How to invest in startups
Investing in startups comes with the potential for high reward, but with that naturally comes high risk. Here’s how you can invest in startups and spread your risk.
The UK is second only to the US as a breeding ground for business startups. Last year 660,000 new businesses were started, up from 608,000 in 2015, and the trend has continued in 2017. Those that grow can make money for their backers. Investing £1 in 1955 in the Numis 1000 index, composed of the smallest UK—listed companies, would have produced £12,144 by the end of 2015, against only £829 if invested in the All—Share index, according to London Business School research. Over ten—year periods since 1955, smaller firms outperformed larger companies five times out of six. So how can you invest in the growth firms of the future? Most new businesses are not listed, but investors can access them through tax—incentivised schemes run by managers, or crowdfunding.
The Enterprise Investment Scheme (EIS), the Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trusts (VCT) all aim to attract much—needed capital into ‘qualifying’ enterprises, to benefit the economy. Generous tax reliefs help offset the real risks of fledgling ventures — after all, nine out of ten startups overall do crash and burn.
The EIS offers 30% tax relief on any profits or losses made on EIS shares — up to a value of £1 million every tax year — as long as they are held for at least three years. The SEIS lifts that relief to 50% but only if you invest £100,000 in qualifying companies. The easiest of the three is the VCT, essentially an investment trust which selects and holds shares in small unquoted companies. Investors subscribe for shares in the trust and enjoy a 30% tax break on investments up to £200,000. Whereas EIS investors are often successful entrepreneurs who offer hands—on consultancy to the investee business, VCTs attract portfolio investors who want expert fund managers in a user—friendly structure.
Platform investors can get exposure to the sector in other ways. Listed startups begin as micro—cap stocks, which are inevitably riskier than small—cap. Their size means they attract less trading, so liquidity is lower, and the smaller they are the more volatility you can expect. Giles Hargreave, one of the UK’s top small company fund managers, says: 'by their nature smaller companies are risky, and at times they will fall sharply and suddenly. I have seen shares fall from £20 to nothing. But those who are patient and invest for the long term will be rewarded.'
In 2017, the junior Alternative Investment Market (AIM) stock market steamed ahead of its big brother. The FTSE AIM All—Share index was up almost 19% from the start of 2017 to mid—December, against 5.7% for the FTSE All—Share index. Ben Yearsley, investment chairman of Shore Financial Planning, says:
'There have been some abject failures and astonishing winners on AIM, and share price movements can often be volatile.
'Investors who are looking for AIM exposure may be best served by enlisting the skills of a fund manager who can analyse the market and invest in a good spread of companies.'
Investment trusts such as Miton UK Microcap (£109 million) and River & Mercantile Microcap (£107 million) — both with impressive track records — may fit the bill. Star fund manager Neil Woodford’s £700 million Patient Capital trust has a mix of quoted and unquoted holdings, with a focus on healthcare and small startups. Some recent high—profile setbacks for its portfolio, launched in 2015, have underlined the risks and the need for a long—term investment horizon. There are also technology—focused trusts such as Herald, which has a UK bias, and Polar Capital, which targets global firms with the highest growth potential. For passive investors, the iShares Micro—Cap ETF is the biggest in a sparse field, tracking the Russell Microcap Index in the US. With an average daily trading volume of around 77,000 shares, it provides liquidity in an illiquid sector, with an expense ratio of 0.6%.
However its ten biggest holdings are really ex-startups — small—caps with $1billion—plus market capitalisations. The closest UK vehicle is the iShares MSCI UK Small Cap UCITS, but as yet there is no tracker fund for the FTSE—AIM All—Share. Active managers would argue that the smallest companies are the area where they can most add value.
At the DIY end of the scale, you can invest as little as £5 in a startup via crowdfunding platforms. It’s cheap and easy, and offers small ticket investors the chance to get involved in financing new ventures. The costs of regulation and of investing are low, and some investments will qualify for the government tax breaks. Last year the top four funding sites raised £200 million for fledgling businesses.
Crowdcube and Seedrs, which together account for over two—thirds of the sector, say companies on their platforms go through rigorous due diligence. But DIY means the risks are substantial. Many exciting—sounding ventures run through their cash before getting to first base. Mobile payments company Droplet raised more than £500,000 in May 2015 on Crowdcube, after boasting of 30,000 users across 600 businesses and a five—star rating for its payments app. But 14 months later it had to admit to making no money.
Even if you pick winners, you will usually only see profits once a company is sold or floats — and don’t expect any income. The ‘eggs in basket’ advice is hugely important when it comes to startups: make sure you spread your risk across different businesses, and limit your exposure to a sensible portion of your portfolio.