Investing in an early-stage startup has a reputation for being a high-stakes game, where the potential for wins can be monumental, but the losses can be just as significant. While exciting, early-stage startups represent a seriously daunting opportunity for investors keen on spotting the “next big thing.”
The UK’s startup ecosystem is thriving, particularly in sectors like fintech, health tech, and technology-driven innovation. However, this surge in opportunities is balanced by the reality that nearly 70% of startups do not survive beyond the first few years.
In this article, we explore why early-stage startups are labelled as high-risk but high-reward investments, how to identify the next big success story, and what key aspects UK investors should consider before diving into early-stage startup investments.
What Are Early-Stage Startups?
Early-stage startups are companies in the earlier stages of development. Companies at this point are primarily pre-revenue or are in an early developmental stage of revenue building. They might have a prototype, proof of concept, or beta product but haven’t yet reached product-market fit yet. The majority of early-stage startups seek funding from angel investors or venture capitalists as a way to engineer their product, extend their team, and bring their business to market.
Examples of Successful Start-Ups
Many of the world’s most successful companies today were once early-stage startups. One such example is Revolut, a UK-based fintech disruptor offering global financial services, which grew into a multi-billion-pound company. Another success story is Deliveroo, which identified a gap in the food delivery market and rapidly grew into a household name in the UK.
These companies are prime examples of how early-stage startups can quickly scale and dominate their industries. Investors who identified these opportunities early on reaped substantial returns as these companies experienced exponential growth.
Why Early-Stage Startups Are Attractive To Investors
Despite the risks, early-stage startups remain appealing to investors for several reasons:
- Higher Potential Returns: Early-stage deals often generate above-average returns because investors get in at the ground level, giving them the opportunity to benefit from higher equity stakes and significant capital appreciation if the company succeeds.
- Influence and Control: Early investors can gain significant equity ownership, which allows them to have a say in the company’s direction, strategy, and decision-making process.
- Sponsoring Innovation: Beyond financial returns, early-stage investors often take pride in supporting innovative products and services that could potentially transform industries.
Appeal of Early-Stage Startup Investments: High Reward Potential
The most intuitive appeal of investing in early-stage startups is the potential for substantial financial returns. When a startup succeeds, an early investor who bought shares at the inception can see their investment multiply many times over. For example, early investors in UK-based companies like Monzo and Skyscanner saw their stakes appreciate significantly as these startups evolved into market leaders.
With a growing focus on fintech, AI, and health tech in the UK, investors who can identify emerging trends and enter early-stage deals in these sectors can position themselves for exponential returns.
Equity and Ownership
Another critical benefit of investing in early-stage startups is the opportunity to secure substantial equity in the company. Unlike investments in publicly traded stocks, where individual ownership stakes are minimal, early-stage investors often receive a larger share of the company. This equity can become highly valuable if the startup is acquired or goes public.
In addition to financial rewards, early investors may also gain influence over the company’s direction, particularly if they hold significant equity or serve on the board. This level of involvement can shape the startup’s future and contribute to its success.
Fostering Innovation and Emerging Technologies
Investing in early-stage startups is not just about financial returns—it’s about backing the next wave of innovation. Early investors in UK-based green energy startups, for instance, are helping to create cutting-edge technologies to combat climate change, while those supporting AI-based health tech companies are fostering advancements that could revolutionise patient care.
By investing in these companies, you become a part of something bigger, playing a role in bringing transformative products and services to market and advancing technological progress.
Tax breaks in the UK
The UK government has introduced several tax benefits that make investing in early-stage startups even more attractive. Schemes like the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) provide substantial tax reliefs:
- SEIS: Offers up to 50% tax relief on investments up to £100,000 and exemption from Capital Gains Tax (CGT) if the shares are held for at least three years.
- EIS: Provides up to 30% tax relief on investments up to £1 million (or £2 million for knowledge-intensive companies) and deferral of CGT.
These schemes reduce the risk of loss, making early-stage investments more appealing, particularly for those looking to diversify with high-growth opportunities.
Risks Associated with Early-Stage Startup Investments
High Failure Rate
Failure is the biggest risk associated with investing at such an early stage for a startup. Up to 90% of startups fail, and most of these failures take place within the first three years. Such reasons include poor market demand, insufficient funding, inadequate management, and hypercompetition.
