Early-Stage Investments: An Overview

Early-stage investing refers to monetary investments in early-stage growth companies. A subset of private equity investing, early-stage investing focuses on a stage earlier in the development cycle, typically just after the company has launched and demonstrated some ability to become a sustainable business. The dollar amounts sought vary widely, but in today’s environment a typical early-stage capital raise is often between $250,000 and $1.5 million.  Early-stage capital is the initial capital raised by a company, helping it grow into a fully-functioning enterprise. The capital raised by early-stage investments is typically used for product development, staffing, marketing, and some minimal operational buildout.

Investors are drawn to early-stage investing because of the potential for higher returns… but with that comes higher risk as well

The appeal is simple.  Early-stage companies give investors an incredible opportunity for higher long-term returns.  Seed investing is the ultimate demonstration of “getting in early,” allowing investors to acquire significant ownership stakes in companies before they’ve proven themselves or gone public and become available to the wider marketplace.  With these significant ownership stakes, with access to the company’s highest growth phases, early investors can end up reaping a substantial percentage of the company’s ultimate value.

Of course, the risks are significant.  A high percentage of very early stage companies fail.  Why?  These businesses don’t exist yet — the founders have to build them from scratch.  Early-stage investing is not like buying shares in a high-growth tech company listed on NASDAQ or another exchange.  Public companies already have fully-developed businesses (or at least they should).  Companies at the early-stage don’t — you are betting on growth prospects and the hope for success, not on a market valuation based on the current business.

There are many variables to consider when looking at early-stage companies

Potential investors need to ask themselves a number of questions, digging deeper than the traditional look at financial statements and annual reports.  Some of the things to consider include:

  • Does the product have an initial user base?  And will the product or service’s appeal grow wider than that initial base?
  • Has the right team been assembled, or can it be assembled in time to find marketplace success?
  • Can an upgraded, market-ready version of the product be built with the available funds?
  • Is enough investment capital being raised to grow the business, or will the company run out of money before it even gets off the ground?

Success at the early-stage

The early-stage investment model only works if the investments have very high return potential.  Most investments in a portfolio will fail, so the ones that do succeed need to make up for the losses — the successes must produce higher-than-public-equity-market returns in order to make the investment strategy worthwhile.  To maximize the chances of these high returns, skilled early-stage investors look for companies in the technology space, or those driven by a new technology platform — the tech world lends itself to highly scaleable growth, rapid business development, and the possibility of quickly rising revenue.

Investors at this stage are not just looking for good, solid businesses — they aim to find game-changing solutions to identifiable problems in particular market segments. In other words, they want home runs, or even grand slams — not just singles or doubles.

The map for success looks like this:

    1. A solid, dynamic team of founders — after all, they are what will make or break the company.
    2. An identifiable market problem.
    3. A highly scalable solution with a big market.

(Note that the size of the market doesn’t necessarily need to be the dominant factor.  While a big enough market — $1 billion plus, to justify a $100 million valuation over time — is important, it doesn’t have to be in the hundreds of millions of dollars to be a viable successful business.)

Timing and exit strategy

Investments in early-stage companies are long-term and not immediately liquid.  Investors do ultimately make money the same way investors make money in other investment classes — by selling their interest to another investor — but it isn’t like the public market, where you can always sell on your timeline.  These investments are measured in years, and any exit strategy presented by the company at such an early stage is purely theoretical.

There are generally two ways investors end up able to exit: the company is acquired, or it continues to grow until an IPO.  The opportunity to sell shares before the company goes public should not be considered a legitimate exit strategy — selling private shares of these highly illiquid companies is difficult, and subject to restrictions from regulatory bodies.  While selling these shares has become more viable recently with the rise of third-party platforms, that really only ends up being an option for the very biggest successes, like Facebook and Twitter, where there is enough demand to create a market.

Investors may experience paper gains over time, as successive financing rounds happen and the notional value of the company (hopefully) increases, but these gains are purely theoretical until an acquisition of IPO.  There can be several rounds of financing that don’t come with a capital event, meaning paper gains but no actual return on the investment.

But if the risks are understood, and an investor is comfortable with the idea that his or her money may be locked up for many years before a possible exit, these investments can indeed turn out to be very rewarding.