Investing in start-ups and small companies
The appeal of investing in start-ups is clear but identifying the few new or small companies which grow and flourish is far from simple. There are investment options throughout a company’s life cycle with points to keep in mind at each stage.
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Even Apple was a start-up once. An investor who bought one single share at Apple’s IPO in 1980 would have paid $22. After the fourth stock split in August 2020, they would own 224 shares – worth $28,197. It’s no surprise then that people look to invest in start-ups for equity growth.
Finding the best start-ups to invest in isn’t easy
For every Facebook, there is a Friends Reunited, for every Amazon, there is a Pets.com, and for every Google, there is an Ask Jeeves. It is not enough to have a big idea, to be successful a company also needs a strong management team to take it forward, supportive shareholders to provide funding, favourable market conditions and a bit of luck.
Start-up investors also need to consider sentiment and liquidity when investing in smaller companies. Often, smaller companies have thin trading volumes, which means there won’t necessarily be a buyer at the right time or right price if you want to sell. This can also mean that smaller companies are disproportionately affected by short-term shifts in market sentiment. Just one or two sellers can cause a significant drop in the price of the shares. Start-up businesses may be concentrated in just one area and therefore may be more vulnerable at times of economic weakness.
Managing the risks of start-up investment opportunities
Investing in a collective fund, managed by someone with a lengthy history of investing in small companies is one option. They will know the questions to ask, can manage the liquidity challenge and will build a diversified portfolio. As at the end of June 2021, the average UK Smaller Companies fund was up 120.4% over five years, with some of the top component funds up over 200%.
Investing in start-ups and small companies throughout their lifecycle
Investors with a strong appetite for risk can get into companies at their earliest stages using peer to peer platforms. It is worth remembering that around 90% of start-ups fail and there may be no buyers for the shares if you change your mind.
Another option for investing in start-ups may be venture capital trusts (VCTs) or enterprise investment schemes (EISs). These also carry significant risks, but there are tax advantages, which can cushion the blow. For a new VCT share offer, UK investors receive a 30% Income Tax credit on investments of up to £200,000 each year. They need to invest at least £5,000 and hold the shares for at least five years, but this can be a valuable incentive. All capital gains and dividends are tax free for UK taxpayers.
VCTs will typically hold significant stakes in 10-15 companies. They will take a share of the profits, give advice and guidance to the management team with the aim of building the value of the business and, ultimately, selling out at a profit – usually via a trade sale or IPO. Many VCT managers have lengthy experience of finding and managing growing businesses.
Private equity is usually the next stage in a company’s lifecycle. A lot of money has gone into private equity in recent years and the sector has supported some of the largest technology companies through to IPO – including Uber and Airbnb. The main route for investors is through specialist investment trusts, such as Hg Capital or HarbourVest. There are also trusts such as Schroder UK Public Private Trust, Schroder British Opportunities and Baillie Gifford’s Schiehallion fund that back early-stage businesses.
Once companies have an established business, in the UK they will often turn to a listing on the Alternative Investment Market (AIM). This brings fewer administrative obligations than a full stock market listing and is therefore good for smaller companies. This has been home to well-recognised success stories, including ASOS and Majestic Wines. There are a number of funds that specialise in selecting AIM stocks – the market is vast and there is bad as well as good, so it needs careful curating.
UK and Global smaller companies funds can offer an entry point
While they may be small, the companies that make up a smaller companies portfolio will be well-established, listed and may be familiar names - for example, research group YouGov, engineering group Renishaw, or retailer Boohoo. Different managers may have a preference for technology companies, or early-stage engineering groups. It’s worth checking a manager’s long-term track record through bull and bear markets when considering start-ups to invest in in 2021.
Small companies and start-ups can be an exciting prospect, but don’t let the lure of life-changing returns blind you to the risks involved. Apple may have made it in style, but plenty of others didn’t. It is a sector that needs careful navigation.
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