This means that high returns are possible, but the risk of losing your money is also very real. As such, any investor would do rigorous due diligence before actual capital commitment to any seed or early-stage startup venture.
Liquidity
Investments at early stages are often illiquid. Once your money is invested, it is tied up for a number of years. Most investors have to wait for their money until there is some kind of liquidity event, such as an acquisition or an initial public offering (IPO), to liquidate the amount. These types of extended commitments do not suit every investor, especially those who require their funds immediately.
Normal waiting periods for early-stage investments in the UK are five to ten years. This makes patience one of the most vital factors behind investment in startups.
Competition and Market Uncertainty
A high rate of completion with a startup is quite different from competition with other startups since it is matched by established companies that have much more money. Even when a newly launched company has something unique and innovative, bigger companies easily just copy it or even improve it, which makes it a headache for a startup to get space in the marketplace.
In addition, startups operate within unknown markets, where demand may go through great speed changes or shifts and where consumer preferences could change rapidly. This is another layer of risk, as investors feel market conditions can often shift such that the product or service of the startup becomes less relevant.
Limited Financial History
Typically, early-stage startups do not have many financial records or performance metrics that investors may rely on. It has made it challenging to measure the likely potential for the success of a startup. Projections and forecasts become the only means of measurement available to the investor, which are at best optimistically biassed rather than fact-based.
Since they have no financial history, in practice, early-stage investors are betting on the founding team’s vision, skills, and ability to execute rather than on any hard financial data.
How to Spot the Next Big Thing
Founders and Team
The founding team is crucial to the startup’s success. Assess the founders’ experience, industry expertise, and past achievements. Are they passionate and resilient? A strong, adaptable team with a solid vision often has a better chance of navigating the challenges of early-stage growth.
Market Potential
Look for startups operating in expanding markets that address significant problems or unmet needs. A startup positioned in a growing market has a greater chance of achieving scale and long-term success.
Scalability
Scalability is another critical element of a startup. Investors need to judge if the business model of a startup has the possibility of helping the business scale up without incurring costs. A scalable business model makes it possible for a startup to scale up rapidly and efficiently, thus ensuring higher chances of success for the startup.
Unique Selling Proposition (USP)
A strong USP sets a startup apart from its competitors. Whether it’s technological innovation, business model uniqueness, or an outstanding customer experience, a clear USP provides a competitive edge.
Early Traction
Early traction, such as growing customer numbers, positive product reviews, or partnerships, is a good indicator of future success. It shows that the startup’s product or service is resonating well in the market.
Varying Your Startup Investments
Investing in a diversified portfolio of startups can mitigate risk. Instead of putting all your capital into one company, spread your investments across multiple startups. This approach increases the likelihood that some investments will yield high returns, even if others fail.
Investment in Various Fields
Diversification across industries is also another form of diversification in terms of risk. For example, one can invest in start-ups in finance, healthcare, and consumer goods, each one operating in its respective market, with its opportunities and challenges.
Portfolio Allocation
Early-stage investments in startups should form an extremely small portion of the overall investment portfolio. The majority of experts will advise that no more than 5-10% of an investment portfolio is used in high-risk assets, like startups. The remaining 90-95% should be invested in more stable assets such as equities, bonds, and the value of real estate, too.
The Role of Angel Investors and Venture Capital in the UK
Angel investors
Angel investors provide crucial early-stage funding and support to startups. The UK Business Angels Association helps connect startups with angel investors, who offer not just capital but also mentorship and industry connections.
Venture Capitalists
While venture capital firms often invest in later funding rounds, many UK-based VCs, like Balderton Capital and Octopus Ventures, participate in early-stage funding rounds. VCs bring substantial resources and expertise, helping startups develop growth strategies and preparing them for future funding rounds or an exit.
High Risk, High Reward—With Careful Consideration
Investing in early-stage startups can yield tremendous financial returns, but the risks are equally high. UK investors must be aware of the potential for failure, illiquidity, and competition associated with startups. Careful analysis of the founding team, market potential, and business viability is essential.
Before investing in early-stage startups, consult with a financial advisor, conduct thorough due diligence, and ensure that your risk tolerance aligns with the volatile nature of these investments. The path may be uncertain, but for those who navigate it well, the rewards can be life-changing.