. The rewards for being an early investor in a successful startup can be substantial, as these companies can scale rapidly and dominate their markets, making early equity investors likely to receive a high return on their capital.
Risks of Investing in Early-Stage Startups
High Failure Rate
One of the biggest risks in initial startup investment is the high failure rate. It’s estimated that around 90% of startups fail, with nearly 60% closing their doors within the first three years. Reasons for failure include lack of market demand, poor management, cash flow problems, and competition from more established companies. UK investors should be aware of these statistics and be prepared for the possibility of losing their investment.
Untested Business Models
Many early-stage startups are still experimenting with their business models. While they may have an excellent idea or concept, they have yet to prove that it can generate revenue sustainably over the long term. This makes it difficult to assess the feasibility of the business. Investors must often make decisions based on the vision of the founders and potential market trends, rather than concrete financial data.
Limited Financial History
Startups in the early stages have limited financial records or performance metrics compared to more mature companies. This makes it challenging for investors to conduct thorough due diligence or accurately predict the company’s future earnings. In most cases, investors are relying on the founder’s vision and the likelihood of market success rather than solid financial projections.
Liquidity
Early-stage venture investments are far less liquid than public equities. Investors cannot sell their shares until the company experiences a liquidity event, such as an acquisition or an initial public offering (IPO). Money invested in a startup may be tied up for several years before investors see any return—if they ever do.
Competition
Startups face constant competitive threats, often from larger companies with significantly more resources. A well-established firm may introduce a similar product or service, making it difficult for the startup to gain market traction before it can establish itself.
Benefits of Investments in Early-Stage Startups
Return Potential
The primary reason investors are drawn to early-stage startups is the potential for high returns. An equity stake purchased in a very early stage can multiply exponentially in value if the startup succeeds. For instance, some early investors in UK-based companies like Monzo saw their initial investments grow many times over as the startups achieved billion-pound valuations. This return potential far exceeds what traditional investments like bonds or dividend-paying stocks can offer.
Portfolio Diversification
Startups provide an excellent opportunity for portfolio diversification. Most investment portfolios consist of a mix of stocks, bonds, and real estate. Including early-stage startups in the mix can balance out conservative investments, although investors should ensure their overall portfolio is not overly dominated by these high-risk assets.
Supporting Innovation and Emerging Technologies
Early-stage startup investors are funding new ideas and cutting-edge technologies. Many UK investors find satisfaction not only in the potential financial returns but also in supporting innovation. Whether it is a fintech solution disrupting traditional banking or health tech revolutionising patient care, helping a startup can contribute to a project that drives significant change.
Equity Stake and Control
For early-stage companies, investments often result in an equity stake that can provide considerable financial returns if the company is successful. It can also open the opportunity to be involved in the company’s strategic direction. Many early-stage investors accept advisory positions or board seats, which allow them to influence key decisions and guide the company’s growth.
SEIS and EIS Tax Relief Benefits for UK Investors
Investing in early-stage startups in the UK can also come with significant tax benefits through the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS). These schemes are designed to encourage investment in small or high-growth UK businesses by offering generous tax relief:
- SEIS: Investors can claim up to 50% income tax relief on investments up to £100,000 per tax year, along with exemption from Capital Gains Tax (CGT) if the shares are held for at least three years.
- EIS: Investors can receive up to 30% income tax relief on investments up to £1 million (or £2 million for knowledge-intensive companies) per tax year, along with CGT deferral and no inheritance tax on shares held for at least two years.
These tax benefits reduce the risk of loss and make early-stage investments more appealing, especially for those looking to diversify their portfolios with high-growth opportunities.
What Investors Should Look for in Early-Stage Startups
Founding Team
The most critical factor for any startup’s success is its founding team. UK investors should evaluate the founders’ experience, skills, and motivation. Have they succeeded in previous ventures? Do they have the right background and connections to succeed in their chosen industry? A highly disciplined, passionate, and adaptable team can often overcome many of the early-stage challenges a startup faces.
Market Potential
The market potential of the startup’s product or service is essential. Is the market large enough to support rapid growth? Is the startup solving a genuine problem, or does its solution stand out against competitors? Understanding market dynamics and a startup’s potential to capture a significant market share is crucial when assessing the investment’s return potential.
Business Model
The startup’s business model is another key consideration. How does the company plan to make money, and will that model scale? Startups with clear, scalable business models have a higher potential for success because they have a path to profitability.
Funding and Exit Strategy
Assess how much capital the startup needs and its plans for future fundraising. Does the startup have a clear exit strategy, such as acquisition or public listing? Understanding the long-term goals of the startup can help early-stage investors gauge the likelihood of achieving high returns.
Due Diligence
Investors must dig deep into startups by conducting extensive due diligence, checking financial projections, competitive analysis, and market positioning. This will help investors make more informed decisions and avoid investing in startups with little chance of success.
The Angel Investors and Venture Capital in the UK
Angel Investors
Angel investors provide capital to early-stage startups, typically in exchange for equity. In the UK, angel investing is highly regarded, and organisations like the UK Business Angels Association facilitate investments in emerging companies. Angels are typically involved in the very first rounds of funding, providing not only capital but also valuable industry connections and guidance.
Venture Capital (VC)
While venture capital is more commonly associated with later rounds of financing, many VCs in the UK, such as Octopus Ventures and Balderton Capital, invest in early-stage startups, particularly those requiring more significant capital to scale. VCs bring extensive experience in helping startups develop strategies for growth and expansion until an eventual exit.
Angel investors and VCs bring value beyond capital by mentoring founders, assisting with business strategy, and opening up broad professional networks. Their involvement can make all the difference in a startup’s long-term success.
Risk vs Reward: Managing the Dangers of Early-Stage Investments
Create a diversified startup investment portfolio
Diversification is the best way to manage a high risk of early-stage startup investment. You don’t have to pour all your funds into a single company. Instead, go for a portfolio of startups. Even if some fail, others may survive and give you handsome returns.
Make a Small Allocation
Due to the inherently high-risk nature of early-stage startups, it’s wise to allocate only a small percentage of your overall investment portfolio to this area. The high percentage should be that which remains in stable, low-risk investments in stocks, bonds, and real estate.
Opportunity for Co-Investment
Reduce your risk by partnering with co-investors, such as experienced angel investors or venture capitalists. Co-investing allows you to leverage the expertise and resources of larger investors, increasing your chances of success.
Long term Commitment
Startups, especially in the early stages, require patient capital. It can take years for a startup to reach a liquidity event, such as an acquisition or IPO. Investors must be prepared for a long-term commitment before seeing any returns.
High Risk, High Reward—But With Careful Consideration
Investing in early-stage startups can yield tremendous financial returns, but it comes with high risks. UK investors must be aware of the potential for failure, illiquidity, and competition associated with startups. Success requires paying close attention and diversifying investments, along with carefully evaluating the founding team, market potential, and business viability.
Early-stage investments in startups present an opportunity—whether through spectacular financial returns or contributing to projects that can change the world—for those willing to take the risk.
Before investing in startups, UK investors should consult their financial advisors, conduct thorough due diligence, and ensure they can cope with the volatile nature of early-stage investments. Uncertainty becomes the journey for those willing to invest, but the rewards can be remarkable for those who navigate it well.