Many might consider investing in early stage companies a high-risk venture. After all, without a steady revenue stream or a customer base or even a stable product, entrepreneurs face the potential for failure every single day.
Is early stage investing right for you?
Venture Investing as an Asset Class
As an investor, you look for not just profits but also a good mix of growth and value in your ventures. Diversification is your go-to strategy for minimizing investment risk, combining different asset classes in your portfolio.
Think of early stage investing as yet another asset class; as investment targets, startups possess similar characteristics and are subject to the same laws and regulations. At the outset, founders would be trying to create proof of market and getting traction – refining the product, maybe putting together a small sales team, and soft-launching with some early customers to demonstrate product-market fit.
Especially with today’s technologies, startups have been known to attempt to scale before they’re ready. But even though the typical early stage company may not always be ready to build their growth machine, neither is it impossible, if they know where to start and have the right guidance and expertise.
Still, not void of risk, this stage of investing tends to be protracted and may require several financing options.
There are two ways that venture capitalists normally invest in early stage startups: either via a priced equity round or by convertible securities:
Investing in a priced equity round
Those investing in later-stage startups (Series A or later) mostly go for this option. Here, the venture and the investor mutually agree on a dollar amount for the value of the company. This “pre-money valuation” is based on the funding needed, in order to achieve the next goal.
Usually, startups use more than one investor for the job, and the funder who contributes the most towards this round also takes point on future investments and sets the direction for the company.
Investing in convertible securities
Because it doesn’t require agreement on pre-money valuation, convertible securities present a simpler financing option and is the more common way to invest in early stage ventures. Instead, the startup simply offers their investors a convertible note. In other words, they take out a loan, usually on fixed terms, with the interest rate subject to further negotiations.
At the end of the term, the investors can decide whether they want to be paid the principal amount plus accrued interest or to settle for equity (shares) in the company.
Adding New Asset Classes to Your Portfolio
Should you add an early stage venture asset class to your investment portfolio? Consider these factors:
#1. Number of early stage ventures in your asset class
Early stage ventures behave similarly and deliver similar risk and return. If your portfolio already contains one or two asset classes, adding one more can be beneficial. What matters here is not the number, but the extent of diversification.
#2. Liquidity issues
Unlike with other investment products, it’s not so quick to sell shares, which is why most funders prefer convertible securities over priced equity investing. But however you decide to invest, what is important is that you clarify as early as possible in the engagement the terms of liquidity.
#3. Tax implications
Startup founders, especially during the initial stages of operation, may not yet concern themselves with taxes and its impact on profits. But as an early stage investor, you need to be aware of the tax implications, as they will affect your own profits later.
With high risk comes high returns. If you invest in an early stage venture and it succeeds, the payoff for both you and the founders will have been worth the gamble. Ask us today about an early stage investment that could be the right fit for you.