Quite frequently we come across news and articles stating that some startup has received a hefty funding. A very common question that strikes our mind is what potential do these investors see in the companies for such a big startup investment. Do these companies really stand upon the expectations of the investors? What has been the historical return of this asset class? What are the major risks faced by the investors on these investments? Let’s address these questions.
WHAT ARE STARTUPS?
As the name suggests, startups are newly created companies, generally with an innovative business idea. They either offer something innovative or believe that the existing similar businesses are operating in a very inefficient manner.
These companies require a lot of funds to develop, produce and market their products or services. They procure this funding from sources like loans from banks and credit unions, venture capitalist, equity crowdfunding. Venture capitalists are big investors that invest in early stage companies with very high growth potential whereas equity crowdfunding is an investment vehicle through which general public can invest in privately held early stage companies to get an exposure to a different asset class.
HISTORICAL RETURNS OF STARTUP INVESTMENTS
We very well know that future projections should not be anticipated solely on the basis of historical performance, but it can help us to gauge the nature of investments.
The following excerpt from a report published by Cambridge Associates LLC shows the historical returns of early stage venture capital Index with respect to the S&P 500 Index and Nasdaq Composite Index.
From the above table, it is evident that investments in startups have outperformed the equity market indices in the long time horizon with a big margin. But in the short run, broad equity market indices have outperformed the investments in startups.
RISKS INVOLVED IN STARTUP INVESTMENTS
Investment in startups is a high risk high return bet. As we saw, they have provided a high return (20%-30%) over a long time horizon but the investor has to face a lot of risks. Some major risks are-
- Principal Risk– According to a survey, over 50% of the startup investments fail in the first 4 years. Failure of a startup means a complete/partial erosion of the equity. A major reason for this is the incompetency, lack of experience or lack of expertise of the management.
- Returns Risk– Startup investments have very high variability of returns. Returns might start coming after five to seven years of investments. Moreover, there is no surety of these returns.
- Liquidity Risk– If you’re planning as investment with regular cash flows, startup investment is not the right choice for you. These are highly illiquid securities and require patience to wait for the returns.
- Fraud Risk– As the disclosures are limited in case of a private company, the promoter of the company might indulge in some fraud and get away with your money. You should research thoroughly and conduct a background check before investing in a startup company.
- Dilution– A company might have to raise capital at different stages of its life for growth and smoother functioning. This would dilute the percentage of stake in the company and the control will be reduced.
EXPECTED FUTURE SUCCESS RATES OF STARTUPS
Startups has been a favorable investment as it grows from a very small base, therefore the percentage return from the amount invested is generally large.
The future of startup investments appears to be bright. They are expected to exhibit a CAGR of 32.5% over the next five years in the US. Also supported by the fact that these investments have outperformed the S&P 500 returns over a long time horizon, these investments appears to be a favorable one especially when done in the seed stage (very early stage) of the company.
A major reason for such an expectation is equity crowdfunding. In the US, around $1.7 Billion are invested through equity crowdfunding and this number is expected to rise to $5 Billion by the end of 2022. Through this, startups can get funding without any strict rules applied by the VCs, therefore they can explore the areas that were unapproachable earlier.
According to the recent reports of Silicon Valley Bank (SVB), founders of majority of the startups says that 2018 seems to be a very promising year and it was easier for them to attain funding than ever before. All of their reports, for US, UK and China exhibits a favourable future outcome.
Also, government of a lot of countries invest in these startups to promote entrepreneurship and growth of the economy. They also see a good potential in them. For example, in a country like India, though having a tight budget, has decided to invest around $15 Billion in the startups over a couple of years.
On the other side of the coin, we should never forget the relationship between risk and return inherent in all the investments. An investor has to be diligent while selecting companies to invest as majority of startups fail and only a few prosper. In fact, due to this large amount of risk and investors losing money, people have started investing very carefully. The trend flew like, in 2009-10, people started getting aware of these investments and investment in startups increased. It showed an upward trend till 2014. Now, total amount of investments made all over the globe is showing a downward trend. For example, the following chart shows the Global Venture Capitalists financing value and the number of funding rounds in technology companies-
The funding rounds of all the startups has shown a similar trend as displayed below-
|US||Europe||Rest of World|
Falling investments does not mean that it is a bad asset class, it’s just that investors are being more conscious and they are investing in the most promising ideas. Success rates of startup investments are completely dependent on the quality of investment and such investments are quite few. The ability of choosing the right company to invest is the main driver of the returns.
Therefore, the future outlook for this asset class appears to be good provided that the investor conducts thorough due diligence. But, there is no concrete basis of saying that these startups are going to perform exceptionally well in future.
HOW TO CHOOSE THE CORRECT INVESTMENT
Returns from startups shows a J-Curve effect i.e. if the value of the investment is plotted in a graph against time, the shape of the curve will appear like a ‘J’. This happens because in the initial years, the startup investments does not provide any returns, in fact it might fall. But as the time passes by, the value of your investment would shoot up, exhibiting a ‘J’ shape curve. That is why, while comparing two different venture capital funds, one should pay attention to their vintage year i.e. their year of commencement. Some Common Factors to consider while investing in startups are-
- Business Model- A thorough research should be conducted on the quality of the investment. Analyze the sustainability of the idea, social impact by the business, technology used, terms and conditions of the instrument being purchased, quality of product being offered etc.
- Entrepreneurs- The background of the entrepreneurs is a very important attribute to consider. Things that should be considered are their experience, expertise, dedication, network, competence, diversity, ability to execute, integrity etc.
- Historical Performance- If the company is already operating, look out for the progress according to the time since commencement and the milestones achieved by the company. Analyze the company’s market impact. One should also consider the problems that were faced in the past.
- Diversification Benefits- Due to very less correlation with the equity markets, investment in startups have proven to be a good diversification tool. Investors having concentrated equity positions and high risk tolerance should consider investing in this asset class.
Investment in startups has been a good diversification tool as well as a decent return enhancer for a long time horizon. People who have low liquidity need and a higher risk tolerance should definitely look forward to get the exposure to this asset class. Furthermore, the introduction of new funds for equity crowdfunding have made investment in startups approachable to general public which wasn’t available before.